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Perfect Competition


Perfect Competition Sometimes referred to as Pure Competition or just The Competitive Firm Kiley studies profits a lot * * * A key point in the competitive market is ... – PowerPoint PPT presentation

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Title: Perfect Competition

Perfect Competition
  • Sometimes referred to as Pure Competition or just
    The Competitive Firm

Market Structure
  • The specific market structure determines their
    pricing and output production.

Background on Markets
  • When economists analyze the production decisions
    of a firm, they take into account the structure
    of the market in which the firm is operating.
  • Four Different Market Structures
  • Perfect Competition
  • Monopoly
  • Monopolistic Competition
  • Oligopoly

Market Model Price/Output
  • Market economy has 4 models and they all vary
    from one seller to many sellers
  • None is typical.
  • Each unique and attempting to operate with his
    self-interest in mind.
  • Each will work towards MCMR
  • (Profit Maximizing point and loss minimizing

Market structure characteristics
  • All four market structures have four
    distinguishing characteristics
  • The number and size of the firms in the market.
  • The ease with which firms may enter and exit the
  • The degree to which firms products are
  • The amount of information available to both
    buyers and sellers regarding prices, product
    characteristics and production techniques.

Characteristics of Pure Competition
  1. There are many sellers and many buyers, none of
    which is large in relation to total sales or
  2. Each firm produces and sells a homogeneous
  3. Buyers and sellers have all relevant information
    with respect to prices, product quality, sources
    of supply, and so on.
  4. There is easy entry into and exit from the

Perfect Competitive Market
  • There are very few if any competitive markets.
  • Why teach about a non-existent form of
  • Many firms actually function as purely

Questions to answer
  • When is a firm making a profit?
  • What are the unique characteristics of
    competitive firms?
  • How much output will a competitive firm produce?
  • When will competitive firm maximize profits?
  • When will the competitive firm shut down?

A Perfectly Competitive Firm is a Price Taker
  • A seller that does not have the ability to
    control the price of the product it sells it
    takes the price determined in the market.

Competitive Markets
  • If an industry is profitable, it lures in new
    firms and existing firms expand. Supply shifts
  • This causes price to fall and profits to decline.
  • Some firms, both old and new, fail and close.

The Demand Curve of the Perfect Competitor
  • Question
  • If the perfectly competitive firm is a price
    taker, who or what sets the price?
  • Answer - The Market

The Demand Curve - continued
  • The perfectly competitive firm is a price taker,
    selling a homogenous commodity with perfect
  • Will sell all units for 5
  • Will not be able to sell at a higher price
  • Will face a perfectly elastic demand curve at the
    going market price

The Demand Curve for a Producer of Secure
Digital Cards
How Much Should the Perfect Competitor Produce?
Profit p Total revenue (TR) Total cost (TC)
TR P x Q
Profit Maximization
Take a personal look?
  • How many of you owned a computer 15 years ago?
  • How many own a compact disc player today?
  • How many have discarded the VCR in favor of a
    another digital tool?
  • Do you own an Ipod?
  • Do you own an IPhone?
  • Do you own an Ipad?
  • Do you own a Blackberry?
  • Do you own a graphing calculator?
  • Did your parents have a graphing calculator?
  • How did your parents type project papers for
    economics class?
  • Competition has brought the above changes about.

Price Taker Discussion
  • When there are many firms, all producing and
    selling the same product using the same inputs
    and technology, competition forces each firm to
    charge the same market price for its good.
  • Because each firm sells the same homogeneous
    product, no single firm can increase the price
    that it charges above the price charged by other
    firms in the market (without losing business.)
  • No single firm can affect the market price by
    changing the quantity of output it supplies-
    because many firms- each firm is small in size.

Demand Curve Individual firm/industry
  • The perfect competitor faces a horizontal or
    perfectly elastic demand curve.
  • The demand curve is identical to the Marginal
    Revenue Curve (because the firm can sell as much
    as it wants to sell at market price.) It is not
    necessary to lower the price to sell more.
  • The demand curve for the entire industry slopes
    downward (this is a result of aggregate entries
    and exits into the market.)

