Perfect competition is characterized by many small firms, homogeneous products, perfect information and free entry and exit. Under perfect competition in the short-run, firms are price takers and maximize profits by producing where marginal revenue equals marginal cost. In long-run equilibrium, firms earn zero economic profit as entry and exit cause supply to equal minimum average total cost. Perfect competition leads to productive and allocative efficiency.

1. Chapter 8
Perfect Competition

2. Perfect Competition
• What is a market structure anyways?
– Def: A market structure describes the key traits of
a market, including the number of firms, the
similarity of the products they sell, and the ease of
entry into and exit from the market.
– The most competitive of the market structures is
“perfect competition.”

3. http://
www.youtube.com/watch?v=9Hxy-TuX9fs&

4. Characteristics of Perfect Competition
• Three Characteristics:
– Many buyers and sellers
– A standardized (or homogenous) product
– Buyers and sellers are fully informed about the
price and availability of all resources and products
– Firms and resources are freely mobile- easy entry
or exit from the market
• No patents, licenses, and no high capital costs.

5. What do these characteristics mean?
• If these conditions exist in a market, an individual
buyer or seller has no control over the price.
• Price is determined by market demand and
supply.
– Once the market establishes price, then a firm is free
to supply whatever quantity that maximizes profit.
– A perfectly competitive firm is so small relative to the
market that the firm’s supply decision does not affect
the market price.

6. Does Perfect Competition Really Exist in the
Real-World?
• Examples of Perfectly Competitive Markets.
– Agricultural products- wheat, corn, livestock
– In the U.S., 75,000 farmers raise hogs, and tens of
millions of U.S. households buy pork products

7. Why is Perfect Competition Important
• The model of perfect competition allows us to
make a number of predictions that hold up
pretty well when compared to the real world.
• It is also an important benchmark for
evaluating the efficiency of other types of
markets.

8. Demand Under Perfect Competition
• Market price
– Where supply and demand are equal
• Demand curve for one supplier
– Horizontal
– Perfectly elastic
• Price taker

9. The Perfectly Competitive Firm as Price
Taker
• Def: A price taker is a seller that has no
control over the price of the product it sells.
– What does it mean to be a price taker?
– Take it or leave it

10. Market Equilibrium and a Firm’s Demand
Curve in Perfect Competition
(a) Market equilibrium (b) Firm’s demand
S
Price per bushel
Price per bushel
$5 $5 d
D
0 1,200,000 Bushels of 0 5 10 15 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 the market price.

11. Short-Run Profit Maximization for a
Perfectly Competitive Firm
• We now know that the perfectly competitive
(PC) firm has no control over price. So, what
can it control? How can it make a profit?
– The PC firm makes ONE decision- What quantity of
output to produce that maximizes profit? How
much should I produce to earn the most profit?
– Two methods of finding this profit
• TR-TC, where TC includes implicit and explicit costs.
• MR=MC

12. The Total Revenue (TR)- Total Costs (TC)
Method
• Using the total revenue - total cost method, where
should a firm produce?
– Where the distance between TR and TC is the
greatest (i.e. where profit is the greatest)

13. EXAMPLE OF FINDING PROFIT
EXAMPLE OF FINDING PROFIT

14. The Marginal Revenue Equals Marginal
Cost Method
• Remember that the Marginal Cost is the change in total
cost as the output level changes one unit.
• So, now we need to introduce marginal revenue (MR),
this concept is very similar to marginal cost.
– Def: Marginal revenue is the change in total revenue
from the sale of one additional unit
change in TR
MR =
change in output

15. Short-Run Cost and Revenue for a
Perfectly Competitive Firm

16. Total cost Total revenue Short-Run Profit
(=$5 × q)
$60 Maximization
Total dollars
Maximum economic
48
profit = $12 (a) Total revenue minus
total cost
15 TR: straight line, slope=5=P
TC increases with output
Bushels of wheat per day Max Economic profit:
0 5 7 10 12 15
where TR exceeds TC by
Marginal cost the greatest amount
Dollars per bushel
Average total cost
e
$5 d = Marginal revenue (b) Marginal cost equals
Profit
4 = Average revenue marginal revenue
a MR: horizontal line at P=$5
Max Economic profit:
at 12 bushels,
Bushels of wheat per day where MR=MC
0 5 7 10 12 15

17. Important Points
• Remember that the demand curve for a
perfectly competitive firm is horizontal.
• In a perfectly competitive firm, P=MR
• MC curve will have a J-Shaped curve
• The firm maximizes profit by producing the
output where marginal revenue equals
marginal cost (MR=MC).

