Chapter 8 Perfect Competition Lecture Slides Economics for Today Irvin B. Tucker © 2011 South-Western, a part of Cengage Learning

What will I learn in this chapter? This chapter discusses how competitive markets determine prices, output, and profits © 2011 South-Western, a part of Cengage Learning

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 © 2011 South-Western, a part of Cengage Learning

What is perfect competition? A market structure characterized by: 1. Large number of small firms 2. Homogeneous product 3. Very easy entry and exit © 2011 South-Western, a part of Cengage Learning

What is meant by a large number of firms? A large number of sellers condition is met when each firm is so small relative to the total market that no single firm can influence the market price © 2011 South-Western, a part of Cengage Learning

What does homogeneous mean? Goods that cannot be distinguished from one another. For example, farmer Brown’s wheat is identical to farmer Jones’s wheat. © 2011 South-Western, a part of Cengage Learning

What conclusion can we make concerning a homogeneous product? If a product is homogeneous, buyers are indifferent as to which seller’s product they buy © 2011 South-Western, a part of Cengage Learning

What does very easy entry mean? Perfect competition requires that a new firm faces no barriers to entry, such as financial, technical, or government-imposed barriers (licenses, permits, patents). © 2011 South-Western, a part of Cengage Learning

© 2011 South-Western, a part of Cengage Learning What is the result of a firm conforming to the perfect competition model? The firm is a price taker, which means it is a seller that has no control over the price of the product. © 2011 South-Western, a part of Cengage Learning

What determines price in perfect competition? Market Demand and Market Supply © 2011 South-Western, a part of Cengage Learning

S D Market Supply Market Demand Exhibit 1(a) Market Supply and Demand 140 S 120 100 Price per unit (dollars) E 80 70 60 Market Demand 40 20 D 20 40 60 80 100 Quantity of Output (thousands of units per hour) © 2011 South-Western, a part of Cengage Learning 11

What determines the individual firm’s demand curve? A horizontal line at the market price © 2011 South-Western, a part of Cengage Learning

D 130 120 100 Demand 2 4 6 8 10 Exhibit 1(b) Individual firm demand 80 Price per unit (dollars) D 70 60 40 20 2 4 6 8 10 Quantity of output ( units per hour) © 2011 South-Western, a part of Cengage Learning

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 © 2011 South-Western, a part of Cengage Learning

Why is the firm’s demand curve horizontal at the market price? Because the firm can sell all it produces at the market price © 2011 South-Western, a part of Cengage Learning

© 2011 South-Western, a part of Cengage Learning 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 © 2011 South-Western, a part of Cengage Learning

What does the perfectly competitive firm control? As a price taker, the only thing the firm controls is how many units it produces © 2011 South-Western, a part of Cengage Learning

How many units should this firm produce? The number of units that will maximize its profits, or minimize its losses © 2011 South-Western, a part of Cengage Learning

What are the two methods to determine how many units to produce? TR and TC method MR and MC method © 2011 South-Western, a part of Cengage Learning

© 2011 South-Western, a part of Cengage Learning Using the total revenue-total cost method, where should a firm produce? Where the distance between TR and TC is the greatest © 2011 South-Western, a part of Cengage Learning

© 2011 South-Western, a part of Cengage Learning

TR TC Loss Exhibit 3(a) Total Revenue and Total Cost 800 700 600 500 Max profit=$205 Total Revenue and Total Cost (dollars) 400 300 200 Maximum profit output 100 Loss 0 1 2 3 4 5 6 7 8 9 10 11 12 9 Quantity of Output (units per hour) 22 © 2011 South-Western, a part of Cengage Learning

Quantity of Output (units per hour) Exhibit 3(b) Profit or loss 250 200 150 Profit (dollars) 100 Profit= $205 50 1 2 3 4 5 6 7 8 10 11 12 9 Loss (dollars) -50 Maximum profit output Loss -100 Quantity of Output (units per hour) 23 © 2011 South-Western, a part of Cengage Learning

What is marginal revenue (MR)? The change in total revenue from the sale of one additional unit of output. ∆ ∆ MR = TR / 1 output © 2011 South-Western, a part of Cengage Learning