Demand Curve
  • Market Demand Curves vs. Firm Demand Curves
  • While the actions of a single competitive firm
    are negligible, the unified actions of many such
    firms are not.
  • The individual firms equilibrium quantity of
    output will be completely determined by the
    amount of output the individual firm chooses to

Profit Maximization
p MC
Profit-maximizing rate of output
Profit Maximization
  • In the short-run, individual firm may make profit
    or loss
  • In long run will break even
  • You can always tell if the firm is making a
    profit or loss by looking at the DEMAND CURVE AND
  • If the demand curve is ABOVE the ATC curve at any
    point the firm will make a profit.
  • If the demand curve is always BELOW the ATC curve
    the firm will lose money.

Profit Maximization when the Firm
is a Price Taker
  • In the short run, the price taker will expand
    output until marginal revenue (price) is just
    equal to marginal cost.

  • This will maximize the firms profits
    (rectangle BACP).
  • When P gt MC then the firm can make more on
    the next unit sold than it costs to increase
    output for that unit. In order for the
    firm to maximize its profits it increases
    output until MC P.
  • When P lt MC then the firm made less on the
    last unit sold than it cost for that unit. In
    order for the firm to maximize its
    profits it decreases output until MC P.

Output / Time
  • In the graph to the right, the firm operates
    at an output level where p MC, but here ATC
    gt MC resulting in a loss for the firm.

  • The magnitude of the firms short-run losses
    is equal to the size of the of the rectangle
  • A firm experiencing losses but covering its
    average variable costs will operate in the

  • A firm will shutdown in the short-run
    whenever price falls below average variable
    cost (P2).
  • A firm will shutdown in the long-run whenever
    price falls below average total cost.

Output / Time
  • For the perfect competitor in the LR, the most
    profitable output is at the minimum point of its
    ATC curve.
  • The firm is forced to operate at peak efficiency
    and that is why it operates at the minimum of its
    ATC curve.. Not anything to do with virtue-------
    just competition.

Total Revenue
Most profitable point for any firm
  • Profit maximization is where
  • MC MR
  • Efficiency
  • A firm operates at peak efficiency when it
    produces its product at the lowest possible cost
    That would be at the MINIMUM POINT OF ITS ATC
    CURVE the break even point.

Profit-Maximization Rule
  • Profit is maximized by producing the quantity of
    output at which MR MC.
  • For Perfect Competition, profit is maximized when
    P MR MC
  • This condition is unique for perfect
    competition and does not hold for other market

  • Marginal Cost
  • A firms goal is not to maximize revenues, but to
    maximize profits.
  • Marginal revenue is compared to marginal costs to
    determine the best level of output.
  • What an additional unit of output brings in is
    its marginal revenue (MR).

Remember Firm Demand Curve is Different from
Industrys Demand Curve
Entry and Exit
  • It is easy to enter or exit an industry in
    perfect competition.
  • If more firms enter (lured in by economic
    profits), the market supply curve shifts right
    and price falls.
  • As price falls, economic profits decrease and
    approach zero.
  • Entry will cease.
  • Some firms could be making losses by this time.
  • Many will cut back output or exit.
  • If so, the supply curve shifts back to the left
    and the price rises.

Long Run
  • In the long run there is time for firms to enter
    or leave the industry. This factor ensures that
    the firm will make ZERO profits in the long run.

Short- vs. Long-Run Equilibrium
Profit - what kind is it???
  • Pure Profit -an amount above that necessary to
    keep the owner in the industry is not considered
    part of total cost
  • Pure profit is the residual after all costs
    (including normal profit) have been met
  • Pure profit will attract other firms into the
  • Normal Profit will not induce firms into the
    market- nor are they low enough to force others
    to leave.. Breaking even..

