perfect competition 11 chapter. objectives after studying this chapter, you will able to define...

PERFECT COMPETITION

11

CHAPTER

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

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.

Competition

How Perfect Competition Arises

Perfect competition arises:

When firm’s 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 don’t care which firm they buy from.

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 price—it must “take” the equilibrium market price.

Each firm’s output is a perfect substitute for the output of the other firms, so the demand for each firm’s output is perfectly elastic.

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 firm’s total revenue equals price, P, multiplied by quantity sold, Q, or P Q.

Competition

A firm’s marginal revenue is the change in total revenue that results from a one-unit increase in the quantity sold.

Figure 11.1 illustrates a firm’s revenue curves.

Competition

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

Competition

Figure 11.1(b) shows the demand curve for the firm’s product, which is also its marginal revenue curve.

Competition

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

Competition

Figure 11.1(c) shows the firm’s total revenue curve.

The Firm’s Decisions in Perfect Competition

A perfectly competitive firm faces two constraints:

A market constraint summarized by the market price and the firm’s revenue curves

A technology constraint summarized by firm’s product curves and cost curves (like those in Chapter 10).


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 firm’s long-run decisions are:

Whether to increase or decrease its plant size.

Whether to stay in the industry or leave it.


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 firm’s the total revenue and total cost curves.

Figure 11.2 on the next slide looks at these curves along with the firm’s total profit curve.


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).


Profit is maximized when the firm produces 9 sweaters a day.

At low output levels, the firm incurs an economic loss—it can’t cover its fixed costs.


At intermediate output levels, the firm earns an economic profit.

At high output levels, the firm again incurs an economic loss—now it faces steeply rising costs because of diminishing returns.


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.


If MR > MC, economic profit increases if output increases.

If MR < MC, economic profit decreases if output increases.

If MR = MC, economic profit decreases if output changes in either direction, so economic profit is maximized.


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 firm’s 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.


In part (a) price equals ATC and the firm earns zero economic profit (normal profit).


In part (b), price exceeds ATC and the firm earns a positive economic profit.


In part (c) price is less than ATC and the firm incurs an economic loss—economic profit is negative and the firm does not even earn normal profit.


The Firm’s Short-Run Supply CurveA perfectly competitive firm’s short run supply curve shows how the firm’s 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 firm’s supply curve is linked to its marginal cost curve.

But there is a price below which the firm produces nothing and shuts down temporarily.


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.


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.


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.


Figure 11.5 shows how the firm’s 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.


If the price is $25, the firm produces 9 sweaters a day, the quantity at which P = MC.

The blue curve in part (b) traces the firm’s short-run supply curve.

If the price is $31, the firm produces 10 sweaters a day, the quantity at which P = MC.


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.


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.


At a price equal to minimum average variable cost—the shutdown price—the industry supply curve is perfectly elastic because some firms will produce the shutdown quantity and others will produces zero.

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.


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.


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


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.


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.


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.


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.


If the price is $25, firms earn zero economic profit with the current plant.


But if the LRAC curve is sloping downward at the current output, the firm can increase profit by expanding the plant.


As the plant size increases, short-run supply increases, the price falls, and economic profit decreases.


Long-run equilibrium occurs when the firm is producing at the minimum long-run average cost and earning zero economic profit.


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 don’t change their plant size.

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.


Starting from a position of long-run equilibrium, the fall in price puts the price below each firm’s minimum average total cost and firms incur an economic loss.


Economic losses induce exit, which decreases short-run supply and shifts the short-run industry supply curve leftward.


As industry supply decreases, the price rises and the market quantity continues to decrease.


With a rising price, each firm that remains in the industry increases production in a movement along the firm’s marginal cost curve (short-run supply curve).


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.


The main difference between the initial and new long-run equilibrium is the number of firms in the industry.


In the new equilibrium, a smaller number of firms produce the equilibrium quantity.


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.


With a falling price, each firm decreases production in a movement along the firm’s 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.


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 firm’s costs as the industry output increases.

External diseconomies are factors beyond the control of a firm that raise the firm’s costs as industry output increases.


In the absence of external economies or external diseconomies, a firm’s 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.


Figure 11.11(a) shows that in the absence of external economies or external diseconomies, the price remains constant when demand increases.


Figure 11.11(b) shows that when external diseconomies are present, the price rises when demand increases.


Figure 11.11(c) shows that when external economies are present, the price falls when demand increases.


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 cost—firms’ cost curves shift downward.

Firms that adopt the new technology earn an economic profit.


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.


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.

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.


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 consumer’s 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.


We derive a competitive firm’s 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.


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.


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*.


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.


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.

THE END

perfect competition 11 chapter. objectives after studying this chapter, you will able to define...

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