Perfect Competition

1

• Perfect Competition

2
Overview

• What you will learn from this lecture
• Market structure
• 3 Requirements for perfect competition

3
Market Structure

• Sellers want to sell at the highest possible
  price
• Buyers seek lowest possible price
• All trade is voluntary
• When we observe buyers and sellers in action
• See that different goods and services are sold in
  vastly different ways
• When economists turn their attention to
  differences in trading they think immediately
  about market structure
• Characteristics of a market that influence
  behavior of buyers and sellers when they come
  together to trade

4
Types of Market

• To determine structure of any particular market,
  we begin by asking
• How many buyers and sellers are there in the
  market?
• Is each seller offering a standardized product,
  more or less indistinguishable from that offered
  by other sellers
• Or are there significant differences between the
  products of different firms?
• Are there any barriers to entry or exit, or can
  outsiders easily enter and leave this market?
• Answers to these questions help us to classify a
  market into one of four basic types
• Perfect competition
• Monopoly
• Monopolistic
• Oligopoly

5
The Three Requirements of Perfect Competition

• Large numbers of buyers and sellers, and
• Each buys or sells only a tiny fraction of the
  total quantity in the market
• Sellers offer a standardized product
• Sellers can easily enter into or exit from market
• Examples?

6
i. A Large Number of Buyers and Sellers

• In perfect competition, there must be many buyers
  and sellers
• How many?
• Number must be so large that no individual
  decision maker can significantly affect price of
  the product by changing quantity it buys or sells

7
ii. A Standardized Product Offered by Sellers

• Buyers do not perceive significant differences
  between products of one seller and another
• For instance, buyers of wheat do not prefer one
  farmers wheat over another

8
iii. Easy Entry into and Exit from the Market

• Entry into a market is rarely freea new seller
  must always incur some costs to set up shop,
  begin production, and establish contacts with
  customers
• But perfectly competitive market has no
  significant barriers to discourage new entrants
• Any firm wishing to enter can do business on the
  same terms as firms that are already there

9
iii. Easy Entry into and Exit from the Market

• In many markets there are significant barriers to
  entry
• Legal barriers
• Existing sellers have an important advantage that
  new entrants can not duplicate
• Brand loyalty enjoyed by existing producers would
  require a new entrant to wrest customers away
  from existing firms
• Significant economies of scale may give existing
  firms a cost advantage over new entrants

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iii. Easy Entry into and Exit from the Market

• Perfect competition is also characterized by easy
  exit
• A firm suffering a long-run loss must be able to
  sell off its plant and equipment and leave the
  industry for good, without obstacles
• Significant barriers to entry and exit can
  completely change the environment in which
  trading takes place

11
Is Perfect Competition Realistic?

• Assumptions are rather restrictive. However, in
  reality one or more of assumptions will be
  violated in vast majority of markets
• Yet when economists look at real-world markets,
  they use perfect competition more often than any
  other market structure
• Why is this?
• Model of perfect competition is powerful
• Many marketswhile not strictly perfectly
  competitivecome reasonably close
• We can evenwith some cautionuse model to
  analyze markets that violate all three
  assumptions
• Perfect competition can approximate conditions
  and yield accurate-enough predictions in a wide
  variety of markets

12
The Perfectly Competitive Firmvs Competitive
Market

• When we examine a competitive market from a
  distance, we get one view of what is occurring
• When we closely examine the individual
  competitive firm, we get an entirely different
  picture
• In learning about competitive firm, must also
  discuss competitive market in which it operates

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Figure 1 The Competitive Industry and Firm
Market
Firm
S
400
400
Demand Curve Facing the Firm
D
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Goals and Constraints of the Competitive Firm

• Perfectly competitive firm faces a cost
  constraint like any other firm
• Cost of producing any given level of output
  depends on
• Firms production technology
• Prices it must pay for its inputs

15
The Demand Curve Facing a Perfectly Competitive
Firm

• Panel (b) of Figure 1 shows demand curve
• Its horizontal, or infinitely price elastic
• Why should this be?
• In perfect competition output is standardized
• No matter how much a firm decides to produce, it
  cannot make a noticeable difference in market
  quantity supplied
• So cannot affect market price

16
The Demand Curve

• Means the firm has no control over the price of
  its output
• Firm is a price taker
• Treats the price of its output as given and
  beyond its control
• Its only decision is how much output to produce
  and sell

17
Cost and Revenue Data for a Competitive Firm

• For a competitive firm, MR at each quantity is
  the same as the market price
• MR Price
• For this reason, marginal revenue curve and
  demand curve facing firm are the same
• A horizontal line at the market price

18
Profit Maximization The Total Revenue and Total
Cost Approach

• Most direct way of viewing firms search for the
  profit-maximizing output level
• At each output level, subtract total cost from
  total revenue to get total profit at that output
  level
• Total Profit TR - TC

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Figure 2a Profit Maximization find greatest TR
- TC
TR
TC
2,800
Maximum Profit per Day 700
2,100
550
Slope 400
20
Profit Maximization The Marginal Revenue and
Marginal Cost Approach

• Firm should continue to increase output as long
  as MRMC
• Remember that profit-maximizing output is found
  where MC curve crosses MR curve from below
• Requires no new concepts or techniques

21
Figure 2b Profit Maximization Find MR MC from
below
MC
400
D MR
22
Measuring Total Profit

• Firms profit per unit
• ( Revenue per unit ) ( cost per unit )
• ?profit per unit P ATC
• Firm earns a profit whenever P ATC
• Which part in the Figure 3(a) shows the profit
  per unit? How about total profit?
• A firm suffers a loss whenever P best level of output
• Which part in the Figure 3(b) shows the loss per
  unit? How about total loss?