Long Run
  • In the LR, no firm will accept losses.
  • It will simply close up shop and go out of
  • But also remember one firm leaving the industry
    WILL NOT affect market price.

Market Entry
Profit Squeeze
Factor Costs
  • Factor costs mean wages, rent and interest- are
    far the most important determinants of whether
    costs are falling, constant or increasing.
  • Usually factor costs will eventually rise which
    makes every industry an increasing costs
    industry. Example as more and more land is used
    by an expanding industry, rent will be bid up
  • Time influences supply Whether industry is in SR
    or LR all can adjust in LR if desire to do so.

LR Continued
  • If one firm is losing money, presumably others
    are too.
  • When enough firms go out of business, industry
    supply declines which pushes price up
  • This price rise is reflected in a new demand
    curve for the individual firm.
  • P D1 D2 S1

OPI Original Price for individual NPI new
price for individual
Rules for Entry and Exit
  • If P gt ATC, economic profits exist.
  • Enter the industry or expand capacity.
  • If P lt ATC, economic losses exist.
  • Reduce capacity (or exit if P lt AVC).
  • If P ATC, economic profits are zero.
  • Maintain existing capacity (no entry or exit).

Lower Costs Improve Profits and Stimulate Output
  • If a firm lowers its costs of production, it will
    encourage increases in output.
  • The cost curves fall, and MC appears to shift
  • Profit maximization occurs at point J before and
    point N after the reduced costs take effect.

The Decision to Shut Down in the Short Run
  • Firms cant always make a profit
  • Ski resort in summer
  • Surf shop in winter
  • Shutting down
  • Firm will shut down if it cannot cover variable
  • Shutting down is not the same as going out of
    business and exiting the industry

Shutdown point for a firm
  • A firm compares total revenue with total cost to
    see what its profit or loss is.
  • Remember there are fixed and variable costs.
  • Fixed costs have to be paid whether operating or
  • Suppose a firms total cost is 300,000 at a
    certain level of output. 200,000 made up of
    variable costs,such as labor and raw materials
    and 100,000made up of fixed costs such as
    interest payments, taxes, and rent.

Shutdown Continued
  • If the firms total revenue is 240,000 it is
    clearly taking a loss. The difference between TR
    and TC in this case is 60,000.
  • Notice that the total revenue of 240,000 pays
    all of the firms variable costs (200,000) and
    also pays 40,000 of its fixed cost. If the firm
    were to shut down on the other hand, its loss
    would total 100,000- the amount of the fixed

  • If competition drives price below AVC for a firm,
    it will shut down and exit the industry.
  • If the exiting firm has inventory, it will dump
    that inventory on the market at a reduced price.
  • This will cause the industry price to drop
    further, possibly causing losses for other
    industry firms.

The Competitive Process (this is the market- not
the individual)
  • Competitive forces drive the products price
    down, making it more affordable to more
    consumers. Thus the market expands.
  • Also, competitive forces spur firms to improve
    quality, add features, and look for lower costs.
  • This is the market mechanism at work.
  • Market mechanism the use of market prices and
    sales to signal desired outputs (or resource

Shutdown Continued
  • As long as a firm can cover ALL of its variable
    cost by remaining in operation, it will do so.
  • Its shutdown point will be where TR no
    longer covers TVC.
  • Shutdown when MR falls below the firms minimum
    AVC. When a firm shuts down, it does not
    necessarily leave the industry. Shutdown is a SR
    responseand is based on fixed costs of
    established plant and variable costs of operating

Profit Maximization and Loss Minimization for the
Perfectly Competitive Firm Three Cases I
  • In Case 1, TR TC and the firm earns profits.
  • It continues to produce in the short run.

