#### Transcript Document

```Chapter 8
Perfect Competition
An Introduction to Perfect
Competition
• Market structure determinants
– Product’s degree of uniformity
– Ease of entry into the market
– Forms of competition among firms
• Industry
– All firms supplying output to a market
2
•2
Perfectly Competitive Market
Structure
• Theoretical construct, difficult to find in the real
world
• Commodity; standardized product
• Fully informed buyers and sellers
• No barriers to entry
– No control over price
– Price takers
•3
Demand Under Perfect Competition
• Market price
– Determined by market supply and and demand
• Demand curve facing one supplier
– Horizontal line at the market price
– Perfectly elastic
• The individual firm is a price taker
•4
Exhibit 1
Market equilibrium and a firm’s demand curve in
perfect competition
(b) Firm’s demand
(a) Market equilibrium
\$5
D
Price per bushel
Price per bushel
S
\$5
d
0
5
10 15 Bushels of
1,200,000 Bushels of
wheat per day
wheat per day
Market price (\$5)- determined by the intersection of the market demand and
market supply curves. A perfectly competitive firm can sell any amount at that
price. The demand curve facing the perfectly competitive firm - horizontal at 5
the market price.
0
Short Run Profit Maximization
• Maximize economic profit
– Quantity at which total revenue (TR) exceeds total
cost (TC) by the greatest amount
• Profit = TR – TC
– If TR > TC: economic profit
– If TC > TR: economic loss
– If TC = TR: zero economic profit, normal profit
•6
Short Run Profit Maximization
• Marginal revenue (MR) = P = AR (perfect
competition)
• Marginal cost (MC)—upward sloping
• Maximize economic profit:
– Increase production as long as each additional unit
adds more to MR than MC
• Golden rule
– Expand output: MR>MC
– Contract output: MR < MC
– Stop when MC=MR
•7
Exhibit 3
Short-run profit maximization
Total dollars
Total cost
\$60
(a)Total revenue minus
total cost
TR: straight line, slope=5=P
TC increases with output
Max Economic profit:
where TR exceeds TC by
the greatest amount
Maximum economic
profit = \$12
48
15
0
Dollars per bushel
Total revenue
(=\$5 × q)
5
7
10 12 15
e
\$5
4
Bushels of wheat per day
Marginal cost
Average total cost
(b) Marginal cost equals
marginal revenue
d = Marginal revenue
MR: horizontal line at P=\$5
= Average revenue
Profit
Max Economic profit:
at 12 bushels,
where MR=MC
a
0
5
7
10 12 15
Bushels of wheat per day
8
SHORT RUN PROFIT
MC = MR
MC
Cost
Market sales price = marginal revenue (MR)
P1
ATC
Total Economic Profit = (P1 – C1) x Q1
C1
AVC
Q1
QUANTITY
9
Minimizing Short-Run Losses
• Total Cost (TC) = Fixed cost (FC) + Variable cost
(VC)
• Shut down in short run: pay fixed cost
• If TC<TR: economic loss
– Produce if TR>VC (P>AVC)
• Revenue covers variable costs and a portion of fixed
cost
• Loss < fixed cost
– Shut down if TR<VC (P<AVC)
• Loss = FC
•10
Exhibit 5
Short-run loss minimization
Total revenue
(=\$3 × q)
Total dollars
Total cost
\$40
30
TC>TR; loss
Minimize loss: 10 bushels
Minimum economic
loss = \$10
15
0
5
10
15
Marginal cost
Dollars per bushel
(a)Total revenue minus
total cost
\$4.00
3.00
2.50
0
Bushels of wheat per day
Average total cost
(b) Marginal cost equals
marginal revenue
Average variable cost
Loss
5
e
10
d = Marginal revenue
= Average revenue
15
Bushels of wheat per day
MR=MC=\$3; ATC=\$4
P=\$3; P>AVC
Continue to produce
in short run
