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PERFECT COMPETITION

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Several thousand farms stretching from Vermont to California are piling up ... We study a fiercely competitive market in this chapter. ... – PowerPoint PPT presentation

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Title: PERFECT COMPETITION


1
11
PERFECT COMPETITION
CHAPTER
2
Objectives
  • After studying this chapter, you will able to
  • Define perfect competition
  • Explain how price and output are determined in
    perfect competition
  • Explain why firms sometimes shut down temporarily
    and lay off workers
  • Explain why firms enter and leave the industry
  • Predict the effects of a change in demand and of
    a technological advance
  • Explain why perfect competition is efficient

3
Say Cheese!
  • Dairy farming is a tough competitive business.
  • Several thousand farms stretching from Vermont to
    California are piling up losses and many farmers
    are quitting.
  • Some farms are switching from milk to cheese
    production.
  • We study a fiercely competitive market in this
    chapter.
  • We explain the changes in price and output as the
    firms in perfect competition respond to changes
    in demand and technological change.

4
Competition
  • Perfect competition is an industry in which
  • Many firms sell identical products to many
    buyers.
  • There are no restrictions to entry into the
    industry.
  • Established firms have no advantages over new
    ones.
  • Sellers and buyers are well informed about prices.

5
Competition
  • How Perfect Competition Arises
  • Perfect competition arises
  • When firms minimum efficient scale is small
    relative to market demand so there is room for
    many firms in the industry.
  • And when each firm is perceived to produce a good
    or service that has no unique characteristics, so
    consumers dont care which firm they buy from.

6
Competition
  • Price Takers
  • In perfect competition, each firm is a price
    taker.
  • A price taker is a firm that cannot influence the
    price of a good or service.
  • No single firm can influence the priceit must
    take the equilibrium market price.
  • Each firms output is a perfect substitute for
    the output of the other firms, so the demand for
    each firms output is perfectly elastic.

7
Competition
  • Economic Profit and Revenue
  • The goal of each firm is to maximize economic
    profit, which equals total revenue minus total
    cost.
  • Total cost is the opportunity cost of production,
    which includes normal profit.
  • A firms total revenue equals price, P,
    multiplied by quantity sold, Q, or P ? Q.

8
Competition
  • A firms marginal revenue is the change in total
    revenue that results from a one-unit increase in
    the quantity sold.
  • Figure 11.1 illustrates a firms revenue curves.

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Competition
  • Figure 11.1(a) shows that market demand and
    supply determine the price that the firm must
    take.

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Competition
  • Figure 11.1(b) shows the demand curve for the
    firms product, which is also its marginal
    revenue curve.

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Competition
  • Because in perfect competition the price remains
    the same as the quantity sold changes, marginal
    revenue equals price.

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Competition
  • Figure 11.1(c) shows the firms total revenue
    curve.

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The Firms Decisions in Perfect Competition
  • A perfectly competitive firm faces two
    constraints
  • A market constraint summarized by the market
    price and the firms revenue curves
  • A technology constraint summarized by firms
    product curves and cost curves (like those in
    Chapter 10).

29
The Firms Decisions in Perfect Competition
  • The perfectly competitive firm makes two
    decisions in the short run
  • Whether to produce or to shut down.
  • If the decision is to produce, what quantity to
    produce.
  • A firms long-run decisions are
  • Whether to increase or decrease its plant size.
  • Whether to stay in the industry or leave it.

30
The Firms Decisions in Perfect Competition
  • Profit-Maximizing Output
  • A perfectly competitive firm chooses the output
    that maximizes its economic profit.
  • One way to find the profit maximizing output is
    to look at the firms the total revenue and total
    cost curves.
  • Figure 11.2 on the next slide looks at these
    curves along with the firms total profit curve.

31
The Firms Decisions in Perfect Competition
  • Part (a) shows the total revenue, TR, curve.

Part (a) also shows the total cost curve, TC,
which is like the one in Chapter 10. Total
revenue minus total cost is profit (or loss),
shown in part (b).
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The Firms Decisions in Perfect Competition
  • Profit is maximized when the firm produces 9
    sweaters a day.

At low output levels, the firm incurs an economic
lossit cant cover its fixed costs.
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The Firms Decisions in Perfect Competition
  • At intermediate output levels, the firm earns an
    economic profit.

