Chapter 8 Perfect Competition Key Concepts Summary Practice Quiz Internet Exercises ©2002 South-Western College Publishing

Who was Adam Smith? The father of modern economics who wrote The Wealth of Nations, published in 1776

What did Adam Smith say about competitive forces? They are like an “invisible hand” that leads people who simply pursue their own interests to serve the interests of society

What is the purpose of this chapter? To explain how competitive markets determine prices, output, and profits

What is market structure? A classification system for the key traits of a market, including the number of firms, the similarity of the products they sell, and the ease of entry and exit

What is perfect competition? 1. many small firms 2. homogeneous product 3. very easy entry and exit 4. price taker

What does homogeneous mean? Goods that cannot be distinguished from one another; for example, one potato cannot be distinguished from another potato

What is a price taker? A seller that has no control over the price of the product it sells

What determines price? Supply and Demand

Market Supply and Demand $140 $130 S $120 $100 $80 $60 $40 D $20 Q 5 10 15 20 25 30 35 40 45

What determines the individual firm’s demand curve? A horizontal line at the market price

Individual firm demand $140 $130 $120 Individual firm demand D $100 $80 $60 $40 $20 5 10 15 20 25 30 35 40 45

Why is this horizontal line the firm’s demand curve? If the firm charges more than this price, it will not sell anything, and it has no incentive to charge less than this price

Why does the firm have no incentive to charge less than the market price? It can sell everything it brings to market at the market price

What does the perfectly competitive firm control? The only thing it controls is how many units it produces

How many units should this firm produce? The number of units whereby it will maximize its profits, or at least minimize its losses

What are the two methods to determine how many units to produce? TR and TC MR and MC

Using the total revenue - total cost method, where should a firm produce? Where the distance between TR and TC is the greatest

P Q TR TC Maximize Profit $500 $400 $300 $200 $100 1 2 3 4 5 Quantity of Output Q 1 2 3 4 5

Maximize Profit Output $150 $100 TR $50 -$50 Quantity of Output Q 1 2 3 4 5

What is marginal revenue? MR = TR / 1 output

What is marginal cost? MC = TC / 1 output

Using the marginal revenue and marginal cost method, where should a firm produce? MR = MC

Why should a firm continue to produce as long as MR > MC? As long as MR is > than MC, money is being made on that last unit

Why will a firm not produce that unit where MR < MC? At the unit of output where MR < MC, money is being lost on that last unit

Why does P = AR in perfect competition? Each additional unit sold is adding the market price to TR and TR divided by P = AR

ATC MC Profit AVC MR=MC 1 2 3 4 5 6 7 8 9 $80 $70 P = MR = AR $60 $50 Price & Cost per unit $40 $30 $20 $10 1 2 3 4 5 6 7 8 9

P Q MC ATC AVC Loss MR=MC P=MR=AR 1 2 3 4 5 6 7 8 9 $70 $60 $50 $40 Price & Cost per unit Loss $40 P=MR=AR $30 $20 $10 Q 1 2 3 4 5 6 7 8 9

P Q MC ATC AVC Loss Short-Run Shutdown P=MR=AR MR=MC 1 2 3 4 5 6 7 8 9 $70 ATC $60 $50 AVC Price & Cost per unit Loss $40 $30 P=MR=AR $20 $10 MR=MC Q 1 2 3 4 5 6 7 8 9

Price (MR) is below minimum average variable cost Firm will shut down Price (MR) is below minimum average variable cost

What is the perfectly competitive firm’s short-run supply curve? The firm’s marginal cost curve above the minimum point on its average variable cost curve

Firm’s Short-Run Supply Curve MC ATC $70 MR3 $60 AVC MR2 $50 $40 MR1 $30 $20 $10 Q 1 2 3 4 5 6 7 8 9

What is the industry’s supply curve? The summation of the individual firm’s MC curves that lie above their minimum AVC points

P S = MC Q Industry Equilibrium $130 $120 $100 $80 $60 $40 $20 5 10 15 20 25 30 35 40 45

What is a normal profit? The minimum profit necessary to keep a firm in operation

In the long-run, what happens when economic profits are made? When firms make more than a normal profit, firms enter the industry, as supply increases, a downward pressure is put on prices

In the long-run, what happens when losses are made? When firms make less than a normal profit, firms leave the industry, as supply decreases, an upward pressure is put on prices

In the long-run, where is equilibrium? At the market price that enables firms to make a normal profit

What exists at long-run perfectly competitive equilibrium? P = MR = SRMC = SRATC = LRAC

Long-Run Competitive Equilibrium SRMC Equilibrium $70 SATC $60 $50 LRAC $40 MR $30 $20 $10 Q 1 2 3 4 5 6 7 8 9

P S = MC D Q Industry Equilibrium $130 $120 $100 $80 $60 $40 $20 5 10 15 20 25 30 35 40 45

What different types of industries can exist in the long-run? Constant-cost Decreasing-cost Increasing-cost

