The document summarizes the key concepts of perfect competition in the short run and long run. In the short run, firms take the market price as given and produce where marginal cost equals marginal revenue to maximize profits. In the long run, if firms earn profits, more will enter the industry, increasing supply and driving prices down until profits are zero and the industry reaches long run equilibrium.

1. Perfect Competition

2. Outline
I. Introduction
II. Perfect Competition in the Short-Run
A. Demand
B. Supply
C. Profit Maximization

3. Introduction
• Characteristics of Perfect Competition
• Large number of buyers and sellers.
• Firms sell identical product.
• No barriers to entry or exit.
• Buyers and sellers have perfect information
• Perfect Comp. is our "Benchmark" Model
– meaning it is not very realistic, but will be used
to compare with more realistic models

4. Firm's Demand Curve
• Consumer Price Taking
• Take market price as given and purchase
according to their demand curve.
• Firms
• Because a firm makes the same thing as so
many other firms, if an individual firm changes
their price, they will lose ALL of their business.
So they have to sell the product at the market
price. Note that they can sell as much as they
want at that price

5. Firm’s Demand Curve
$
p* D
0 Q

6. Firm's Horizontal Demand Curve
• At P > p*, Sales = 0
• At P < p*, Less Profits then if Sell at p*
• p* found from Market Equilibrium Price

7. Market Demand Curve
• Downward Sloping
• Obeys Law of Demand

8. Marginal Revenue
• Marginal Revenue is the increase in
revenue from selling one more unit
• If the firm gets price p* for every unit it
sells, then p* is the marginal revenue at all
quantities.
• MR = ∆ in TR
∆ in Q
• Horizontal Demand Curve means MR = P

9. Profit Maximization
• We assume that the firm is profit
maximizing.
• Profit = Total Revenue - Total Cost
• Total Revenue is P*Q.
• We know what the Total Cost curve looks
like, so let’s graph both

10. Total Revenue and Total Cost
TR
$ TC
Q

11. Profit Maximizing
• Since the perfectly competitive firm cannot
choose the price, the only choice left for the
firm is to choose how much to produce.
• The firm will choose the quantity where
TR-TC is the largest, in other words - where
the difference between the TR and TC
curves is the biggest

12. Total Revenue and Total Cost
TR
$ TC
Q* Q

13. Profit Maximizing
• Note that the slope of the TR and TC curves
are the same at this quantity.
• This means the the derivative of TR is the
same as the derivative of TC at Q*.
• There is a way we can find Q* without
calculus, though.
• We will need to graph the MR and MC
curves

14. Profit Max without Calculus
$
MC
MR
Q1 Q2 Q3Q4 Q

15. Profit Maximizing
• Consider the quantity Q1 in the previous
graph
• At that quantity MR>MC, meaning that the
additional revenue from selling one more is
greater than the cost of making one more.
• This means the firm will make more profit
by making one more, so they will
• The same is true at Q2

16. Profit Maximizing
• But at Q3, MR=MC, meaning that the firm
will gewt exactly as much money from
selling one more as it cost them to make
one more.
• So the firm has no interest in making one
more

17. Profit Maximizing
• And at Q4, MR<MC, meaning that it costs
more to make one more than it will bring in
when it is sold. This means the firm will
lose money.
• So the firm would want to decrease
production to bring MC down

18. The Golden Rule
• A profit maximizing firm will always
produce where MC=MR.
• In the case of Perfect Competition, we
know MR=P, so we could also say that a
profit maximizing firm produces where
P=MC.

19. Firm’s Supply Curve
• In other words, given a price, the firm looks
to the MC curve and produces that quantity.
This is a supply curve. The Perfectly
Competitive firm’s MC curve (the upward
sloping portion of it, at least) is its Supply
Curve

20. Profit
• We can also determine exactly how much
profit the firm is making.
• We know profit = total revenue - total cost
• Since ATC=TC/Q, we know ATC*Q=Total
Cost
• We also knoe that total revenue = price*Q
• So Profit=(p*Q)-(ATC*Q)=(p-ATC)*Q, or
graphically...

