Chapter 10: Perfect Competition Prepared by: Kevin Richter, Douglas College Charlene Richter, British Columbia Institute of Technology © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. Chapter Objectives 1. List the six conditions for a perfectly competitive market. 2a. Explain why producing an output at which marginal cost equals price maximizes total profit for a perfect competitor. 2b. Demonstrate why the marginal cost curve is the supply curve for a perfectly competitive firm. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. Chapter Objectives 3a. Determine the output and profit of a perfect competitor graphically and numerically. 3b. Explain the role of profits as market signals. 4a. Construct a market supply curve by adding together the marginal cost curves of individual firms. 4b. Explain why perfectly competitive firms make zero economic profit in the long run. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. Chapter Objectives 5. Explain the adjustment process from short-run equilibrium to long-run equilibrium. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. Perfect Competition The concept of competition is used in two ways in economics. Competition as a process is a rivalry among firms. Competition as a market structure. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

Perfectly Competitive Market A perfectly competitive market is one in which economic forces operate unimpeded. It has highly restrictive assumptions which provide us with a reference point we can use in comparing different markets. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

Perfectly Competitive Market In a perfectly competitive market: The number of firms is large. The firms' products are identical. There is free entry and exit, that is, there are no barriers to entry. There is complete information. Firms are profit maximizers. Both buyers and sellers are price takers. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

Necessary Conditions for Perfect Competition There is free entry and free exit. Firms are free to enter a market in response to market signals such as price and profit. Barriers to entry are social, political, or economic impediments that prevent other firms from entering the market. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

Necessary Conditions for Perfect Competition Both buyers and sellers are price takers. A price taker is a firm or individual who takes the market price as given. Neither supplier nor buyer possesses market power. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

Demand Curves for the Firm and the Industry The demand curve facing the firm is different from the industry demand curve. A perfectly competitive firm’s demand schedule is perfectly elastic even though the demand curve for the market is downward sloping. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

Market Demand Curve Versus Individual Firm Demand Curve Market supply 1,000 3,000 Price $10 8 6 4 2 Quantity 10 20 30 Price $10 8 6 4 2 Quantity Market demand A B C Individual firm demand © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

Profit-Maximizing Level of Output Marginal revenue (MR) – the change in total revenue associated with a one-unit change in quantity. Marginal cost (MC) – the change in total cost associated with a one-unit change in quantity. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

Marginal Cost, Marginal Revenue, and Price MC 1 2 3 4 5 6 7 8 9 10 $28.00 20.00 16.00 14.00 12.00 17.00 22.00 30.00 40.00 54.00 68.00 Price = MR Quantity Produced Marginal Cost $35.00 35.00 Costs 1 2 3 4 5 6 7 8 9 10 Quantity 60 50 40 30 20 C A P = D = MR A B © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

Marginal Cost Curve Is the Firm’s Supply Curve Cost, Price $70 60 50 40 30 20 10 1 Quantity 2 3 4 5 6 7 8 9 C A B © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

Firms Maximize Total Profit Firms seek to maximize total profit, not profit per unit. Firms do not care about profit per unit. As long as an increase in output yields even a small amount of additional profit, a profit-maximizing firm will increase output. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

Profit Maximization Using Total Revenue and Total Cost TC TR Total cost, revenue $385 350 315 280 245 210 175 140 105 70 35 Quantity 1 2 3 4 5 6 7 8 9 Loss Maximum profit =$81 Profit $130 Profit =$45 Loss © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

Costs Relevant to a Firm © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

Costs Relevant to a Firm © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

Determine Profit From a Graph Find output where MC = MR. The intersection of MC = MR (P) determines the quantity the firm will produce if it wishes to maximize profits. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

Determine Profits Graphically Quantity Price 65 60 55 50 45 40 35 30 25 20 15 10 5 1 2 3 4 6 7 8 9 12 D MC A P = MR B ATC AVC E Profit C Loss (a) Economic Profit (b) Zero economic profit (c) Loss © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. Shutdown Point The shutdown point is the point at which the firm will be better off if it shuts down than if it stays in business. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. Shutdown Decision MC 2 4 6 8 Quantity Price 60 50 40 30 20 10 ATC Loss P = MR AVC A $17.80 © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. Profits as Signals © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

Long-Run Competitive Equilibrium MC 60 50 40 30 20 10 Price 2 4 6 8 Quantity SRAC LRAC P = MR © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

Long-Run Competitive Equilibrium In order to stay in business the entrepreneur must receive his opportunity cost or normal profits (the amount the owners of business would have received in the next-best alternative). © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

Long-Run Competitive Equilibrium Normal profits are included as a cost. Economic profits are profits above normal profits. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

Long-Run Competitive Equilibrium Firms with super-efficient workers or machines will find that the price of these specialized inputs will rise. Rent is the income received by those specialized factors of production. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

Long-Run Competitive Equilibrium The zero profit condition is enormously powerful. As long as there is free entry and exit, price will be pushed down to the average total cost of production. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. Increase in Demand An increase in demand leads to higher prices and higher profits. Existing firms increase output. New firms enter the market, increasing output still more. Price falls until all profit is competed away. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. Increase in Demand If input prices remain constant, the market is a constant-cost industry, and the new equilibrium will be at the original price but with a higher output. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

Market Response to an Increase in Demand Quantity Price Firm Price Quantity MC AC D1 S0SR D0 S1SR B B $9 840 $9 C Profit 12 7 700 SLR 7 A 1,200 10 A © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

Long-Run Market Supply Two other possibilities exist: Increasing-cost industry – factor prices rise as new firms enter the market and existing firms expand capacity. Decreasing-cost industry – factor prices fall as industry output expands. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

Canadian Retail Industry During the 1990s the Canadian retail industry illustrated how a competitive market adjusts to changing market conditions. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

Canadian Retail Industry Many retailers were lost or absorbed by competitors: Eaton’s, Bretton’s, Pascal’s, Robinson’s, K-Mart and many others. Initially, these firms saw their losses as the temporary result of reduced demand in a slowing economy. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

Canadian Retail Industry As prices fell, P=MR fell below their ATC. But since price remained above the AVC, many firms closed their less profitable locations and continued to operate. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

Canadian Retail Industry When demand did not recover, firms ran out of options. Many firms realized as they moved into the long run that they have to exit the Canadian retail industry. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. Shutdown Decision Price Quantity MC ATC Loss AVC P = MR © 2006 McGraw-Hill Ryerson Limited. All rights reserved.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. Perfect Competition End of Chapter 10 © 2006 McGraw-Hill Ryerson Limited. All rights reserved.