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Chapter 7 Perfect Competition

Econ 1900 Laura Lamb

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1. Perfect competition

2. Monopolistic competition

3. Oligopoly

4. Pure Monopoly

7.1 Four market models

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What are the major characteristics of each market model?

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Large number of firms

Standardized products

Price takers

Easy entry & exit of firms

7.2 Perfect competition

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Then why do we study it?

◦ helps analyze industries with characteristics similar to perfect competition.

◦ provides a context in which to apply revenue and cost concepts developed in previous chapters.

◦ provides a norm or standard against which to compare and evaluate the efficiency of the real world.

Rare in the real world

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Demand is perfectly elastic for each firm◦ Not for the industry◦ Individual firms can sell as much as they want at

the market price

Demand in perfect competition

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Product price Quantity Demanded

Total Revenue Marginal Revenue

8888888

0123456

Demand schedule for a firm

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Average Revenue

Total Revenue

Marginal Revenue

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1. Compare total revenue & total cost

2. Compare marginal revenue & marginal cost

7.3 Profit Maximization in the Short –Run: two approaches

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Total Revenue & Total Cost Schedule

Quantity (cans/day)

Total Revenue ($/day)

Total cost ($/day)

Economic profit($/day)

01234567891011121314

081624324048566472808896

104112

15222730323334363944516076

104144

-15-14-11-607142025282928200

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Consider the market for maple syrup

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Where is the break-even point for the firm?

◦ This is where a normal profit is made◦ No economic profit at this point

Break-even point

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MR = MC rule: in the short run, a firm will maximize profit by producing at the output level where MR = MC.

Method 2

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Quantity (cans/day)

Total Revenue ($/day)

Marginal Revenue

Total Cost ($/day)

Marginal Cost

Economic profit($/day)

01234567891011121314

081624324048566472808896104112

88888888888888

15222730323334363944516076104144

75321123579162840

-15-14-11-607142025282928200

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Use the MR=MC Rule

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***The MR=MC rule is applicable to all market models***

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For perfectly competitive firms: MR = MC is equivalent to P= MC

Why?

Note

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1. Suppose the price dropped from $8/can to $6/can, how would the profit maximizing level of output change?

3. Now suppose, the price drops to $4/can. How much should be produced?

Questions

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Quantity (cans/day)

Total revenue

($/day)

MR ($/day) Total cost

($/day)

MC ($/day) Economic profit

(TR-TC)

789101112

283235404448

444444

363944516076

2357916

-8-7-8-11-16-28

At a price of $4/can:

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If a loss is incurred, the firm should continue to produce as long as the price is greater than average variable cost (AVC).

Modified rule: MR = MC if P>minimum AVC

A loss minimizing situation

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In the example of Dave’s Maple Syrup: when P=$8, quantity supplied = 10 when P=$4, quantity supplied = 8

◦ appears rational in light of the law of supply!

◦ The short-run supply curve is the section of the MC curve starting at minimum AVC (and above).

7.4 Marginal cost and the short-run supply curve

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In what situations would the supply curve for the firm shift?

The Supply curve can shift

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Quantity supplied by 1 firm

Total quantity supplied by 1000 firms

Product price Total quantity demanded

10865

10,0008,0006,0005,000

8421

3,0005,0006,00010,000

Equilibrium in the firm & the industry

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Is the industry profitable at the equilibrium?

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1. The firm should produce is P≥minimum AVC

2. The firm should produce the quantity at MR=MC

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Individual firms must take price as given, but the supply plans of all competitive producers as a group are a major determinant of product price.

Firm versus the industry

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Assumptions:1. Entry and exit of firms are the only

long‑run adjustments 2. Firms in the industry have identical cost

curves.3. The industry is a constant‑cost industry

the entry and exit of firms will not affect resource prices or location of unit‑cost schedules for individual firms.

7.5 Profit maximization in the long- run

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**In the long run, product price = minimum ATC

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If P>minimum ATC →economic profits will attract new firms to the industry →increased supply of the product →price is driven down to minimum ATC.

If P<minimum ATC →economic losses will cause some firms to leave the industry →decreased supply of the product →price is driven up to minimum ATC.

Long-run adjustments

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A change in consumer tastes increases the demand for product

trace the steps to a new long-run equilibrium

Illustrate with two graphs, one for the firm and one for the industry.

Example 1

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Household income decreases causing a fall in demand for the product.

trace the steps to a new long-run equilibrium

Illustrate with two graphs, one for the firm and one for the industry.

Example 2

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**In the long run, equilibrium price & quantity always occur where ATC is at a minimum for a perfectly competitive firm.

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The product price will be exactly equal to each firm’s point of minimum average total cost.

Some conclusions about long-run equilibrium

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Perfectly elastic ◦ Level of output does not affect price in the long-

run.

Long-run supply for a constant cost industry

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Upward sloping as industry expands output.

Long-run supply for an increasing cost industry

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Downward sloping as the industry expands output.

Long-run supply for a decreasing cost industry

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In the long run:◦ Productive efficiency occurs where P = minimum

ATC

◦ Allocative efficiency occurs where P = MC allocative efficiency implies maximum consumer and

producer surplus.

7.6 Perfect competition & Efficiency

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When a pharmaceutical company introduces a new drug, it typically owns the patent and can price and produce as a monopolist, earning economic profits.

When patent rights expire, firms pursuing economic profits enter the market for that drug.

Prices of these drugs typically drop 30-40 percent. ◦ Those lower prices increase efficiency and consumer

surplus.

Efficiency Gains from entry of new firms in the pharmaceutical industry