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Figure 3a Measuring Profit or Loss
Economic Profit
ATC
MC
Profit per Ounce (100)
d MR
400
300
24
Figure 3b Measuring Profit or Loss
Economic Loss
MC
Loss per Ounce (100)
ATC
300
d MR
200
25
The Firms Short-Run Supply Curve

• A competitive firm is a price taker
• Then decides how much output it will produce at
  that price
• Using the MR and MC approach, Profit-maximized
  output under the given price level can be found
• Exception
• If the firm is suffering a loss large enough to
  justify shutting down
• It will not produce along its MC curve
• It will produce zero units instead

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Figure 4 Short-Run Supply Under Perfect
Competition
(a)
(b)
ATC
Firm's Supply Curve
MC
3.50
d1MR1
3.50
2.50
2.50
d2MR2
2.00
2.00
d3MR3
AVC
1.00
1.00
d4MR4
0.50
0.50
d5MR5
1,000
4,000
7,000
2,000
4,000
7,000
2,000
5,000
5,000
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The Shutdown Price

• Definition price at which a firm is indifferent
  between producing and shutting down
• Can summarize all of this information in a single
  curvefirms supply curve
• Supply curve has two parts
• For all prices above minimum point on its AVC
  curve, supply curve coincides with MC curve
• For all prices below minimum point on AVC curve,
  firm will shut down
• A vertical line segment at zero units of output
• Figure 4 For all prices below 1the shutdown
  priceoutput is zero and the supply curve
  coincides with vertical axis

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The (Short-Run) Market Supply Curve

• In short-run, number of firms in industry is
  fixed
• Given supply curve of each individual firm in a
  market, we can easily determine the short-run
  market supply curve
• Shows amount of output that all sellers in market
  will offer at each price
• To obtain market supply curve sum quantities of
  output supplied by all firms in market at each
  price
• As we move along this curve, we are assuming that
  two things are constant
• Fixed inputs of each firm
• Number of firms in market

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Figure 5 Deriving The Market Supply Curve
Market Supply Curve
Firm's Supply Curve
3.50
3.50
2.50
2.50
2.00
2.00
1.00
1.00
0.50
0.50
400,000
700,000
2,000
4,000
7,000
200,000
500,000
5,000
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Short-Run Equilibrium

• How does a perfectly competitive market achieve
  equilibrium?
• In perfect competition, market sums buying and
  selling preferences of individual consumers and
  producers, and determines market price
• Each buyer and seller then takes market price as
  given
• Each is able to buy or sell desired quantity
• Competitive firms can earn an economic profit or
  suffer an economic loss

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Figure 6 Perfect Competition
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Figure 7 Short-Run Equilibrium in Perfect
Competition
S
MC
ATC
d1
3.50
3.50
Loss per Bushel at p 2
d2
2.00
2.00
D1
Profit per Bushel at p 3.50
D2
7,000
4,000
400,000
700,000
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Profit and Loss in the Long Run

• Economic profit and loss are the forces driving
  long-run change
• Entry of outsiders if expecting continued
  economic profit
• Exit of insiders if expecting losses
• In real world entry and exit occur literally
  every day
• In some cases, we see entry occur through
  formation of an entirely new firm or occur when
  an existing firm adds a new product to its line
• Exit can occur in different ways
• Firm may go out of business entirely, selling off
  its assets and freeing itself once and for all
  from all costs
• Firm switches out of a particular product line,
  even as it continues to produce other things

34
From Short-Run Profit to Long-Run Equilibrium

• As we enter long-run, much will change
• Economic profit will attract new entrants
• Increasing number of firms in market
• As number of firms increases, market supply curve
  will shift rightward causing several things to
  happen
• Market price begins to fall
• As market price falls, demand curve facing each
  firm shifts downward
• Each firmstriving as always to maximize
  profitwill slide down its marginal cost curve,
  decreasing output

35
From Short-Run Profit to Long-Run Equilibrium

• This process of adjustment continues, requiring
  market supply curve to shift rightward enough,
  and the price to fall enough
• Until when the reason for entrypositive
  profitno longer exits
• So that each existing firm is earning zero
  economic profit
• In a competitive market, positive economic profit
  continues to attract new entrants until economic
  profit is reduced to zero