Profit Maximization and Loss Minimization for the
Perfectly Competitive Firm Three Cases II
  • In Case 2, TR lt TC and the firm takes a loss.
  • It shuts down in the short run because it
    minimizes its losses by doing so it is better to
    lose 400 in fixed costs than to take a loss of

Profit Maximization and Loss Minimization for the
Perfectly Competitive Firm Three Cases III
  • In Case 3, TR lt TC and the firm takes a loss.
  • It continues to produce in the short run because
    it minimizes its losses by doing so it is better
    to lose 80 by producing than to lose 400 in
    fixed costs by not producing.

What Should a Perfectly Competitive Firm Do in
the Short Run?
  • The firm should produce in the short run as long
    as price (P) is above average variable cost
  • It should shut down in the short run if price is
    below average variable cost.

Long-run Equilibrium
  • The two conditions necessary for long-run
    equilibrium in a price-taker market are
    depicted here.
  • First, the quantity supplied and the quantity
    demanded must be equal in the market, as
    shown below at P1 with output Q1.
  • Second, the firms in the industry must earn zero
    economic profit (that is, the normal market
    rate of return) at the established market
    price (P1 below).

The Lure of Profits
  • In competitive markets, economic profits attract
    new entrants.
  • Low entry barriers permit new firms to enter
    competitive markets.
  • The entry of new firms shifts the market supply
    curve to the right.
  • As long as economic profits are available in
    short-run competitive equilibrium, new entrants
    will continue to be attracted.
  • p MC
  • Short-run competitive equilibrium

  • Profits and losses act as signals to firms
  • Signals
  • Convey information about the profitability of
    various markets
  • Positive profits
  • A signal of profitability. More firms will enter
    the industry.
  • Negative profits (losses)
  • A signal that resources could be doing better
    elsewhere. Firms will exit the industry.

The Competitive Process
  • If economic profits are high, consumers are
    willing to pay more than the opportunity cost of
    resources to acquire a product.
  • It signals they want more of that industrys
  • Profit-seeking producers respond by producing
    more to satisfy consumer demand.
  • This is allocative efficiency the industry will
    end up producing the right output mix.

The Competitive Process
  • If economic profits are negative (losses),
    consumers are unwilling to pay the opportunity
    cost of resources to acquire a product.
  • It signals they want fewer of that industrys
  • Profit-seeking producers respond by producing
    less to satisfy a waning consumer demand.
  • This is also allocative efficiency the industry
    will end up producing the right output mix.

A Shift of Market Supply Any short-run
equilibrium will not last.
  • As supply increases, price drops, to the minimum
    of ATC.
  • Once at minimum of ATC, there are no longer
    economic profits to attract firms to enter.
  • In long-run equilibrium, entry and exit cease,
    and zero economic profit (i.e., normal profit)
  • Long-run equilibrium
  • p MC minimum ATC

Short- vs. Long-Run Equilibrium
Long-Run Rules for Entry and Exit
Technology improvements noted below
Two terms to remember
Allocative Efficiency
  • The market mechanism works best in competitive
  • Market mechanism - The market mechanism is the
    use of market prices and sales to signal desired
  • Allocative efficiency means that we are producing
    the right output mix.
  • The price signal the consumer gets in a
    competitive market is an accurate reflection of
    opportunity cost.

Production Efficiency
  • Production efficiency means that we are producing
    at minimum average total cost.
  • Efficiency (production) Maximum output of a
    good from the resources used to produce it.
  • When competitive pressure on prices is carried to
    the limit, the products in question are also
    produced at the least possible cost.
  • Society is getting the most it can from its
    available (scarce) resources. This market model
    is the best buy for consumers.

Reality of Attaining a Profit
  • The sequence of events common to a competitive
    market situation includes the following.
  • High prices and profits signal consumers demand
    for more output.
  • Economic profit attracts new suppliers.
  • The market supply shifts to the right
  • Prices slide down the market demand curve.
  • A new equilibrium is reached with increased
    quantities being produced and sold and the
    economic profit approaching zero.
  • Producers experience great pressure to keep ahead
    of the profit squeeze by reducing costs.

Profits Are The Bottom Line
Kiley studies profits a lot