18. MR=MC Method
• Why should a firm continue to produce as
long as MR > MC?
• Why should a firm continue to produce as
long as MR < MC?

19. Why does P=AR=MR=Demand Curve
• P=AR(average revenue)
• P=MR

20. Total cost Total revenue Short-Run Profit
(=$5 × q)
$60 Maximization
Total dollars
Maximum economic
48
profit = $12 (a) Total revenue minus
total cost
15 TR: straight line, slope=5=P
TC increases with output
Bushels of wheat per day Max Economic profit:
0 5 7 10 12 15
where TR exceeds TC by
Marginal cost the greatest amount
Dollars per bushel
Average total cost
e
$5 d = Marginal revenue (b) Marginal cost equals
Profit
4 = Average revenue marginal revenue
a MR: horizontal line at P=$5
Max Economic profit:
at 12 bushels,
Bushels of wheat per day where MR=MC
0 5 7 10 12 15

21. A Perfectly Competitive Firm Facing a
Short-Run Losses
If market conditions cause the price to fall, then
the firm could experience losses in the short-run.
When this occurs, then there is NO level of
output that the firm could produce to earn a
profit
What should they do?
Firms will continue to operate at these losses for a
short-time.
They will operate at this loss when the price is high
enough to cover average variable cost, but not
average total cost.

22. Example of Minimizing Losses
Example of Minimizing Losses

23. Minimizing Short-Run Losses

24. Total cost Total revenue
(=$3 × q)
Short-Run Loss
Minimization
Total dollars
$40
30 Minimum economic (a) Total revenue minus
loss = $10
total cost
15
TC>TR; loss
Bushels of wheat per day Minimize loss: 10
0 5 10 15 bushels
Marginal cost Average total cost
Dollars per bushel
(b) Marginal cost equals
Average variable cost
$4.00 marginal revenue
Loss e
3.00 d = Marginal revenue MR=MC=$3; ATC=$4
2.50 = Average revenue P=$3; P>AVC
Continue to produce
Bushels of wheat per day in short run
0 5 10 15

25. A Perfectly Competitive Firm Facing
Shut-Down
• What if the price drops below AVC?
– If the price drops below AVC then the firm will
shut-down.
– The firm is better off to shut-down and produce
no output.

26. Example of Shut-Down
Example of Shut-Down

27. http://www.youtube.com/watch?v=61GCogalzVc

28. The Perfectly Competitive Firm’s Short-
Run Supply Curve
• We are going to now develop the S-R supply
curve for the individual firm.
• The perfectly competitive firms’ S-R supply
curve is its marginal cost curve above the
minimum point on its average variable cost
curve.
• Why is it above the AVC curve?

29. Summary of Short-Run Output Decisions
Break-even
point Marginal cost Firm’s short-run S curve
5
p5 d5 p5>ATC, q5, economic profit
Average total cost
4
Dollars per unit
p4 d4 p4=ATC, q4, normal profit
Average variable cost
3
p3 d3 ATC>p3>AVC, q3, loss <FC
2
p2 d2 p2=AVC, q2 or 0, loss=FC
p1 1 d1 p1<AVC, shut down,
Shutdown
q1=0,loss=FC
0 point
q1 q2 q3 q4 q5 Quantity per period

30. The Perfectly Competitive Industry’s S-R
Supply Curve
• Now, we are going to derive the industry’s S-R
supply curve.
– The perfectly competitive industry’s S-R supply
curve is the horizontal summation of the MC
curves of all firms in the industry above the
minimum point of each firm’s AVC curve.