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Figure 8a/b From Short-Run Profit To Long-Run
Equilibrium
S1
MC
A
A
4.50
4.50
d1
ATC
D
900,000
9,000
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Figure 8c/d From Short-Run Profit To Long-Run
Equilibrium
S1
S2
MC
A
A
4.50
4.50
d1
ATC
E
E
2.50
2.50
d1
D
900,000
9,000
5,000
1,200,000
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From Short-Run Loss to Long-Run Equilibrium

• What if we begin from a position of loss?
• Same type of adjustments will occur, only in the
  opposite direction
• In a competitive market, economic losses continue
  to cause exit until losses are reduced to zero
• When there are no significant barriers to exit
• Economic loss will eventually drive firms from
  the industry
• Raising market price until typical firm breaks
  even again

39
Distinguishing Short-Run from Long-Run Outcomes

• In short-run equilibrium, competitive firms can
  earn profits or suffer losses
• In long-run equilibrium, after entry or exit has
  occurred, economic profit is always zero
• When economists look at a market, they choose the
  period more appropriate for question at hand

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The Notion of Zero Profit in Perfect Competition

• We have not yet discussed plant size of
  competitive firm
• The same forcesentry and exitthat cause all
  firms to earn zero economic profit also ensure
• In long-run equilibrium, every competitive firm
  will select its plant size and output level so
  that it operates at minimum point of its LRATC
  curve

41
Perfect Competition and Plant Size

• Figure 9(a) illustrates a firm in a perfectly
  competitive market
• But panel (a) does not show a true long-run
  equilibrium
• How do we know this?
• In long-run typical firm will want to expand
• Why?
• Because by increasing its plant size, it could
  slide down its LRATC curve and produce more
  output at a lower cost per unit
• By expanding firm could potentially earn an
  economic profit
• Same opportunity to earn positive economic profit
  will attract new entrants that will establish
  larger plants from the outset
• Entry and expansion must continue in this market
  until the price falls to P
• Because only then will each firmdoing the best
  that it can doearn zero economic profit

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Figure 9 Perfect Competition and Plant Size
LRATC
LRATC
MC1
ATC1
d1 MR1
MC2
P1
ATC2
E
P
d2 MR2
q1
q
.
43
A Summary of the Competitive Firm in the Long-Run

• Can put it all together with a very simple
  statement
• At each competitive firm in long-run equilibrium
• P MC minimum ATC minimum LRATC
• In figure 9(b), this equality is satisfied when
  the typical firm produces at point E
• Where its demand, marginal cost, ATC, and LRATC
  curves all intersect
• In perfect competition, consumers are getting the
  best deal they could possibly get

44
A Change in Demand

• Short-run impact of an increase in demand is
• Rise in market price
• Rise in market quantity
• Economic profits
• What happens in long-run after demand curve
  shifts rightward?
• Market equilibrium will move from point A to
  point C
• Long-run supply curve
• Curve indicating quantity of output that all
  sellers in a market will produce at different
  prices
• After all long-run adjustments have taken place

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Figure 10a/b An Increasing-Cost Industry
INITIAL EQUILIBRIUM
MC
S1
ATC1
d1 MR1
P1
P1
A
A
D1
q1
Q1
46
Figure 10 An Increasing-Cost Industry
NEW EQUILIBRIUM
B
PSR
PSR
S2
dSR MRSR
B
ATC2
C
SLR
P2
P2
d2 MR2
C
D2
q1
q1
QSR
Q2
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Increasing, Decreasing, and Constant Cost
Industries

• Increase in demand for inputs causes price of
  those inputs to rise
• This type of industry (which is the most common)
  is called an increasing cost industry
• Entry causes input prices to rise
• Shifts up typical firms ATC curve
• Raises market price at which firms earn zero
  economic profit
• As a result, long-run supply curve slopes upward

48
Increasing, Decreasing, and Constant Cost
Industries

• Other possibilities
• Industry might use such a small percentage of
  total inputs thateven as new firms enterthere
  is no noticeable effect on input prices
• Called a constant cost industry
• Entry has no effect on input prices, so typical
  firms ATC curve stays put
• Market price at which firms earn zero economic
  profit does not change
• Long-run supply curve is horizontal
• Decreasing cost industry, in which entry by new
  firms actually decreases input prices
• Entry causes input prices to fall
• Causes typical firms ATC curve to shift downward
• Lowers market price at which firms earn zero
  economic profit
• As a result, long-run supply curve slopes downward

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Market Signals and the Economy

• In real world, demand curves for different goods
  and services are constantly shifting
• As demand increases or decreases in a market,
  prices change
• Economy is driven to produce whatever collection
  of goods consumers prefer
• In a market economy, price changes act as market
  signals, ensuring that pattern of production
  matches pattern of consumer demands
• When demand increases, a rise in price signals
  firms to enter market, increasing industry
  output
• When demand decreases, a fall in price signals
  firms to exit market, decreasing industry output

50
Market Signals and the Economy

• Market signal
• Price changes that cause firms to change their
  production to more closely match consumer demand
• No single person or government agency directs
  this process
• This is what Adam Smith meant when he suggested
  that individual decision makers act for the
  overall benefit of society
• Even though, as individuals, they are merely
  trying to satisfy their own desires
• As if guided by an invisible hand