Perfect Competition 14 Perfect Competition There’s no resting place for an enterprise in a competitive economy. — Alfred P. Sloan CHAPTER 14 Copyright

Perfect Competition 1

4

Perfect Competition

There’s no resting place for an enterprisein a competitive economy.

— Alfred P. Sloan

CHAPTER

14

Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin


4Chapter Goals

• Discuss the six conditions for a perfectly competitive market

• Demonstrate why the marginal cost curve is the supply curve for a perfectly competitive firm

• Explain why producing an output at which marginal cost equals price maximizes total profit for a perfect competitor

• Determine the output and profit of a perfect competitor graphically and numerically

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4Chapter Goals

• Construct a market supply curve by adding together individual firms’ marginal cost curves

• Explain why perfectly competitive firms make zero economic profit in the long run

• Explain the adjustment process from short-run equilibrium to long-run equilibrium

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4A Perfectly Competitive Market

• For a market to be perfectly competitive, six conditions must be met:

1. Both buyers and sellers are price takers – a price taker is a firm or individual who takes the price determined by market supply and demand as given

2. The number of firms is large – any one firm’s output compared to the market output is imperceptible and what one firm does has no influence on other firms

• A perfectly competitive market is a market in which economic forces operate unimpeded

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4A Perfectly Competitive Market

3. There are no barriers to entry – barriers to entry are social, political, or economic impediments that prevent firms from entering a market

4. Firms’ products are identical – this requirement means that each firm’s output is indistinguishable from any other firm’s output

5. There is complete information – all consumers know all about the market such as prices, products, and available technology

6. Selling firms are profit-maximizing entrepreneurial firms – firms must seek maximum profit and only profit

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4The Definition of Supply and Perfect Competition

• When a firm operates in a perfectly competitive market, its supply curve is its short-run marginal cost curve above average variable cost

• Supply is a schedule of quantities of goods that will be offered to the market at various prices

• These strong six conditions are seldom met simultaneously, but are necessary for a perfectly competitive market to exist

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4Demand Curves for the Firm and the Industry

P

Q

Market demand is downward sloping

Market Supply

Firm demand is perfectly elastic (horizontal)

P0

Market Demand

P

Q

P0

Firm Demand

P = D = MR

Q1 Q2 Q3

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4Profit Maximizing Level of Output

• Marginal revenue (MR) is the change in total revenue associated with a change in quantity

• A firm maximizes profit when marginal revenue equals marginal cost

• The goal of the firm is to maximize profits, the difference between total revenue and total cost

• Marginal cost (MC) is the change in total cost associated with a change in quantity

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4Profit Maximizing Level of Output

If MR < MC, • a firm can increase profit by decreasing its output

If MR > MC, • a firm can increase profit by increasing output

• The profit-maximizing condition of a competitive firm is:

MR = MC

• For a competitive firm, MR = P

• A firm maximizes total profit, not profit per unit

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4Marginal Cost, Marginal Revenue, and Price Table

Price = MR ($) Q Marginal Cost ($)

35 028

20

16

14

12

17

22

30

40

54

35 1

35 2

35 3

35 4

35 5

35 6

35 7

35 8

35 9

35 10

If MC < P, increase production

Profit maximizing quantity is where MC = P

If MC > P, decrease production

The profit-maximizing condition of a competitive firm is:

MC = MR = P

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4Marginal Cost, Marginal Revenue, and Price Graph

P

Q

Marginal Cost

$35 P = D = MR

MC < P, increase output to

increase total profit

MC = P at 8 units,total profit is maximized

MC > P, decrease output to increase total profit

MC = P

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4The Marginal Cost Curve is the Supply Curve

Because the marginal cost curve tells us how much of a good a firm will supply at

a given price, the marginal cost curve is the

firm’s supply curve

PMarginal

Cost

$35

Q

$19.50

$61

86 10

Firm’s Supply Curve=

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4Profit Maximization using Total Revenue and Total Cost

• Total cost is the cumulative sum of the marginal costs, plus the fixed costs

• An alternative method to determine the profit-maximizing level of output is to look at the total and total cost curves

• Total profit is the difference between total revenue and total cost curves

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4Total Revenue and Total Cost Table

Q Total Revenue ($) Total Cost ($) Total Profit ($)

0 0 40 -40

1 35 68 -33

2 70 88 -18

3 105 104 1

4 140 118 22

5 175 130 45

6 210 147 63

7 245 169 76

8 280 199 81

9 315 239 76

10 350 293 57

Total profit is maximized at 8 units of output

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4Total Revenue and Total Cost Table

Total Cost, Total Revenue TC

$175

Q

$130

$280

85

TR The total revenue curve is a straight line

The total cost curve is bowed upward at most

quantities reflecting increasing marginal cost

Max profit = $81 at 8 units of

output

3

Losses LossesProfits

Profits are maximized when the vertical

distance between TR and TC is greatest

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4Determining Profits Graphically: A Firm with Profit

