Perfect Competition

Assumptions of Perfect Competition

1. Homogeneous or identical products every other seller’s product.

– every seller’s product is the same as 2. Many small independent firms 3. Easy entry & exit into the industry – all resources are perfectly mobile.

4. Firms, consumers, & resource owners have perfect knowledge of relevant economic & technical data.

The perfectly competitive firm is a price taker that sells its product at the market price. Why?

If the firm tried to charge more than the market price, it would lose all its business to its competitors who sell the identical product.

The firm can sell as much as it wants at the market price, since it is very small relative to the market. The firm, therefore, has no incentive to charge less than the market price.

Since the perfectly competitive firm always sells its product for the market price, the demand curve for its product is horizontal at the market price.

P D Q

Consider a perfectly competitive firm whose product sells for $10. The firm’s costs are as shown below.

Quantity of output (Q) 0 1 2 3 4 5 6 7 8 Price (P) 10 10 10 10 10 10 10 10 10 Total Revenue (TR) Total Fixed Cost (TFC) Total Variable Cost (TVC) 12 12 12 0 2 3 12 5 12 12 12 12 12 8 13 23 38 69 Total Cost (TC) Total Profit (  ) Marginal Revenue (MR) Marginal Cost (MC)

Total Revenue is TR = PQ Quantity of output (Q) 0 1 2 3 4 5 6 7 8 Price (P) 10 10 10 10 10 10 10 10 10 Total Revenue (TR) 0 10 20 Total Fixed Cost (TFC) Total Variable Cost (TVC) 12 12 12 0 2 3 30 12 5 40 50 60 70 80 12 12 12 12 12 8 13 23 38 69 Total Cost (TC) Total Profit (  ) Marginal Revenue (MR) Marginal Cost (MC)

Total Cost is TC = TFC + TVC.

Quantity of output (Q) 0 1 2 3 4 5 6 7 8 Price (P) 10 10 10 10 10 10 10 10 10 Total Revenue (TR) 0 10 20 Total Fixed Cost (TFC) Total Variable Cost (TVC) 12 12 12 0 2 3 30 12 5 40 50 60 70 80 12 12 12 12 12 8 13 23 38 69 20 25 35 50 81 Total Cost (TC) 12 14 15 17 Total Profit (  ) Marginal Revenue (MR) Marginal Cost (MC)

Profit is  = TR –TC Quantity of output (Q) 0 1 2 3 4 5 6 7 8 Price (P) 10 10 10 10 10 10 10 10 10 Total Revenue (TR) 0 10 20 Total Fixed Cost (TFC) Total Variable Cost (TVC) 12 12 12 0 2 3 30 12 5 40 50 60 70 80 12 12 12 12 12 8 13 23 38 69 20 25 35 50 81 Total Cost (TC) 12 14 15 17 20 25 25 20 -1 Total Profit (  ) -12 Marginal Revenue (MR) Marginal Cost (MC) -4 5 13

Marginal Revenue is MR = ΔTR/ΔQ .

For a perfectly competitive firm, MR is constant & equal to the price of the product.

Quantity of output (Q) 0 1 2 3 4 5 6 7 8 Price (P) 10 10 10 10 10 10 10 10 10 Total Revenue (TR) 0 10 20 Total Fixed Cost (TFC) Total Variable Cost (TVC) 12 12 12 0 2 3 30 12 5 40 50 60 70 80 12 12 12 12 12 8 13 23 38 69 20 25 35 50 81 Total Cost (TC) 12 14 15 17 20 25 25 20 -1 Total Profit (  ) -12 Marginal Revenue (MR) -- Marginal Cost (MC) -4 5 10 10 13 10 10 10 10 10 10

Marginal Cost is MC = ΔTC/ΔQ Quantity of output Price Total Revenue 4 5 6 7 8 0 1 2 3 10 10 10 10 10 10 10 10 10 40 50 60 70 80 0 10 20 30 Total Fixed Cost 12 12 12 12 12 12 12 12 12 Total Variable Cost 0 2 3 Total Cost Total Profit Marginal Revenue Marginal Cost 12 14 15 -12 -4 5 -- 10 10 -- 2 1 5 8 13 23 38 69 17 20 25 35 50 81 13 20 25 25 20 -1 10 10 10 10 10 10 2 3 5 10 15 31

Notice that when Q = 6, MR=MC and profit is at its maximum.

