CI-Microeconomics-Ch9-Slides-2015.pptx

CHAPTER 9
PERFECT COMPETITION
Microeconomics
Curtis & Irvine, 2015

Learning Outcomes
By the end of this chapter you should understand…
• The nature of the competitive marketplace
• The firm’s supply decision
• Industry supply
• Dynamics: entry and exit of firms in the long run
• Industry supply in the long run
• Globalization and technological change
• Perfect competition and market efficiency
©Microeconomics, Curtis & Irvine, 2015

The Perfectly Competitive Market Place
• A perfectly competitive industry is one in which
many suppliers, producing an identical product,
face many buyers, and no one participant can
have an impact on market price
• Firms maximize profit — the difference between
total revenue and total cost
• Free entry and exit of firms – this is critical
• Buyers and sellers have full information

Critical Feature of Competition
• An important implication is that no one firm can have an
impact on market price by altering its own price or its own
output level
• Called price-taking behaviour
• Not an assumption, but a result
• In other words, the firm can sell as little or as much output as it
could possibly produce at the going market price

Critical Feature (cont.)
• Graphically, it means that the demand curve facing the
individual firm is horizontal at the going market price
• Note that in perfectly competitive markets, there are two demand
curves
• One facing the firm
• One facing the market
• The firm’s demand curve is infinitely elastic

The Competitive Firm’s Optimal Output
Demand Facing
Individual Firm
MC
Suboptimal –
too little q1
Optimum
q0
Suboptimal –
too much q2
P0
Price
Quantity

Firm’s Supply Decision
• Marginal revenue (MR) is the additional revenue obtained by the
firm from selling one more unit of output
• It is the change in total revenue (TR) resulting from a unit
change in output
• MR = Δ TR / Δ Q
• In perfectly competitive markets, and only in this case, P = MR
• If P > AVC, firm can cover its variable costs
• If the firm has sunk its fixed costs, it should stay in production
even if it cannot cover all of its costs

Short-Run Supply for the Competitive Firm
q1 q2
P1
Price
Quantity
Below P1, firm should shut down
P2 Cover the variable, not the total costs
q3
P3 Break-even Point
P4
Above P3, firm makes profits
MC
ATC
AVC
Short-run supply curve is MC
above the shut down point

Life and Death in the Short Run: Sunk Costs
• If the firm cannot make a profit, should it shut
down?
• If it can cover its variable costs, having already
sunk its fixed costs, it should stay in production
•
• Hence its supply curve is that part of MC above
AVC

Snowboard Profit Maximization
L Q TR
0 0 0
1 15 1050
2 40 2800
3 70 4900
4 110 7700
5 145 10150
6 175 12250
7 200 14000
8 220 15400
9 235 16450
10 240 16800
TC
4000
5000
6000
7000
8000
9000
10000
11000
12000
13000
ATC
266.7
125.5
85.8
63.6
55.2
51.4
50
50
51.1
54.2
AVC
66.7
50
42.9
36.4
34.5
34.3
35
36.4
38.3
41.7
MC
66.7
40
33.3
25.0
28.6
33.3
40.0
50.0
66.7
200
Production
Decision
No Production
Where
P < min AVC
Shut Down
Price covers AVC
Profit where
P > min of ATC.
Q determined
By P = MC

Industry Supply in the Short Run
SB = MCB
P2
Price
Quantity
SA = MCA
P1
•SA + SB = Industry
Supply.
•In general, industry
supply is horizontal sum of
all individual supplies
With P < P1
neither supplier
supplies
With P > P2
both suppliers
supply
Market supply = SA
between P1 and P2
Market supply =
SA + SB above P2

Industry Dynamics: Entry and Exit of Firms
• Normal Profits
• Reflect the opportunity cost of production
• Firms do not operate in the long run if they cannot make normal
profits
• Supernormal/Economic Profits
• Profits above normal profits that induce firms to enter an industry.
Implies P > ATC
• Long-run equilibrium
• P = minimum ATC

Industry Dynamics: Entry and Exit of Firms
• Consider the following adjustment from a short-run
equilibrium to a long-run equilibrium
• Always have 2 graphs: one for the market and one for the
firm

Market Equilibrium
Market S = sum of
firms’ MC curves
QE
PE
Price
Quantity
Market D = sum of
individual demands
Market equilibrium
Consequences for the individual/representative firm…..