AVC

MC

Q

P

ATC

Find output where MC = MR, this is the profit maximizing Q

P = D = MR

MC = MR

Qprofit max

Find profit per unit where the profit max Q

intersects ATC

ATC at Qprofit max

P

ATCProfits

Since P>ATC at the profit maximizing quantity, this firm is earning profits

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4Determining Profits Graphically: A Firm with Zero Profit or Losses

AVC

MC

Q

P

ATC

MC = MR

Qprofit max

ATC at Qprofit max

P =ATC

P = D = MR

Since P=ATC at the profit maximizing quantity,

this firm is earning zero profit or loss



intersects ATC

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4Determining Profits Graphically: A Firm with Losses

AVC

MC

Q

P

ATC

MC = MR

Qprofit max

ATC at Qprofit max

P

ATC P = D = MR

Since P<ATC at the profit maximizing quantity, this firm is earning losses



intersects ATC Losses

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4Determining Profits Graphically:

The Shutdown Decision

AVC

MC

Q

P

ATC

Qprofit max

PShutdown

P = D = MR

• The shutdown point is the point below which the firm will be better off if it shuts down than it will if it stays in business

• If P>min of AVC, then the firm will still produce, but earn a loss

• If P<min of AVC, the firm will shut down

• If a firm shuts down, it still has to pay its fixed costs

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4Short-Run Market Supply and Demand

• The market (industry) supply curve is the horizontal sum of all the firms’ marginal cost curves

• While the firm’s demand curve is perfectly elastic, the industry’s demand curve is downward sloping

• The market supply curve takes into account any changes in input prices that might occur

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4

ATCProfits

Short-Run Market Supply and Demand Graph

P

Q

Market Supply

P

Market Demand

P

Q

P P = D = MR

MC

ATC

Qprofit max

Market Firm

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4Long-Run Competitive Equilibrium

• Profits create incentives for new firms to enter, market supply will increase, and the price will fall until zero profits are made

• At long run equilibrium, economic profits are zero

• The existence of losses will cause firms to leave the industry, market supply will decrease, and the price will increase until losses are zero

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4Long-Run Competitive Equilibrium

• Normal profit is the amount the owners would have received in their next best alternative

• Zero profit does not mean that the entrepreneur does not get anything for his efforts

• Economic profits are profits above normal profits

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4Long-Run Competitive Equilibrium Graph

P

Q

P = D = MR

MC

SRATC

LRATC

At long-run equilibrium, economic profits are zero

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4

SR Profits

Market Response to an Increase in Demand Graph

P

Q

S0(SR)

P0

D0

P

Q

P0

MC

ATC

Q0,2

Market Firm

S1(SR)

D1

P1

1

P11 1

Q1

2

2 2

Q0 Q1 Q2

1

1 22

S(LR)

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4Long-Run Market Supply

• If the long-run industry supply curve is upward sloping, the market is an increasing-cost industry

• If the long-run industry supply curve is perfectly elastic, the market is a constant-cost industry

• If the long-run industry supply curve is downward sloping, the market is a decreasing-cost industry

• In the short run, the price does more of the adjusting, and in the long run, more of the adjustment is done by quantity

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4Application: Kmart

• After 2 years of losses, Kmart realized that the decrease in demand was permanent

• Although Kmart was making losses, Kmart decided to keep 300 stores open because P>AVC

• They moved from the short run to the long run and closed the stores because prices had fallen below their long-run average costs

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4Chapter Summary

• The necessary conditions for perfect competition are:

1. Buyers and sellers are price takers

2. The number of firms is large

3. There are no barriers to entry

4. Firms’ products are identical

5. There is complete information

6. Sellers are profit-maximizing entrepreneurial firms

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4Chapter Summary

• Competitive firms maximize profit where MR = MC

• Profit is (P – ATC)(Q) at the profit-maximizing level of output

• Perfectly competitive firms shut down if P < AVC

• The supply curve of a competitive firm is its MC curve above minimum AVC

• The short-run market supply curve is the horizontal sum of the MC curves above AVC for all the firms in the market

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4Chapter Summary

• In the short run, competitive firms can make a profit or loss. In the long run they make zero profits.

• If there are profits:• Firms enter the industry• Supply increases • Price decreases, eliminating profit

• If there are losses:• Firms leave the industry• Supply decreases• Price increases, eliminating losses

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4Chapter Summary

• The long-run industry supply curve is a schedule of quantities supplied where firms are making zero profit

• Constant-cost industries have horizontal long-run supply curves

• Increasing-cost industries have upward sloping long-run supply curves

• Decreasing-cost industries have downward sloping supply curves

• The slope of the long-run supply curve depends on what happens to factor costs when output increases

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4Preview of Chapter 15:

Monopoly

• Summarize how and why the decisions facing a monopolist differ from the collective decisions of competing firms

• Determine a monopolist’s price, output, and profit graphically and numerically

• Explain why MR = MC maximizes total profit for a monopolist

• Show graphically the welfare loss from monopoly

• Explain why a price-discriminating monopolist will earn more profit than a normal monopolist

• Explain why there would be no monopoly without barriers to entry

• Discuss three normative arguments against monopoly

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Documents

Perfect Competition 14 Perfect Competition There’s no resting place for an enterprise in a competitive economy. — Alfred P. Sloan CHAPTER 14 Copyright