21. Profit
p MC
ATC
p* MR
AVC
atc
Q* Q

22. Profit
p MC
ATC
p* MR
The Area of this AVC
Rectangle is the Profit
atc
Q* Q

23. Loss
• Note that as long as p>ATC at q*, there will
be a profit.
• But it may be possible that no matter how
much is produced, the firm will still lose
money
• In this case the Q* is the quantity where the
firm loses the least amount of money
• For example...

24. Loss
p MC
ATC
AVC
atc
p* MR
Q* Q

25. Loss
p MC
ATC
AVC
atc The area is
the loss
p* MR
Q* Q

26. The decision of whether to stay
open
• Just because a firm is losing money in the
short run doesn’t mean it should close its
doors. Often we hear of major firms like
IBM posting a loss, but they stay open
• When does a firm shut down?
• Break Even Point - P = ATC
• Firm is earning normal profits.

27. The decision of whether to stay
open
• If AVC<P*<ATC, then the firm is losing
money, BUT they are getting enough
revenue to pay all of the variable cost and
some of the fixed cost. If they shut down,
they will have to pay all of the fixed cost
with no revenue. So they are better off
staying open and being able to pay some of
the fixed costs than shutting down and not
being able to pay ALL of the fixed cost.

28. The Shut Down Point
• Shut-down Point - P = min AVC
• Firm is indifferent between staying in business
and going out of business.
• Firm Supply Curve
• MC curve at or above the Shut-down Point

29. Market Supply
• Sum of Individual Firm's Supply Curves
• Upward Sloping - Obeys Law of Supply

30. Profit Maximizing in the Short
Run
• In the short run, the firm takes the market
price, given by the intersection of the
market supply and demand curves.
• The firm then produces where MC=MR and
takes a profit or loss as long as P>AVC

31. Profit Maximizing in Short Run
P P S
D
Firm
Q Market Q

32. Profit Maximizing in Short Run
P P S
p*
D
Firm
Q Market Q

33. Profit Maximizing in Short Run
P P S
MR
p*
D
Firm
Q Market Q

34. Profit Maximizing in Short Run
P MC P S
MR
p*
D
Firm
Q Market Q

35. Profit Maximizing in Short Run
P MC P S
MR
p*
ATC
D
Firm
Q Market Q

36. Profit Maximizing in Short Run
P MC P S
MR
p*
ATC
AVC
D
Firm Q*
Q Market Q

37. Profit Maximizing in Short Run
P MC P S
MR
p*
ATC
AVC
D
Firm Q*
Q Market Q

38. Profit Maximizing in Short Run
P MC P S
MR
p*
Profit ATC
AVC
D
Firm Q*
Q Market Q

39. Profit Maximizing in Short Run
• It is also possible that the market price is so
low (of the ATC is so hight) that the firm
will lose money

40. Profit Maximizing in Short Run
(Losses)
P MC P S
ATC
Loss AVC
p*
MR
D
Firm Q*
Q Market Q

41. The Long Run
• Recall that the long run is defined as the
time it takes for fixed costs to change.In
other words - all costs are variable. The
ATC curve equals the AVC curve
• Also recall that Perfect Competition
assumes that there is costless and entry and
exit. In other words people can start up
firms or shut down firms without any cost
whatsoever

42. Perfect Comp. in the Long Run
• If there are profits being made in an
industry, firms will enter.
• If there are losses in an industry, firms will
leave
• But what happens to the market when
things like this happen?
• Consider the previous example where the
firm was making profits in the short run

43. Profit Maximizing in Short Run
P MC P S
MR
p*
Profit ATC
D
Firm Q*
Q Market Q

44. Profit Maximizing in Long Run
• Firms see this profit and enter the industry
• More firms in an industry means market
supply increases
• This drive price down and profits down
• Firms continue to enter until the price is
driven down so low that profits are zero.
Then no more firms want to enter and there
is a long run equilbrium

45. Profit Maximizing in Long Run
P MC P SS
MR
p*
ATC
MR
D
Firm Q*Q*
Q Market Q

46. Profit Maximizing in Long Run
• Note that price is driven down to the bottom
of the ATC curve
• In the long run, since profits MUST be zero,
MR (price) will have to cross the MC curve
where it intersects the ATC curve.