Firm’s Profit Maximizing Behavior
Price
Quantity
h
qE is the firm’s
optimal output
PE derives
from the
industry S/D
PE
MC
ATC
AVC
Profit
Profits are a signal for new firms
to enter – remember our
assumption on freedom of entry
m
k
Total profit = qE × (PE – ATC)

Entry of Firms due to Supernormal Profits
S
QE
Profits exist
when the
price is PE
Price
Quantity
D
S’ = Sum of new and
existing firms’ MC
Q’
P’
The equilibrium
price falls with the
entry of firms
Now, what happens at the firm level?

Short-run and Long-run Dynamics
• Market supply expands, price declines and profits are reduced
• When economic profits are fully competed away, there is no incentive
for further entry – it is positive economic profits that induce entry
• Thus, in the long-run, perfect competition ensures that economic
profits are zero – normal profits remain however
• Where are normal profits in our functions and graphs?
• Answer: in the cost curves – they are an essential component of
activity; without them supply would not be forthcoming. We might
think of them as a fixed cost or as a variable cost that reflects the
opportunity cost of the resources involved

Long-run Industry Supply
• The LR industry supply is horizontal at the price corresponding to the
minimum of a typical firm’s LR average cost curve
Why?
• Free entry ensures that LR economic profits will be zero
• If some firms produce at a low cost and others at a higher cost, the latter
will not survive in the long run
• Only those suppliers choosing the least cost production will survive
• This least cost method involves producing at a point where the AC is
minimal in the long run – i.e. the min of the LRAC
• With zero economic profits this least cost must also be the price
Illustrated….

Long-Run Industry Supply
Initial zero-profit
equilibrium PE
Quantity
S1= Initial SR supply
P2
D1
SL
Q1
D2
Q2
S2: the SR supply curve
after entry has competed
away economic profits
D3: Demand decline
resulting in losses
Q3
P3
Equilibrium Long-Run Price =
Minimum of Long-Run ATC =
Long-Run Supply Curve
S3: SR supply curve
after exit restores
economic profits
D increase causes economic
profits, which induces firm entry

Increasing and Decreasing Cost Industries
$
Industry Output
Constant-cost LR
industry supply curve
Increasing-cost LR
Decreasing-cost LR
When the costs of individual suppliers rise (fall) as the output of the
industry increases, we have an increasing (decreasing) cost industry.
Increasing cost example: landings at a major airport
In terms of the firm’s LAC: additional suppliers cause it to shift up or down
Think of
input costs
depending
on the
number of
participants

Globalization and Technological Change
• The reduction in costs associated with globalization has effectively
increased the minimum efficient scale for many industries
• Globalization has also eliminated many traditional industries
• Globalization also reduces the cost of components

Efficient Resource Allocation under
Perfect Competition
• Perfect Competition may represent an efficient market structure
• It results in resources being used up to the point where the demand
and supply values are equal
• If these curves represent true costs and benefits then the
equilibrium is efficient
• If it is efficient it maximizes the sum of consumer and producer
surpluses

Chapter Summary
• In a competitive market, each buyer and seller is a price taker, for a
homogeneous product
• There must be free entry & exit, full information and very many
participants
• For a competitive firm, price is equal to its marginal revenue
• Profit maximization dictates an output where MC = MR
• A firm’s supply curve is that part of its marginal cost curve above the
minimum point of its AVC curve
• The industry supply curve in the short run is the horizontal sum of the
supply curves of the firms.

Chapter Summary
• A long-run equilibrium in a competitive industry requires a price equal to
the minimum point of a firm’s long-run ATC - its breakeven point
• All firms must produce using such a plant size, otherwise they cannot
compete
• In the long run, shifts in demand are met by changes in the number of
firms in an industry
• Increasing and decreasing cost industries
• Technological change and globalization have resulted in reduced
supplier costs
• Perfect competition can result in an efficient resource allocation, provided
private costs reflect social costs

CI-Microeconomics-Ch9-Slides-2015.pptx

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