Perfect Competition

Completely Unrealistic Yet Entirely Relevant

Market Structures

In Economics, we identify four basic market structures.

A market structure reflects three basic characteristics

Number of firms in the market

Product differentiation

Ease of entry into the market

Four Market Structures

Perfect Competition – many firms selling the same product Monopolistic Competition – many firms selling differentiated productsOligopoly – few firms selling differentiated (yet very similar) productsMonopoly – a great board game, ALWAYS buy the railroads if you can!

HA HA Seriously, that is the LAST “monopoly is a board game” joke for the year…well, maybe.In reality, a monopoly is always one firm selling a unique product.

Perfect CompetitionVery many firms

Generally, the firms are very small, could be just one person who works for him or herself.

Wide selling radiusIn perfect competition, the small firm must sell its products in a wide market, usually nationally or internationally

Standardized productsThe product produced by one firm cannot differ in any way from that produced by anotherNo need for advertisement or any other forms of non-price competition

Price-TakersA firm in perfect competition cannot set the price of their productThe market will determine the price, the firm can only choose the quantity soldAttempts at changing the price by a firm will result in less than the profit maximized position

Free Entry and ExitFirms may come and go with no barriers (legal, technological, financial, etc.)

Examples of Perfect Competition

Truthfully, there are not many.Farming used to be a good example, but today most farms are owned by large corporations and entry into the market is very financially difficult for small farmersStock Market

Each share of a stock is exactly the same as the next share

Why would the following NOT be perfectly competitive?Airline IndustryClothing IndustryTelevision BroadcastingPrivate Education

The Industry and the FirmAn industry is a place where many firms sell their products to many buyers.Within the industry, the supply curve reflects all of the supply curves of all of the firms added together.Within the industry, the demand curve reflects all of the demand curves of all of the buyers added together.The equilibrium point in the industry tells us two things.

First, the price that all firms in the perfectly competitive industry MUST accept.Second, the total quantity of the product that will be produced by all of the firms in the industry.

Since, each firm within a perfectly competitive industry is so small, they can choose to produce as much or as little as they want

If they were large enough to have a significant market share, the industry would no longer be perfectly competitive.

The Graph

S

S

Industry supply curve

Industry demand

curve

(b)

Total Sales in Chicago in Thousands of Truckloads

per Year

D

D

400 300 200 100 0

Firm’s demand curve P

ric

e p

er

Bu

sh

el

in C

hic

ag

o

(a)

Truckloads of Corn Sold by Farmer Jasmine

per Year

$3 $3 E C B A

4 3 2 1 0

Note the EQ price

Horizontal Demand Curve

The Graph – What to Know

The Difference Between the Industry and Firm

For the firm, Marginal Revenue = Demand = Average Revenue = Price…or…

Mr. Darp, seen here, is always horizontal at the market price

Let’s Get the Numbers DownC

EN

SO

RE

D

Profit Maximization – Short Run

We know that profit maximization occurs where MR = MC.In the case of a perfectly competitive firm, MR = P, so P = MC at the profit maximized levelAt this point, we can determine the quantity that will be produced by the firm.What happens to the quantity produced when the demand in the industry increases?What happens when the variable costs of production increase at each level of production?

The Short-Run Profit

In order to determine the profit of the firm, we have to analyze the revenue and costs.We know, at the point of profit maximization, what the average revenue (AR) is. What is it? It’s the PRICE! (AR = P)Now, all we need to know is the average cost of each unit we product (ATC). Profit = P – ATC since this tells us how much profit will be made at the profit maximized level.Exercise:

In the last table, identify the AVERAGE TOTAL COST for each level of production.Graph the MR, AR, MC, and AC.

Identifying Short-Run Profit

AC MC

1.50

2.25

Rev

enu

e an

d C

ost

per

Bu

shel

Bushels of Corn per Year

$3.00

50,000 0

D = MR = AR

B

A

The Profit

Let’s identify1. Total Revenue2. Total Cost3. Total Profit

Graphical Analysis

The graph tells usThe total revenue (big box)

The total cost (the bottom portion)

The total profit (the box between the AR (D) line and the total cost box)

Complete #1 from Activity 34

Sometimes, Mr. Darp aint so nice…

In the instance where MR. DARP is above ATC, the firm will be making economic profit (i.e. profit even with opportunity costs being accounted for).

What might happen, however, if the industry demand were to fall? Let’s see…

Minimized Short-Run Losses

When the ATC is above AR at the profit maximized point, the firm is actually going to lose money.In this instance, their loss is minimized. If they choose to produce at another level, the loss becomes worse.In the short-run, the firm will have a decision to make…

Continue to operate in the short-run and lose money orShut down and lose money

Rule: In the short run, a firm will continue to operate ifA. Profits are being madeB. Losses are smaller than fixed costs (revenue is above the average variable cost curve)/

Graphically Speaking

In the short run, a firm will remain open when MR=D=AR=P is above the ATC curve orMR=D=AR=P is below the ATC curve but above the AVC curve

In the short run, a firm will shut-down whenMR=D=AR=P is below the AVC curve

In your notes, draw an example of each.Note: that in the short-run, the firms supply curve is its MC curve above the AVC curve.

So, what happens in the long run?

Firms, in the long run, will be able to escape from fixed costs if they wish to.Under the condition where a firm is taking any kind of loss in the short run, the firm will exit the industry in the long-run…Under any condition where a firm is making a profit in the short-run, the firm will continue to operate...

Exit and Entry

In the long run, firms can exit with no trouble. Other firms can also enter the industry with no trouble.What will cause a firm to leave the industry in the long-run?What will cause a firm to enter the industry in the long-run?The next step…

Industry Supply

As firms enter and exit the industry, the industry supply curve is affected.If there is above zero-economic profit being made by firms in and industry, more firms will enter the industry…If more firms enter the industry, the supply of the industry will shift to the right…What will happen to price? What will this do to the profit maximizing firm that is making profit in the short-run?

Competition in the Long-Run

S1

(1,600 firms) S1

D1

Industry

(b)

D

D S0

(1,000 firms) S0

72

Quantity of Corn in Millions of Bushels

50

A

E

Pri

ce p

er B

ush

el

(a)

45

Quantity of Corn in Thousands of Bushels

40 50

D0

AC

Firm

MC

2.25 2.25

$3.00

Pri

ce p

er B

ush

el

$3.00 e

a

b

More firms…MRDARP falls…

Long-Run Profit

As more firms enter, those firms making an economic profit will see their profit shrink…This process will continue until all firms in the long-run are making ZERO ECONOMIC PROFITS.The long-run condition for firms in perfect competition is ZERO ECONOMIC PROFITS…Under this condition, MR=MC=ATC. The same situation occurs for firms that are taking losses…

Losses and Zero Economic Profit

If firms are taking losses in the short-run, they will exit in the long-run….As firms exit, the industry supply curve shifts to the left…What will happen to the industry price?What will happen for firms taking losses in the short-run that stay open?Again, the price will rise until all firms operating in long-run equilibrium are making ZERO ECONOMIC PROFIT.

What does this mean?

Fact: In perfect competition, firms will operate with ZERO-ECONOMIC PROFIT.Fact: In perfect competition, firms will operate at maximized efficiency. Firms that survive in the long-run will produce at the lowest point on their ATC curve.Fact: In perfect competition, consumers will pay the lowest price possible for any given good or service.Not Fact: Perfect competition is real and alive and well…