31. Aggregating Individual Supply to Form
Market Supply
(a) Firm A (b) Firm B (c) Firm C (d) Industry, or market, supply
SA SB SC
Price per unit
SA + SB + SC = S
p’ p’ p’ p’
p p p p
0 10 20 0 10 20 0 10 20 0 30 60
Quantity Quantity Quantity Quantity per period
per period per period per period

32. Short-Run Profit Maximization and Market Equilibrium
Market price $5 determines the S = horizontal sum of the supply
perfectly elastic demand curve (and curves of all firms in the industry
MR) facing the individual firm. Intersection of S and D: market price
$5

33. L-R Equilibrium for a Perfectly Competitive
Firm
• In the L-R, all inputs are variable.
• If there are economic profits, then new firms
enter, shifting the S-R industry supply curve to
the right, causing price to fall until the profits
are zero.
• But if there are economic losses, existing firms
leave, shifting the S-R industry supply curve to
the left, and prices rise to the point where
economic profit is zero.

34. L-R Conclusions
• P=MR=SRMC=SRATC=LRAC
• If these variables do not change, then the
firms have no reason to change output levels.

35. Long-Run Equilibrium for a Firm and the Industry
(a) Firm (b) Industry or market
MC S
Dollars per unit
Price per unit
ATC
LRAC
e
p d p
D
Quantity Quantity
0 q per period 0 Q
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 produce a total of Q units of output at
price p.

36. Example of Long-Run Adjustment to
Example of Long-Run Adjustment to
a Change in Demand
a Change in Demand

37. Long-Run Adjustment to an Increase in Demand
(a) Firm (b) Industry or market
MC S S’
Dollars per unit
d’ b
Price per unit
p’ p’
Profit ATC
LRAC
a
p d p c S*
D’
D
Quantity Quantity
0 q q’ per period 0 Qa Qb Qc
per period
Increase in D to D’ moves the market Long run: new firms enter the
equilibrium point from a to b; firm’s demand industry; supply increases to S’; price
increases to d’; economic profit in short run. drops back to p; firm’s demand drops
back to d.

38. The Long-Run Industry Supply
Curve
• The long-run industry supply curve shows the
relationship between price and quantity
supplied once firms fully adjust to any short-
term economic profit of loss resulting from a
change in demand.

39. Constant-Cost Industries
• Each firm’s long-run average cost curve does not
shift up or down as industry output changes.
• Each firm’s per-unit costs are independent of the
number of firms in the industry.
• Thus, the long-run supply curve for a constant-
cost industry is horizontal.
• It uses such a small portion of the resources
available that increasing output does not bid up
resource prices.
– Example: Pencil Market

40. Increasing-Cost Industries
• This occurs when the expanding output bids
up the prices of resources or otherwise
increases per-unit production costs, and these
higher costs shift up each firm’s cost curves.
• Example
– The expansion of oil production could bid up the
prices of drilling rigs.

41. An Increasing-Cost Industry
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 down to dc; normal
profit.

42. Perfect Competition
and Efficiency
 Productive efficiency: Making Stuff Right
 Produce output at the least possible cost
 Min point on LRAC curve
 P = min average cost in long run
 Allocative efficiency: Making the Right Stuff
 Produce output that consumers value most
 Marginal benefit = P = Marginal cost
 Allocative efficient market
7

43. What’s So Perfect About
Perfect Competition?
 Consumer surplus
 Consumers pay less price than they are willing to
pay (along Demand curve)
 Producer surplus
 Producers are willing to accept less (along
Supply curve; MC) than what they are receiving
(the market price)
 Gains from voluntary exchange
 Consumer and producer surplus
 Productive and allocative efficiency
 Maximum social welfare
 The overall well-being of people in the
economy.
 The surplus (or bonus) from the market
exchange that the sellers and buyers receive.

44. LO7 Exhibit 13
Consumer Surplus and Producer Surplus
for a Competitive Market
Dollars per unit
Consumer surplus: area above the
S
market-clearing price ($10) and
below the demand.
Consumer
surplus e Producer surplus: area above the
$10
Producer short-run market supply curve and
surplus below the market-clearing price
6 D
5
m At p=$5: no producer surplus; the
price just covers each firms AVC.
At p=$6: producer surplus is the
Quantity
0 100,000 200,000 area between $5, $6, and S curve.
120,000 per period