11
SHORT RUN LOSS--PRODUCE
MC
Cost
ATC
ATC1
Economic Loss – C1 > P1
P1
MC=MR
Market price –Marginal Revenue (MR)
AVC
AVC1
Q1
Quantity
SHORT RUN LOSS—SHUT DOWN
MC
Cost
ATC
Loss on fixed
cost
AVC
Loss on average variable cost
P1
Market price – marginal revenue
MC = MR
QUANTITY
Firm and Industry Short-Run S curves
• Short-run firm supply curve
– Upward sloping portion of MC curve
– Above minimum AVC curve
• Short-run industry supply curve
– Horizontal sum of all firms’ short-run supply curves
•14
Exhibit 6
Summary of short-run output decisions
Break-even
Firm’s short run S curve
Marginal cost
point
5
p5>ATC, q5, economic profit
d5
Average total cost
4
p4=ATC, q4, normal profit
d4
Average variable cost
3
ATC>p3>AVC, q3, loss <FC
d3
2
p2=AVC, q2 or 0, loss=FC
d2
1
d1
p1<AVC, shut down,
Shutdown
q1=0,loss=FC
point
Dollars per unit
p5
p4
p3
p2
p1
0
q1
q2 q3 q4 q5
Quantity per period
15
Exhibit 7
Aggregating individual supply to form market supply
Price per unit
(a) Firm A
(b) Firm B
SA
(c) Firm C
SB
(d) Industry, or market, supply
SC
SA + SB + SC = S
p’
p’
p’
p’
p
p
p
p
0
10 20
0
Quantity
per period
10 20
0
Quantity
per period
10 20
Quantity
per period
0
30
60
Quantity per period
16
Firm Supply and Market Equilibrium
• Short run, perfect competition
– Market converges to equilibrium P and Q based on
market supply and demand
– Options available to the firm
• Max profit
• Min loss
• Shuts down temporarily
•17
Exhibit 8
(a) Firm
MC = s
ATC
\$5
4
d
AVC
Profit
(b) Industry, or market
Price per unit
Dollars per unit
Short-run profit maximization and market equilibrium
∑ MC = S
\$5
D
0
5
10 12
Bushels of
wheat per day
Market price \$5 determines the perfectly
elastic demand curve (and MR) facing
the individual firm.
0
Bushels of
1,200,000
wheat per day
S = horizontal sum of the supply curves
of all firms in the industry
Intersection of S and D: market price \$5
18
Perfect Competition in the Long Run
• Long run
– Firms enter/exit the market
– Firms adjust scale of operations
• Until average cost is minimized
– All resources are variable
•19
Perfect Competition in the Long Run
• Economic profit in short run
– New firms enter market in long run
– Existing firms expand in long run
– Market supply increases—supply curve shifts to
the right
• P decreases
• Economic profit disappears
• Firms break even—price decreases to the minimum of
the ATC curve
•20
Perfect Competition in the Long Run
• Economic loss in short run
– Some firms exit the market in long run
– Some firms reduce scale in long run
– Market supply decreases—supply curve shifts to
the left
• P increases
• Economic loss disappears
• Firms break even--price increases to the minimum of
the ATC curve
•21
Zero Economic Profit in the Long Run
• Firms enter, leave, change scale
• Market:
– supply shifts; price changes
• Firm
– d(P=MR=AR) shifts
– Long run equilibrium
• MR=MC =ATC=LRAC
• Normal profit
• Zero economic profit
•22
Exhibit 9
Long-run equilibrium for a firm and the industry
(a) Firm
(b) Industry, or market
S
ATC
LRAC
e
p
d
Price per unit
Dollars per unit
MC
p
D
0
q
Quantity
per period
0
Q
Quantity
per period
Long run equilibrium: P=MC=MR=ATC=LRAC. No reason for new firms to
enter the market or for existing firms to leave. As long as the market
demand and supply curves remain unchanged, the industry will continue to
23
produce a total of Q units of output at price p.