At high output levels, the firm again incurs an
economic lossnow it faces steeply rising costs
because of diminishing returns.
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The Firms Decisions in Perfect Competition
  • Marginal Analysis
  • The firm can use marginal analysis to determine
    the profit-maximizing output.
  • Because marginal revenue is constant and marginal
    cost eventually increases as output increases,
    profit is maximized by producing the output at
    which marginal revenue, MR, equals marginal cost,
    MC.
  • Figure 11.3 on the next slide shows the marginal
    analysis that determines the profit-maximizing
    output.

38
The Firms Decisions in Perfect Competition
  • If MR gt MC, economic profit increases if output
    increases.

If MR lt MC, economic profit decreases if output
increases.
If MR MC, economic profit decreases if output
changes in either direction, so economic profit
is maximized.
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The Firms Decisions in Perfect Competition
  • Profits and Losses in the Short Run
  • Maximum profit is not always a positive economic
    profit.
  • To determine whether a firm is earning an
    economic profit or incurring an economic loss, we
    compare the firms average total cost, ATC, at
    the profit maximizing output with the market
    price.
  • Figure 11.4 on the next slide shows the three
    possible profit outcomes.

41
The Firms Decisions in Perfect Competition
  • In part (a) price equals ATC and the firm earns
    zero economic profit (normal profit).

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The Firms Decisions in Perfect Competition
  • In part (b), price exceeds ATC and the firm earns
    a positive economic profit.

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The Firms Decisions in Perfect Competition
  • In part (c) price is less than ATC and the firm
    incurs an economic losseconomic profit is
    negative and the firm does not even earn normal
    profit.

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The Firms Decisions in Perfect Competition
  • The Firms Short-Run Supply Curve
  • A perfectly competitive firms short run supply
    curve shows how the firms profit-maximizing
    output varies as the market price varies, other
    things remaining the same.
  • Because the firm produces the output at which
    marginal cost equals marginal revenue, and
    because marginal revenue equals price, the firms
    supply curve is linked to its marginal cost
    curve.
  • But there is a price below which the firm
    produces nothing and shuts down temporarily.

51
The Firms Decisions in Perfect Competition
  • Temporary Plant Shutdown
  • If price is less than the minimum average
    variable cost, the firm shuts down temporarily
    and incurs a loss equal to total fixed cost.
  • This loss is the largest that the firm must bear.
  • If the firm were to produce just 1 unit of output
    at price below average variable cost, it would
    incur an additional (and avoidable) loss.

52
The Firms Decisions in Perfect Competition
  • The shutdown point is the output and price at
    which the firm just covers its total variable
    cost.
  • This point is where average variable cost is at
    its minimum.
  • It is also the point at which the marginal cost
    curve crosses the average variable cost curve.
  • At the shutdown point, the firm is indifferent
    between producing and shutting down temporarily.
  • It incurs a loss equal to total fixed cost from
    either action.

53
The Firms Decisions in Perfect Competition
  • If the price exceeds minimum average variable
    cost, the firm produces the quantity at which
    marginal cost equals price.
  • Price exceeds average variable cost, and the firm
    covers all its variable cost and at least part of
    its fixed cost.

54
The Firms Decisions in Perfect Competition
  • Figure 11.5 shows how the firms short-run supply
    curve is constructed.
  • If price equals minimum average variable cost,
    17 in this example, the firm is indifferent
    between producing nothing and producing at the
    shutdown point, T.

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The Firms Decisions in Perfect Competition
  • If the price is 25, the firm produces 9 sweaters
    a day, the quantity at which P MC.

If the price is 31, the firm produces 10
sweaters a day, the quantity at which P MC.
The blue curve in part (b) traces the firms
short-run supply curve.
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The Firms Decisions in Perfect Competition
  • Short-Run Industry Supply Curve
  • The short-run industry supply curve shows the
    quantity supplied by the industry at each price
    when the plant size of each firm and the number
    of firms remain constant.

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The Firms Decisions in Perfect Competition
  • The quantity supplied by the industry at any
    given price is the sum of the quantities supplied
    by all the firms in the industry at that price.

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The Firms Decisions in Perfect Competition
  • At a price equal to minimum average variable
    costthe shutdown pricethe industry supply curve
    is perfectly elastic because some firms will
    produce the shutdown quantity and others will
    produces zero.

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Output, Price, and Profit in Perfect Competition
  • Short-Run Equilibrium
  • Short-run industry supply and industry demand
    determine the market price and output.
  • Figure 11.7 shows a short-run equilibrium at the
    intersection of the demand and supply curves.

