Part 6Perfect Competition

• Many markets are characterized by competitive conditions

• Theory of competitive markets is based on a model of “perfect competition” – an idealized competitive market

- Many buyers and sellers

- Identical outputs

- Free entry and exit

- Complete information

The Firm Under Perfect Competition

• Firm must be small relative to the size of the market (minimum efficient scale must be small relative to the market)

• Individual firms cannot affect the market price (price taker)

• Price is set in the market as a whole, the individual firm adjusts output so as to maximize profit given the market price

The Firm’s Total Revenue and Marginal

Revenue Curves• As the market price is given, the

firm’s total revenue is its output times the market price (P x Q)

• The TR function will be a straight line from the origin

• The firm’s marginal revenue is MR = ΔTR/ΔQ

As all units of output sell for the same price

MR = P

The Firm’s TR and MR Curves

Q

TR

100

125

TR

P = $1.25

Q

MR

1.25 MR = P

Profit Maximization

• The firm has to decide whether to produce at all, and if so what output to produce

• The firm will produce in the short run so long as its variable costs can be covered

• Assuming the firm produces at all, the profit maximizing output is where there is the maximum excess of TR over TC or where MR = MC

Profit Maximum: TR and TC

TC

TR

Q’ Q”

Economic Profit

$

Q

Q

Profit

Loss

0Q’ Q”Q*

Profit/Loss

Profit Max

Profit Maximum: MR and MC

Q

$

MRP

MC

Q*

Why does MC = MR imply profit max?What would happen to TR and TC if outputwent up or down by a unit?

Profit in the Short Run

P

Q*

MC

ATC

MR

Economicprofit

$

Q

Q

MC

ATC

MR

Q*

$

P

Normal profitor break even

Economic Loss in the Short Run

MRP

ATC

MC

Q

$

Q*

Economic loss

Firm will produce Q* as long as P>AVC

Firm’s Short Run Supply Curve

• The firm’s short run supply curve will be its MC curve above its AVC curve

• If P is equal to or grater than Min AVC the firm will produce where P = MR = MC

• If P < Min AVC the firm’s loss minimizing strategy is to shut down. Loss will equal TFC

Firm’s Short Run Supply Curve

MC

P

P’

P”

Q Q’ Q”

MR

MR’

MR”

AVC

ATC

Q

$

At prices below P the firm will shut downAt prices between P and P’ the firm willproduce where MC=MR at an economic loss At prices above P’ the firm will produce whereMC=MR at an economic profit

Shut down point

Break even ornormal profitpoint

Market Supply Curve

• We can now derive the market supply curve

• The supply curve of each firm is its MC curve above its min AVC point

• The market supply curve is the horizontal sum of the supply curves of all the firms in the industry

Short Run Equilibrium of the Market and Firm

• Market demand curve is the horizontal sum of all the demand curves of individuals

• Short run market supply curve is the horizontal sum of all the short run supply curves of all the firms currently in the industry

• Market price and quantity is determined by D = S

• Each individual firm will produce at its profit max point of MR = MC

SR Equilibrium of Market and Firm

S = ΣhMC

D = ΣhDi

P*

Q* Q

PMarket equilibrium

ATC

MC

q

P

q*

P* MR

Equilibrium of the firm

Shifts in Demand in the Short Run

• Shifts in demand will create a movement along the market short run supply curve, changing market price

• Each individual firm will adjust output to its new profit max level as price changes, moving along its own short run supply curve

Long Run Adjustments

• In the long run capital is not fixed• Firms can change the size of their

plants and move along their LAC curves

• Firms can enter or leave the industry. They will enter if there is economic profit and leave if they are suffering economic losses

• If firms change size or the number of firms in the industry changes the short run industry supply curve will shift

• What conditions must hold for a perfectly competitive industry to be in long run equilibrium?

Long Run Equilibrium

• Market price must adjust (via shifts in the short run supply curve) until all firms are just making normal profit

• With normal profit there is no economic profit to attract new entrants and no economic losses to create exit

• Also, for their to be no prospect of economic profit, price must equal minimum LAC

• Otherwise firms could make economic profit by changing their plant size which would shift the SR supply curve of the industry

Long Run Equilibrium for Market and Firm

S = ΣhSMC

D = ΣhDi

Q*

P*

Q

P

MRP*

LACSMCATC

q*

Long Run Supply Curve

S

D D’

Q Q’

P

P’

D shifts to D’, raising market price to P’.This will create excess profit for firms attracting new entrants and shifting S to S’where all economic profit is again eliminatedand new entry stops .

This diagram shows a constant cost industry.Long run supply curve is horizontal

S’

LRS

Q

P

Possible Long Run Supply Curves

• Constant cost industry -- horizontal LRS. Changes in the size of the industry do not affect firms’ costs of production

• Increasing cost industry – upward sloping LRS. As an industry grows a factor price rises as a result, increasing costs for all firms

• Decreasing cost industry – downward sloping LRS. As an industry grows a factor price falls as a result, decreasing costs for all firms—network effects

• Technological change shifts the LRS

Are Competitive Markets Efficient?

• In long run competitive equilibrium price is such that D=S and production is at min LAC

• Productive efficiency—min LAC• The market D curve is can be

interpreted as willingness to pay or marginal benefit curve

• The market supply curve can be seen as the marginal opportunity cost of production curve

• Competitive equilibrium is allocatively efficient (maximizes social surplus) provided all costs and benefits are reflected in the market D and S curves

Economic Inefficiencies

• The efficient allocation may not be achieved even in competitive markets

• Not all resources may be privately owned (open access resources)

• It may not be possible for firms to capture peoples’ willingness to pay (public goods, external benefits)

• Not all social costs may be reflected in the prices firms pay for factors of production (external costs)

• Economic inefficiencies may also arise from lack of competition --Monopoly