Quantity of output Price Total Revenue 4 5 6 7 8 0 1 2 3 10 10 10 10 10 10 10 10 10 40 50 60 70 80 0 10 20 30 Total Fixed Cost 12 12 12 12 12 12 12 12 12 Total Variable Cost 0 2 3 Total Cost Total Profit Marginal Revenue Marginal Cost 12 14 15 -12 -4 5 -- 10 10 -- 2 1 5 8 13 23 38 69 17 20 25 35 50 81 13 20 25 25 20 -1 10 10 10 10 10 10 2 3 5 10 15 31

3 4 5 6 7 8 Notice also that at that profit-maximizing output, price is equal to marginal cost P=MC Quantity of output Price 0 1 2 10 10 10 Total Revenue 0 10 20 Total Fixed Cost 12 12 12 Total Variable Cost 0 2 3 Total Cost Total Profit Marginal Revenue Marginal Cost 12 14 15 -12 -4 5 -- 10 10 -- 2 1 10 10 10 10 10 10 30 40 50 60 70 80 12 12 12 12 12 12 5 8 13 23 38 69 17 20 25 35 50 81 13 20 25 25 20 -1 10 10 10 10 10 10 2 3 5 10 15 31

P = MC because for the perfectly competitive firm, P = MR & for the profit-maximizing firm, MR = MC.

Quantity of output Price Total Revenue 4 5 6 7 8 0 1 2 3 10 10 10 10 10 10 10 10 10 40 50 60 70 80 0 10 20 30 Total Fixed Cost 12 12 12 12 12 12 12 12 12 Total Variable Cost 0 2 3 Total Cost Total Profit Marginal Revenue Marginal Cost 12 14 15 -12 -4 5 -- 10 10 -- 2 1 5 8 13 23 38 69 17 20 25 35 50 81 13 20 25 25 20 -1 10 10 10 10 10 10 2 3 5 10 15 31

On a graph, the perfectly competitive firm making a positive economic profit looks like this. The horizontal demand curve lies above the minimum of the ATC curve.

$

P MC ATC D = MR Q*

Quantity

Sometimes the best the firm can do is break even (make zero economic profits). This occurs when the price (& the demand curve) are at the minimum of the ATC curve.

$

P MC ATC AVC D = MR

Quantity

What if the demand curve lies below the minimum of the ATC curve but above the minimum of the AVC curve? $

P MC ATC AVC D = MR

Quantity

Then the firm will have an economic loss.

However, the firm will still operate. If the firm were to shut down & produce nothing, its loss would equal its fixed cost.

But since the price is greater than the variable costs per unit (AVC), by operating the firm will be able to cover its variable costs & part of its fixed costs. So its loss would be smaller than the amount of fixed cost.

So it pays to operate, as long as the price is above the minimum of the average variable cost.

Mathematically, the situation works like this: P > AVC So, PQ > AVC (Q), [Now since AVC = TVC / Q , AVC (Q) = TVC.] So, PQ > TVC TR > TVC TR – TC > TVC – TC   > TVC > – TC – TC + TVC   > -1(TC > – TFC – TVC) If the firm produced nothing,  = TR – TC = TR – (TVC+TFC ) = 0 – (0+TFC) = – TFC So the firm does better by operating than by shutting down.

If the price equals the minimum value of the AVC curve, the firm will lose the same amount if it shuts down or if it operates.

$

MC ATC AVC P D = MR

Quantity

However, if the price is

below

the minimum of the AVC curve, the firm is unable to cover even the variable costs, & it should shut down.

It would lose more by operating than by shutting down.

Consequently, the minimum of the AVC curve is called the shutdown point.