What is a constant-cost industry? An industry in which the expansion of industry output by the entry of new firms has no effect on the firm’s cost curves

What does the long-run supply curve look like in a constant-cost industry? It is perfectly elastic, which is horizontal

Increase in demand sets a higher equilibrium price Entry of new firms increases supply Initial equilibrium price is restored Perfectly elastic long-run supply curve

What is a decreasing-cost industry? An industry in which the expansion of industry output by the entry of new firms decreases the firm’s cost curves

What does the long-run supply curve look like in a decreasing-cost industry? It is downward sloping

Increase in demand sets a higher equilibrium price Entry of new firms increases supply Equilibrium price and ATC decrease Downward sloping long-run supply curve

What is an increasing-cost industry? An industry in which the expansion of industry output by the entry of new firms increases the firm’s cost curves

What does the long-run supply curve look like in a increasing-cost industry? It is upward sloping

Increase in demand sets a higher equilibrium price Entry of new firms increases supply Equilibrium price and ATC increase Upward sloping long-run supply curve

Key Concepts

Key Concepts What is perfect competition? What is a price taker? What determines price? What determines the individual firm’s demand curve? Why does the firm have no incentive to charge less than the market price? Using the marginal revenue and marginal cost method, where should a firm produce?

Key Concepts cont. Why does MR = P in perfect competition? What is a normal profit? In the long-run, what happens when economic profits are made? In the long-run, what happens when losses are made? In the long-run, where is equilibrium? What different types of industries can exist in the long-run?

Summary

Market structure consists of three market characteristics: (1) the number of sellers, (2) the nature of the product, (3) the case of entry into or exit from the market.

Perfect competition is a market structure in which an individual firm cannot affect the price of the product it produces. Each firm in the industry is very small relative to the market as a whole, all the firms sell a homogeneous product, and firms are free to enter and exit the industry.

A price-taker firm in perfect competition faces a perfectly elastic demand curve. It can sell all it wishes at the market-determined price, but it will sell nothing above the given market price. This is because so many competitive firms are willing to sell at the going market price.

The total revenue-total cost method is one way the firm determines the level of output that maximizes profit. Profit reaches a maximum when the vertical difference between the total revenue and the total cost curves is at a maximum.

P Q TR TC Maximize Profit $500 $400 $300 $200 $100 1 2 3 4 5 Quantity of Output Q 1 2 3 4 5

The marginal revenue equals marginal cost method is a second approach to finding where a firm maximizes profits. Marginal revenue is the change in total revenue from a one-unit change in output. Marginal revenue for a perfectly competitive firm equals the market price.

The MR = MC rule states that the firm maximizes profit or minimizes loss by producing the output where marginal revenue equals marginal cost. If the price (average revenue) is below the minimum point on the average variable cost curve, the MR = MC rule does not apply, and the firm shuts down to minimize its losses.

ATC MC Profit AVC MR=MC 1 2 3 4 5 6 7 8 9 $80 $70 P = MR = AR $60 $50 Price & Cost per unit $40 $30 $20 $10 1 2 3 4 5 6 7 8 9

P Q MC ATC AVC Loss MR=MC P=MR=AR 1 2 3 4 5 6 7 8 9 $70 $60 $50 $40 Price & Cost per unit Loss $40 P=MR=AR $30 $20 $10 Q 1 2 3 4 5 6 7 8 9

P Q MC ATC AVC Loss Short-Run Shutdown P=MR=AR MR=MC 1 2 3 4 5 6 7 8 9 $70 ATC $60 Price & Cost per unit $50 AVC Loss $40 $30 P=MR=AR $20 $10 MR=MC Q 1 2 3 4 5 6 7 8 9

The perfectly competitive firm’s short-run supply curve is a curve showing the relationship between the price of a product and the quantity supplied in the short run.

The individual firm always produces along its marginal cost curve above its intersection with the average variable cost curve. The perfectly competitive industry’s short-run supply curve is the horizontal summation of the short-run supply curves of all firms in the industry.

P S = MC Q Industry Equilibrium $130 $120 $100 $80 $60 $40 $20 5 10 15 20 25 30 35 40 45

Long-run perfectly competitive equilibrium occurs when the firm earns a normal profit by producing where price equals minimum long-run average cost equals minimum short-run average total cost equals short-run marginal cost.

Long-Run Competitive Equilibrium SRMC Equilibrium $70 SATC $60 $50 LRAC $40 MR $30 $20 $10 Q 1 2 3 4 5 6 7 8 9

A constant-cost industry is an industry whose total output can be expanded without an increase in the firm’s average total cost. Because input prices remain constant, the long-run supply curve in a constant-cost industry is perfectly elastic.

A decreasing-cost industry is an industry in which lower input prices result in a downward-sloping long-run supply curve. As industry output expands, the firm’s average total cost curve shifts downward, and the long-run equilibrium market price falls.

An increasing-cost industry is an industry in which input prices rise as industry output increases. As a result, the firm’s average total cost curve rises, and the long-run supply curve for an increasing-cost industry is upward sloping.

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