Long-Run Adjustment to a Change in D
• Effects of an Increase in Demand
– Short run
• market demand increases, P increases
• Firms increase quantity supplied
• Economic profit
– Long run
•
•
•
•
New firms enter the market
Market supply increases, P decreases
Firm’s horizontal demand curve decreases
Normal profit
•24
Exhibit 10
Long-run adjustment to an increase in demand
(a) Firm
(b) Industry, or market
S
d’
ATC
LRAC
p’
Profit
p
d
Price per unit
Dollars per unit
MC
S’
b
p’
a
c
p
S*
D’
D
0
q
q’
Quantity
per period
0
Qa Qb
Qc
Quantity
per period
Increase in D to D’ moves the market equilibrium point from a to b; firm’s
demand increases to d’; economic profit in short run.
Long run: new firms enter the industry; supply increases to S’; price
drops back to p; firm’s demand drops back to d
25
Long-Run Adjustment to a Change in D
• Effects of a Decrease in Demand
– Short run
• Market demand decreases, P decreases
• Firms decrease quantity supplied
• Economic loss
– Long run
•
•
•
•
Firms exit the market
Market supply decreases, P increases
Firm’s demand curve increases
Normal profit
•26
Exhibit 11
Long-run adjustment to a decrease in demand
(a) Firm
(b) Industry, or market
S’’
ATC
LRAC
d
p
p’’
0
Loss
q’’
d’’
q
Quantity
per period
Price per unit
Dollars per unit
MC
g
a
S*
p
p’’
0
S
f
Qg
Qf
D’’
Qa
D
Quantity
per period
Decrease in D to D’’ moves the market equilibrium point from a to f; firm’s
demand decreases to d’’; economic loss in short run.
Long run: firms exit the industry; supply decreases to S’’; price
increases back to p; firm’s demand rises back to d
27
The Long-Run Industry Supply Curve
• Short run
– Change quantity supplied along MC curve
• Long run industry supply curve S*
– Perfectly horizontal at the minimum of the ATC
curve (break even price)
• Constant-cost industries
– LRAC doesn’t shift with output
– Long run S* curve for industry: straight horizontal
line
•28
Increasing Cost Industries
– Average costs increase as output expands
• Effects of an increase in demand
– Short run
• Market demand increases; P increases;
• Firms increase output; Economic profit
– Long run
• New firms enter the market;
• Market: supply increases; price decreases
• Firm: MC and ATC increase (shift upward), higher
minimum of ATC curve
•29
Exhibit 12
An increasing-cost industry
(a) Firm
(b) Industry, or market
MC
S
pc
b ATC’
db
ATC
dc
pa
da
pb
c
a
Price per unit
Dollars per unit
MC’
S*
b
pb
pc
S’
a
c
pa
D’
D
0
q
qb
Quantity
per period
0
Qa Qb Qc
Quantity
per period
D increases to D’, new short-run equilibrium: point b. Higher price pb; firm’s
demand curve shifts up (db); economic profit, which attracts new firms.
Input prices go up, MC and ATC curves shift up.
Market S increases to S’; new price pc, firm’s demand curve shifts
30
down to dc; normal profit.
Perfect Competition and Efficiency
• Productive efficiency: Making Stuff Right
– Produce output at the least possible cost
• Min point on LRAC curve
• P = min average total cost in long run
• Allocative efficiency: Making the Right Stuff
– Produce output that consumers value most
• Marginal benefit = P = Marginal cost
• Allocative efficient market
•31
Competition?
• Consumer surplus
• Consumers pay less (P) than they are willing to pay
(along D curve)
• Producer surplus
• Producers are willing to accept less (along S curve; MC)
than what they are receiving (P)
• Gains from voluntary exchange
• Consumer and producer surplus
• Productive and allocative efficiency
• Maximum social welfare
•32
Exhibit 13
Dollars per unit
Consumer surplus and producer surplus for a
competitive market
\$10
6
5
Consumer surplus: area above the
market-clearing price (\$10) and
S below the demand.
Consumer
surplus
e
Producer
surplus
m
0
Producer surplus: area above the
short-run market supply curve and
below the market-clearing price
100,000
200,000
120,000
D
At p=\$5: no producer surplus; the
price just covers each firms AVC.
At p=\$6: producer surplus is the area
between \$5, \$6, and S curve.
Quantity
per period
33
```