Graphically, the firm’s horizontal demand curve lies below the minimum of the AVC curve: $

MC ATC AVC P D = MR

Quantity

So we have these five possible cases: $

P 1 P 2 P 3 P 4 P 5

1. Positive economic profits 2. Break even 3. Operate at a loss 4. Lose same amount if operate or shutdown 5. Shutdown

MC ATC AVC

Quantity

Using this information and the fact that the firm maximizes profits by producing where MR = MC, we can determine the firm’s short run supply curve.

If the price is P 1 , the firm produces output Q 1 , where MR = MC.

(The numbering of the prices in the upcoming slides does not correspond to the numbering in our 5 case discussion.)

ATC

$

MC AVC P 1 D 1 = MR 1 Q 1

Quantity

If the price is P 2 , the firm produces output Q 2 .

$

P 2 MC ATC AVC D 2 = MR 2 Q 2

Quantity

If the price is P

3

, the firm produces output Q

3

.

$

P 3 MC ATC AVC D 3 = MR 3 Q 3

Quantity

If the price is P

4

, the firm produces output Q

4

.

$

P 4 Q 4 MC ATC AVC D 4 = MR 4

Quantity

If the price is P 5 , the firm produces output Q 5 (or shuts down – it loses the same amount either way).

$

P 5 Q 5 MC ATC AVC D 5 = MR 5

Quantity

So in determining the quantity the firm would supply at each price, we have actually traced out the points of the MC curve above the minimum of the AVC curve.

$

MC ATC AVC

Quantity

So this is the firm’s short run supply curve.

Price

S

Quantity

To determine the industry or market short run supply curve, horizontal sum the individual firms’ supply curves.

Price

S 1 S 2 S 3 S 4 S 5

Industry supply curve Quantity

That means that for each price, we add the amounts all the firms are willing to supply. For example, if there are five firms who at a price of $25 will supply 10, 20, 30, 40, & 50 units each, the total supplied by the industry at that price is 10 + 20 + 30 + 40 + 50 = 150 .

Price

S 1 S 2 S 3 S 4 S 5

Industry supply curve 25 10 20 30 40 50 Quantity 150

How do perfectly competitive firms & industries adjust to changes in demand conditions & what are the implications for the long run market supply curve?

Let’s start with the simplest case, which is the constant cost industry.

Constant Cost Industry

an industry in which costs of production remain constant as industry output expands

P Market

Start with the market.

S P 0 Q* D Q

P P 0

Put in a typical firm in long run equilibrium (zero profits).

Market Firm MC P ATC S P 0 D= MR Q* D Q q* q

P P 0

Suppose demand increases.

Market Firm MC S ATC D= MR Q* P 0 D D’ Q q* q

P P 1 P 0

Price rises and profits are made.

Market Firm MC S P 1 P 0 ATC D 1 = MR 1 D= MR Q* Q 1 D D’ Q q* q 1 q

New firms enter the industry, increasing supply.

P Market Firm MC P 1 P 0 S S’ P 1 P 0 ATC D 1 = MR 1 D= MR Q*Q 1 D D’ Q q* q 1 q

Price falls to original level, & profits return to zero.

P P 1 P 0 Market S S’ P 1 P 0 MC Firm ATC D 1 = MR 1 D= MR Q* Q 1 Q 2 D D’ Q q* q

The Long Run Supply Curve

The initial market point and the final one are long run equilibrium points and therefore are on the long run supply curve for this industry. (The middle point - the black one - is not on the long run supply curve, since it is not a long run equilibrium point.) For a constant cost industry, the long run supply curve is a horizontal line.

P P 1 P 0

The Long Run Supply Curve

Market S S’

long run supply curve

Q* Q 1 Q 2 D D’ Q

Increasing Cost Industry

an industry in which costs of production increase as industry output expands

P Market

Start with the market.

S P 0 Q* D Q

P P 0

Put in a typical firm in long run equilibrium (zero profits).

Market Firm MC P ATC S P 0 D= MR Q* D Q q* q

P P 0

Suppose demand increases.

Market Firm MC S ATC D= MR Q* P 0 D D’ Q q* q

P P 1 P 0

Price rises and profits are made.

