Perfect Competition Economics

1. Perfect Competition in the Long Run
You got to know when to hold 'em, know when to fold 'em,
Know when to walk away and know when to run.
-Kenny Rogers
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2. Recall the characteristics of
perfect competition
Perfect Competition Monopolistic Competition Oligopoly Duopoly Monopoly
At the absolute end of this spectrum, competition is fierce.
Characteristics of perfect competition:
Product is homogeneous
This means that each producer
makes a very similar product.
Examples include blue crab
fisherman and wheat farmers,
whose good are similar.There are many, many buyers and sellers
and each firm constitutes a very small
fraction of the market
Firms have no control over price
There are no barriers to entry
This means that producers have
no impact on the market. If they
decide not to produce, market
prices don’t change.
Examples include roadside
farmers markets.
This means that producers take
the market price for their goods.
They do not have enough power
to influence it.
Examples include tomato farmers
and fishermen.
This means that anyone can
easily engage in this activity. You
could become a fisherman
tomorrow if you wanted. It
doesn’t mean you’ll succeed, but
you can do it.
Market Structure
Overview
Slide 2 of 19

3. This module: We’ll analyze
perfectly competitive firms in the long run
Perfect Competition Monopolistic Competition Oligopoly Duopoly Monopoly
Perfect
Competition
This is the
topic of the
next
module.
Then we’ll discuss all the firms
in the middle in Module 11.
In this module, we’ll
explore these firms in
the long run.
Slide 3 of 19

4. In the long run…things can change!
In the previous module, we learned how Joe, our
perfectly competitive catfish farmer maximized his
profit in the short run.
Because he was a price taker, he took the price that
the market gave him…that was $131 per unit in our
example.
Over time (in the long run) however, prices can
change (as can many other things).
For example, what if a report came out stating that
catfish was harmful to health? Price would fall.
Slide 4 of 19

5. Let’s look at two scenarios
In the first scenario, we’ll assume that catfish
prices fall drastically…perhaps to $71 per unit.
We can use the MR=MC rule to determine Joe’s
profit maximizing rate of output at that new price
and see what kind of profit Joe will earn.
We can then see if it is worthwhile for Joe to
operate at this lower price. Perhaps he should
just go out of business.
We’ll call that analysis the “Shut Down
Decision”.
Slide 5 of 19

6. Scenario #1: What if prices for
catfish fell to $71?
Recall, Joe was selling catfish at $131 per
bushel.
What if prices fell to $71. What is Joe’s profit
maximizing output
Perfect
Competition
Slide 6 of 19

7. What if prices for catfish fell?
Should Joe shut down?
Using MR>MC would dictate that Joe produce 5 units.
But if Joe produces his profit maximizing rate of output, which
is 5 units, his profit is $-115.
It is cheaper to just shut down and lose the $100 in fixed costs!
Joe Should
Shut Down!
Perfect
Competition
In the second scenario, well
reduce catfish prices to $81
instead of $71 and repeat
the shut down decision
analysis.
Joe definitely does not want to produce the 6th unit…it costs
more (MC=$80) than it brings in (MR=$71).
Slide 7 of 19

8. Scenario 2: What if catfish
prices fell instead to $81
Using MR>MC would dictate that Joe produce 6 units.
At that rate of output, profit is $-64.
That beats losing $100 in the short run! That is
called loss minimization!
What if prices fell to
$81 instead of $71?
Joe Should not
shut down in
the short run!
Perfect
Competition
Slide 8 of 19

9. Do companies really operate
in loss minimization?
Absolutely. They defer maintenance or other costs
just trying to hang in there until things turn around.
Failure to upgrade
Unsanitary
Conditions
Willingness to let
parts of facility
deteriorate
Just look for these signs:
Perfect
Competition
B
Slide 9 of 19

10. It is cheaper for Joe to
shut down.
The shut down decision can
be seen graphically, too
As long as price (which is
MR) is above the AVC, the
perfectly competitive
producer should stay open!
Note the new curve! To
make a shut down
decision, we need to
examine AVC also
Profit
We saw that at a price
of $131, there is clearly
profit for Joe to make!
LossLoss
At his profit maximizing
rate of output (MR=MC
at 9 units) MR is well
above ATC and AVC!
We saw that at a price
of $71,it is time for Joe
to shut down.
At the new profit
maximizing rate of
output (MR=MC at 5
units) MR is below ATC
and AVC!
But at a price of $81, it
was worthwhile for Joe
to stay open in the
short run.
Note that MR>AVC!
At the new profit
maximizing rate of
output (MR=MC at 6
units) MR is above
AVC, but below ATC.
At $81 per unit, Joe
should not shut down in
the short run. He is
engaged in loss
minimization!
Perfect
Competition
Slide 10 of 19

11. 0 Units
-$10
Shutdown
No
Individual Exercise: Give the shut
down decision a try!
Try filling out these blank cells and then
answering the questions below..
Perfect
Competition
Slide 11 of 19

12. Perfect Competition
from the industry perspective
So far, we have
talked about an
individual firm’s
perspective.
But remember that all
firms collectively become
the supply side of the
market.
Perfect
Competition
Slide 12 of 19

13. In perfect competition, there is a constant
churn of firms entering and exiting the market
In cases where there are no profits to be
made, firms go our of business.
In cases where there are profits being
made, firms enter the industry to compete.
Perfect
Competition
Slide 13 of 19

14. Also recall that individual supply decisions
collectively add up to the market supply
Each individual determines their own supply.
Those individual supply curves are added
together to get a market supply curve
Perfect
Competition
Slide 14 of 19

15. Firm entry and exit affects
the overall market
Imagine this
represents a
market where
perfectly
competitive firms
are making
profits.
As other
business people
see profits being
made in this
industry, they
open a
business and
compete.
With more
suppliers, the
supply curve
shifts right.
As more
business people
enter the
market, the
supply curve
moves right
even further.
Perfect
Competition
Slide 15 of 19

16. Where there are profits, firms
enter and drive prices down
Imagine the graph on the left represents a perfectly
competitive market and the graph on the right represents cost
and revenue curves for the typical firm in that industry.
Given that there are profits being made, new entrants in the
market are lured in. They want to compete in this market to
earn some of the profits.
The entry of new business shifts the market supply curve right
and drives prices down. However, there are still profits being
made, which will attract more entrants.
New firms will continue to enter this market until price reaches
the lowest point on the Average Total Cost curve. With no
profit to be made, no new firms enter and this industry is in
equilibrium.
Perfect
Competition
Market for Wheat Individual Wheat Producer
Slide 16 of 19

17. As consumers, we love
perfect competition
We as consumers love perfect competition. It
provides a mechanism that causes prices to find
the lowest point on the ATC.
In other words, we get these goods for as low a price as
they can possibly be produced.
Perfect
Competition
Slide 17 of 19

18. A summary of perfect
competition in the long run
Perfect
Competition
The existence of economic
profits lures firms to enter.
The existence of economic
losses induces firms to exit.
This churning process of firms constantly entering and exiting the market, like
the tide of an ocean, is a characteristic of perfect competition
Slide 18 of 19

19. Churn in perfectly a competitive industry
Here’s a headline and excerpt from a recent article
Note the churning process and the constant drive to finds
ways to produce at a lower price.
Keeping Dairy Cows on Pasture
Lowers Cost of Milk
Small dairy farmers are going
bankrupt by the thousands, largely
due to declining milk prices.
Keeping the cost of production low
is one of the keys to staying
solvent.
Perfect
Competition
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