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Output, Price, and Profit in Perfect Competition
  • A Change in Demand
  • An increase in demand bring a rightward shift of
    the industry demand curve the price rises and
    the quantity increases.

A decrease in demand bring a leftward shift of
the industry demand curve the price falls and
the quantity decreases.
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Output, Price, and Profit in Perfect Competition
  • Long-Run Adjustments
  • In short-run equilibrium, a firm may earn an
    economic profit, earn normal profit, or incur an
    economic loss and which of these states exists
    determines the further decisions the firm makes
    in the long run.
  • In the long run, the firm may
  • Enter or exit an industry
  • Change its plant size

69
Output, Price, and Profit in Perfect Competition
  • Entry and Exit
  • New firms enter an industry in which existing
    firms earn an economic profit.
  • Firms exit an industry in which they incur an
    economic loss.
  • Figure 11.8 on the next slide shows the effects
    of entry and exit.

70
Output, Price, and Profit in Perfect Competition
  • As new firms enter an industry, industry supply
    increases.
  • The industry supply curve shifts rightward.

The price falls, the quantity increases, and the
economic profit of each firm decreases.
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Output, Price, and Profit in Perfect Competition
  • As firms exit an industry, industry supply
    decreases.
  • The industry supply curve shifts leftward.

The price rises, the quantity decreases, and the
economic profit of each firm increases.
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Output, Price, and Profit in Perfect Competition
  • Changes in Plant Size
  • Firms change their plant size whenever doing so
    is profitable.
  • If average total cost exceeds the minimum
    long-run average cost, firms change their plant
    size to lower costs and increase profits.
  • Figure 11.9 on the next slide shows the effects
    of changes in plant size.

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Output, Price, and Profit in Perfect Competition
  • If the price is 25, firms earn zero economic
    profit with the current plant.

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Output, Price, and Profit in Perfect Competition
  • But if the LRAC curve is sloping downward at the
    current output, the firm can increase profit by
    expanding the plant.

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Output, Price, and Profit in Perfect Competition
  • As the plant size increases, short-run supply
    increases, the price falls, and economic profit
    decreases.

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Output, Price, and Profit in Perfect Competition
  • Long-run equilibrium occurs when the firm is
    producing at the minimum long-run average cost
    and earning zero economic profit.

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Output, Price, and Profit in Perfect Competition
  • Long-Run Equilibrium
  • Long-run equilibrium occurs in a competitive
    industry when
  • Economic profit is zero, so firms neither enter
    nor exit the industry.
  • Long-run average cost is at its minimum, so firms
    dont change their plant size.

84
Changing Tastes and Advancing Technology
  • A Permanent Change in Demand
  • A decrease in demand shifts the demand curve
    leftward. The price falls and the quantity
    decreases.

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Changing Tastes and Advancing Technology
  • Starting from a position of long-run equilibrium,
    the fall in price puts the price below each
    firms minimum average total cost and firms incur
    an economic loss.

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Changing Tastes and Advancing Technology
  • Economic losses induce exit, which decreases
    short-run supply and shifts the short-run
    industry supply curve leftward.

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Changing Tastes and Advancing Technology
  • As industry supply decreases, the price rises and
    the market quantity continues to decrease.

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Changing Tastes and Advancing Technology
  • With a rising price, each firm that remains in
    the industry increases production in a movement
    along the firms marginal cost curve (short-run
    supply curve).

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Changing Tastes and Advancing Technology
  • A new long-run equilibrium occurs when the price
    has risen to equal minimum average total cost so
    that firms do not incur economic losses, and
    firms no longer leave the industry.

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Changing Tastes and Advancing Technology
  • The main difference between the initial and new
    long-run equilibrium is the number of firms in
    the industry.

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Changing Tastes and Advancing Technology
  • In the new equilibrium, a smaller number of firms
    produce the equilibrium quantity.

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Changing Tastes and Advancing Technology
  • A permanent increase in demand has the opposite
    effects to those just described and shown in
    Figure 11.9.
  • An increase in demand shifts the demand curve
    rightward. The price rises and the quantity
    increases.
  • Economic profit induces entry, which increases
    short-run supply and shifts the short-run
    industry supply curve rightward.
  • As industry supply increases, the price falls and
    the market quantity continues to increase.