Market Firm MC S P 1 P 0 ATC D 1 = MR 1 D= MR Q* Q 1 D D’ Q q* q 1 q

New firms enter the industry, increasing supply.

P P 1 P 0 Market S S’ P 1 P 0 MC Firm ATC D 1 = MR 1 D= MR Q*Q 1 D D’ Q q* q 1 q

However, as industry output expands, demand for the inputs rises. The prices of the inputs increase, and therefore production costs increase. So we see an upward shift in the cost curves.

P P 1 P 0

Cost curves shift upward.

Market S S’ P 1 P 0 MC 1 Firm ATC 1 ATC D 1 = MR 1 D= MR MC Q*Q 1 D D’ Q q* q 1 q

The market supply curve shifts to the right just enough, so that the equilibrium price will be at the minimum of the new ATC curve and we have zero profits.

So the price rises and then falls but not to the original price level.

P 1 P 2 P 0 P

The new long run equilibrium price is higher than the original price.

Market S S’ P 1 P 2 P 0 MC 1 Firm ATC 1 ATC D 1 = MR 1 D 2 =MR 2 D= MR MC Q*Q 1 D D’ Q q 2 q* q 1 q

The Long Run Supply Curve

The initial market point and the final one are long run equilibrium points and therefore are on the long run supply curve for this industry. For a increasing cost industry, the long run supply curve is upward sloping.

P P 1 P 2 P 0

The Long Run Supply Curve

Market S S’

long run supply curve

Q*Q 1 D D’ Q

Decreasing Cost Industry

an industry in which costs of production fall as industry output expands

P Market

Start with the market.

P 0 S Q* D Q

P

Put in a typical firm in long run equilibrium (zero profits).

Market Firm MC P ATC P 0 P 0 D= MR S Q* D Q q* q

P

Suppose demand increases.

Market Firm MC ATC D= MR P 0 S Q* P 0 D D’ Q q* q

P P 1 P 0 S

Price rises and profits are made.

Market Firm MC ATC P 1 P 0 D 1 = MR 1 D= MR Q* Q 1 D D’ Q q* q 1 q

New firms enter the industry, increasing supply.

Market P P 1 P 0 P 1 P 0 S S’ Q*Q 1 D D’ Q Firm MC ATC D 1 = MR 1 D= MR q* q 1 q

As industry output expands, area infrastructure (such as roads and bridges) improves and therefore costs of transporting inputs and outputs decrease. So we see an downward shift in the cost curves.

Cost curves shift downward.

Market P P 1 P 0 P 1 P 0 S S’ Q*Q 1 D D’ Q Firm MC ATC D 1 = MR 1 D= MR q* q 1 q

The market supply curve shifts to the right just enough, so that the equilibrium price will be at the minimum of the new ATC curve and we have zero profits.

So the price rises and then falls to below the original price level.

The new long run equilibrium price is lower than the original price.

P Market Firm MC ATC P 1 P 0 P 2 S S’ Q*Q 1 P 1 P 0 P 2 D D’ Q q* q 1 q 2 D 1 = MR 1 D= MR D 2 = MR 2 q

The Long Run Supply Curve

The initial market point and the final one are long run equilibrium points and therefore are on the long run supply curve for this industry. For a decreasing cost industry, the long run supply curve is downward sloping.

The Long Run Supply Curve

Market P P 1 P 0 P 2 S S’ Q*Q 1 Q 2 D D’ Q

long run supply curve

We have seen that in long run equilibrium, the perfectly competitive firm always operates at the minimum of its SR ATC curve. In LR equilibrium, it will also be at the minimum of its LR ATC. Why? When the firm is maximizing LR profits, MR = LR MC.

Since for a perfectly competitive firm, P=MR, P = LR MC.

But since the firm has zero economic profits, P = LR ATC.

So LR MC must equal LR ATC. Where does that occur?

At the minimum of the LR ATC.

So in LR equilibrium, a perfectly competitive firm operates at the minimum of both the SR & LR ATC curves, where those curves intersect the LR & SR MC curves.

LR MC P SR MC LR ATC SR ATC P 0 D= MR q* q