47. Losses in the Long Run
• But what if there are losses in the long run?
• If there are any losses in the long run, firms
will want to leave the industry
• When firms leave, market supply decreases
• This drives up price and drives down losses
• Firms leave as long as there are losses.
Once profits hit zero, firms stop leaving.
• Consider the example from earlier...

48. Losses in the Long Run
P MC P S S
ATC
MR
p*
MR
D
Firm Q*
Q Market Q

49. In the Long Run...
• In the Long Run in a perfectly competitive
market...
– there are ALWAYS zero profits
– P=MC=ATC
– The firm produces at the lowest possible cost

50. Long Run Supply
• Let’s say that we have been discussing the
PB&J market as perfectly competitive
• If there are profits being made, firms enter
and drive profits down.
• But as firms enter the PBJ industry, what is
happening to the jelly industry?
• Demand for jelly is rising and the price of
jelly is rising

51. Long Run Supply
• If the price of jelly is rising, all of the cost
curves in the PBJ industry will rise
• Which means the bottom of the ATC curve
is rising
• Which, in turn, means that the zero profit
price has gone up

52. Increasing Cost Industries
• Thus the PBJ indsutry is called an
increasing cost industry, because as more
firms enter the industry and the market
quantity rises, the zero profit price rises
• We can draw a Long Run Supply Curve
which demonstrates the relationship
between the long run quantity supplied and
the zero profit price

53. Increasing Cost Industries
• If the industry is an increasing cost
industry, the long run supply curve will be
upward sloping - indicating that as the long
run quantity increases, the zero profit price
increases

54. Constant Cost Industries
• But what if costs do not change as firms
enter and leave the industry?
• Then the zero profit price will not change as
quantity supplied in the long run changes.
• In this case the Long Run Supply Curve is
flat

55. Decreasing Cost Industries
• What if more firm enter the industry and
that allows Jelly Makers to take advantage
of economies of scale and make jelly
cheaper.
• Then as the long run quantity supplied
increases, costs for the firms go down and
thus the zero profit price is going down.
• This means the long run supply curve will
be downward sloping

56. Long Run Supply Curves
$
S (increasing cost)
S (constant cost)
S (decreasing cost)
Q

57. The Benefits of Perfect
Competition
• Recall in the beginning of the semester we
discussed Productive Efficiency - producing
as much as possible with a given amount of
recources.
• In order to do that the firm must produce at
its lowest cost point. Any higher cost per
unit will not allow the firm to make as much
with the same resources

58. Productive Efficiency
• Therefore, a perfectly competitive market,
in the long run, will always be productively
efficient
• This is because, in the long run, a perfectly
competitive firm always produces at the
bottom of the ATC curve

59. Allocative Efficiency
• We will now introduce another type of
efficiency - Allocative Efficiency
• Allocative Efficiency asks the question -
“Are we making sure everyone who is
willing to buy the good has got together
with everyone who is willing to sell them
the good?”

60. Allocative Efficiency
• In the context of perfect competition, we are
asking if, given the quantity produced is the
amount people are willing to pay (the
demand curve) equal to the amount people
are willing to sell for (the MC curve)?
• The answer is yes, so a perfectly
competitive market is allocatively efficient
as well.

61. Allocative Efficiency
• Note that at any quantity less than the
equilibrium Q*, the amount people are
willing to pay is more than the MC,
meaning that it will cost firms less to make
one more than people are willling to pay.
• If the market produces less than Q*, it is
then inefficient, since the firm could sell
one for more than cost and someone would
buy it. Both parties win.

62. A Note on Efficiency and Perfect
Competition
• Note that a perfectly competitive market in
the long run is both allocative and
productively efficient
• That is to say, the market makes as much as
it possibly could and makes sure everyone
who is willing to buy a good gets together
with everyone who is selling.
• This is done without any government
interference. Why do we need a govt?