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Changing Tastes and Advancing Technology
  • With a falling price, each firm decreases
    production in a movement along the firms
    marginal cost curve (short-run supply curve).
  • A new long-run equilibrium occurs when the price
    has fallen to equal minimum average total cost so
    that firms do not earn economic profits, and
    firms no longer enter the industry.
  • The main difference between the initial and new
    long-run equilibrium is the number of firms in
    the industry. In the new equilibrium, a larger
    number of firms produce the equilibrium quantity.

102
Changing Tastes and Advancing Technology
  • External Economics and Diseconomies
  • The change in the long-run equilibrium price
    following a permanent change in demand depends on
    external economies and external diseconomies.
  • External economies are factors beyond the control
    of an individual firm that lower the firms costs
    as the industry output increases.
  • External diseconomies are factors beyond the
    control of a firm that raise the firms costs as
    industry output increases.

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Changing Tastes and Advancing Technology
  • In the absence of external economies or external
    diseconomies, a firms costs remain constant as
    industry output changes.
  • Figure 11.11 illustrates the three possible cases
    and shows the long-run industry supply curve,
    which shows how the quantity supplied by an
    industry varies as the market price varies after
    all the possible adjustments have been made,
    including changes in plant size and the number of
    firms in the industry.

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Changing Tastes and Advancing Technology
  • Figure 11.11(a) shows that in the absence of
    external economies or external diseconomies, the
    price remains constant when demand increases.

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Changing Tastes and Advancing Technology
  • Figure 11.11(b) shows that when external
    diseconomies are present, the price rises when
    demand increases.

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Changing Tastes and Advancing Technology
  • Figure 11.11(c) shows that when external
    economies are present, the price falls when
    demand increases.

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Changing Tastes and Advancing Technology
  • Technological Change
  • New technologies are constantly discovered that
    lower costs.
  • A new technology enables firms to producer at a
    lower average cost and lower marginal costfirms
    cost curves shift downward.
  • Firms that adopt the new technology earn an
    economic profit.

111
Changing Tastes and Advancing Technology
  • New-technology firms enter and old-technology
    firms either exit or adopt the new technology.
  • Industry supply increases and the industry supply
    curve shifts rightward.
  • The price falls and the quantity increases.
  • Eventually, a new long-run equilibrium emerges in
    which all the firms use the new technology, the
    price has fallen to the minimum average total
    cost, and each firm earns normal profit.

112
Changing Tastes and Advancing Technology
  • The adjustment process as old-technology firms
    exit or adopt the new technology and
    new-technology firms enter can create great
    changes in local geographic prosperity.
  • Some regions experience economic decline while
    others experience economic growth.

113
Competition and Efficiency
  • Efficient Use of Resources
  • Resources are used efficiently when no one can be
    made better off without making someone else worse
    off.
  • This situation arises when marginal benefit
    equals marginal cost.

114
Competition and Efficiency
  • Choices, Equilibrium, and Efficiency
  • We can describe an efficient use of resources in
    terms of the choices of consumers and firms
    coordinated in market equilibrium.
  • We derive a consumers demand curve by finding
    how the best (most valued by the consumer) budget
    allocation changes as the price of a good
    changes.
  • So consumers get the most value out of their
    resources at all points along their demand
    curves, which are also their marginal benefit
    curves.

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Competition and Efficiency
  • We derive a competitive firms supply curve by
    finding how the profit-maximizing quantity
    changes as the price of a good changes.
  • So firms get the most value out of their
    resources at all points along their supply
    curves, which are also their marginal cost
    curves.
  • In competitive equilibrium, the quantity demanded
    equals the quantity supplied, so marginal benefit
    equals marginal cost.
  • All gains from trade have been realized.

116
Competition and Efficiency
  • Competitive equilibrium is efficient only if
    there are no external benefits or costs.
  • External benefits are benefits that accrue to
    people other than the buyer of a good.
  • External costs are costs that are borne not by
    the producer of a good or service but by someone
    else.

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Competition and Efficiency
  • Figure 11.12 illustrates an efficient allocation
    of resources in a perfectly competitive industry.
  • In part (a), each firm is producing at the lowest
    possible long run average total cost at the price
    P and the quantity q.

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Competition and Efficiency
  • Figure 11.12(b) shows the market.
  • Along the demand curve D MB the consumer is
    efficient.
  • Along the supply curve S MC the producer is
    efficient.

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Competition and Efficiency
  • The quantity Q and price P are the competitive
    equilibrium values.
  • So competitive equilibrium is efficient.

The consumer gains the consumer surplus,
and the producer gains the producer surplus.
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THE END
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