8- 1

Perfect

Competition

• Michael J. Murray

Slides and Images, © Worth Publishers Inc.

8- 2

Market Structure Analysis

By observing a few industry characteristics,

we can predict pricing and output behavior

of the firm.

These factors are important:

• Number of firms

• Nature of product

• Barriers to entry

• Extent of control over price

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Primary Market Structures

1. Competition

2. Monopolistic Competition

3. Oligopoly

4. Monopoly

8- 4

Competitive Markets

Characteristics of Competitive

Markets:

• Many buyers and sellers

• Homogeneous (standardized)

products

• No barriers to market entry or exit

• No long-run economic profits

• No control over price

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Monopolistic Competition

Characteristics of Monopolistic

Competition:

• Many buyers and sellers

• Differentiated products

• No barriers to market entry or exit

• No long-run economic profits

• Some control over price

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Oligopoly

• Characteristics of Oligopoly:

• Fewer firms

• Mutually interdependent decisions

• Substantial barriers to entry

• Potential for long-run economic

profits

• Shared market power and

considerable control over price

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Monopoly

• Characteristics of Monopoly:

• One firm

• No close substitutes for product

• Nearly insuperable barriers to entry

• Potential for long-run economic

profits

• Substantial market power and

control over price

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Competitive Markets

In a competitive market, each firm

is a price taker.

• Price taker: Individual firms in

competitive markets get their prices from

the market since they are so small they

cannot influence market price.

Each firm’s total revenue will be

equal to

price x quantity sold = (PxQ)

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Marginal Revenue

Marginal revenue: change in total

revenue that results from the sale

of one added unit of a product.

• Reminder: Total revenue = P x Q

• MR = DTR/DQ

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A Firm in a Competitive Market

D

S

Industry Output Firm’s Output

Pri

ce (

$)

Pri

ce (

$)

Panel A

(Industry)

Panel B

(Firm)

200 200

Qe

d=MR=P=$200

q1 q2

The individual firm takes the market price as given.

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The Short Run and the Long Run

Reminder: in the short run, plant

size is fixed…

We focus here on short-run profit

maximization (at a given plant size)

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The Profit-Maximizing Rule

• A firm maximizes profit by producing

at the point where marginal revenue

equals marginal cost (MR = MC) • If a firm is earning zero economic profits at this

point, it means that it is earning a normal rate of

accounting profit.

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Economic Profits

MC

ATC

AVC

d=MR=P=$200 200

180

Co

sts

($)

Output 84

Profit

Profit = (P – ATC) x Quantity

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The Short Run and the Long Run

In the short run, one factor of

production is fixed, usually the plant

size. • Firms cannot enter or leave the industry.

• In the long run, all factors are variable. • Firms will enter the industry in response to

profits.

• Firms will leave the industry in response to

losses.

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Normal Profits

MC

ATC

AVC PL

Co

sts

($)

Output

d=MR=P=$177.60

200

180

75

The firm earns zero economic profit. This is a normal rate of return.

Normal profits: equal to zero economic profits, where P = ATC

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Loss Minimization

If price falls below average total cost,

the firm will incur a loss.

The firm can minimize the loss by

following this rule: • Continue to produce (in the short run) as long

as price covers average variable cost.

• Shut down in the short run if price falls below

average variable cost.

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Loss Minimization

MC

ATC

AVC

d=MR=P=$170

$177.85

$170

Co

sts

($)

Output 65

Loss

Loss = Negative Profit = (P – ATC) x Quantity= -$510.25

If price falls to $170…

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Shutdown rule: when the price falls below minimum AVC,

firm should shut down immediately.

When to Shut Down?

MC

ATC

AVC

d=MR=P=$162.50 $162.50

Co

sts

($)

Output 65

Loss

Losses begin to exceed fixed costs. The firm will do better

to close down and limit losses to fixed costs.

If price falls below $162.50

(minimum AVC)…

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Short-Run Supply Curve The firm’s short-run supply curve is its

marginal cost curve above the

minimum point on the average variable

cost curve.

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Long Run Adjustments

• If firms in the industry are earning short run

economic profits, new firms can be

expected to enter the industry in the long

run, or existing firms may increase the

scale of their operations.

• Losses will lead to the exit of some firms.

• Final equilibrium in the long run is the point

at which industry price is just tangent to the

minimum point on the ATC curve.

• P = MR = MC = LRATCmin

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Profit

Economic profits attract more

supply…

D

S0

Industry Output

Pri

ce (

$)

Panel A

(Industry)

P0

Q0

S1

P1

QL

MC

ATC

AVC

P1

Co

sts

($

)

Firm’s Output

P0

Panel B

(Firm)

As long as there are above-normal profits, industry supply

increases and market price falls. Profits decline toward zero

economic profits.

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Losses cause firms to exit

Supply decreases, price rises and profits must rise

(or losses must decrease).

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Competition and the Public

Interest

The long-run outcome in

competitive markets will have:

• Productive Efficiency: Goods are

supplied at the lowest possible

opportunity cost.

• Allocative Efficiency: The mix of goods

and services produced are just what

society desires. The price that consumers

pay is equal to marginal cost and is also

equal to the least average total cost.

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Long Run Industry Supply

Long run industry supply:

•How much does the expansion of an

industry influence resource prices?

•When an industry expands, this new

demand for raw materials and labor

may push up the price of some inputs.

•Increasing cost industry: an industry that

faces higher prices and costs as industry

output expands.

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Constant Cost Industries

• Constant cost industries: expand in

the long run without significant

changes in average cost.

• Some fast food restaurants re-create

their operations from market to market

without a noticeable rise in costs.

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Increasing Cost Industries

• Increasing cost industry: An

industry that experiences higher

costs as it expands.

• Examples?

• Oil industry

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Increasing, Constant, and

Decreasing Cost Industries