What is marginal cost (MC)? The change in total cost from the sale of one unit of output. ∆ ∆ MC = TC / 1 output © 2011 South-Western, a part of Cengage Learning

© 2011 South-Western, a part of Cengage Learning Using the marginal revenue and marginal cost method, where should a firm produce? MR = MC © 2011 South-Western, a part of Cengage Learning

Why should a firm continue to produce as long as MR > MC? As long as MR is greater than MC, profit is being made on that last unit produced and sold. © 2011 South-Western, a part of Cengage Learning

Why will a firm not produce any unit where MR < MC? At any unit of output where MR < MC, the firm incurs a loss. © 2011 South-Western, a part of Cengage Learning

Price and Cost per unit (dollars) Quantity of output (units per hour) Exhibit 4(a) Price, Marginal Revenue, and Cost per Unit MC 120 100 MR=MC 80 Price and Cost per unit (dollars) MR 70 Profit=$205 ATC 60 AVC 40 20 2 4 6 8 9 10 12 Quantity of output (units per hour) © 2011 South-Western, a part of Cengage Learning 29

Quantity of Output (units per hour) Exhibit 4(b) Profit or loss 250 200 150 Profit (dollars) 100 Profit= $205 50 1 2 3 4 5 6 7 8 10 11 12 9 Loss (dollars) -50 Maximum profit output Loss -100 Quantity of Output (units per hour) © 2011 South-Western, a part of Cengage Learning

© 2011 South-Western, a part of Cengage Learning Exhibit 5 Short-Run Loss Minimization Using the Marginal Revenue Equals Marginal Cost Method for a Perfectly Competitive Firm © 2011 South-Western, a part of Cengage Learning 31

Price (MR) is below minimum average variable cost Firm will shut down Price (MR) is below minimum average variable cost © 2011 South-Western, a part of Cengage Learning

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 © 2011 South-Western, a part of Cengage Learning

Price & Cost per unit (dollars) Quantity of Output (units per hour) Exhibit 6 The Short-Run Shutdown Point for a Perfectly Competitive Firm 120 MC 110 100 90 80 70 Price & Cost per unit (dollars) ATC 60 AVC Shutdown point 50 40 MR 25 10 0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of Output (units per hour) © 2011 South-Western, a part of Cengage Learning 34

MC C B A Exhibit 7 The Firm’s Short-Run Supply Curve 120 Supply curve 100 C 90 MR3 80 70 Price per unit (dollars) ATC 60 B AVC 45 MR2 A 30 MR1 20 10 0 1 2 3 4 5 8 9 11 12 5.5 7 10 Quantity of output (units per hour) © 2011 South-Western, a part of Cengage Learning 35

What is the perfectly competitive industry’s supply curve? The horizontal summation of the MC curves of all firms in the industry above that lie above the minimum point on their AVC curves. © 2011 South-Western, a part of Cengage Learning

Exhibit 8 Deriving the Industry Short-Run Supply Curve Computech MC curve + Western Computer Co. = Industry Supply Curve MC MC S= ∑ MC 90 90 90 Price and marginal 40 40 40 cost per unit (dollars) 7 11 11 15 18 26 Quantity of Output (units per hour) Quantity of Output (units per hour) Quantity of Output (units per hour) © 2011 South-Western, a part of Cengage Learning

Exhibit 9(a) Individual Short-Run Competitive Equilibrium 2 4 8 10 12 120 MC 100 Price and cost per unit (dollars) 80 E MR 60 Profit ATC 40 AVC 20 6 2 4 8 9 10 12 Quantity of output (units per hour) © 2011 South-Western, a part of Cengage Learning 38

Exhibit 9(b) Industry Short-Run Competitive Equilibrium S = MC 120 100 80 Price and Cost per unit (dollars) E 60 40 20 D 20 40 60 80 100 120 Quantity of output (thousands of units per hour) © 2011 South-Western, a part of Cengage Learning 39

© 2011 South-Western, a part of Cengage Learning What is a normal profit? The minimum profit necessary to keep a firm in operation © 2011 South-Western, a part of Cengage Learning

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 © 2011 South-Western, a part of Cengage Learning

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 © 2011 South-Western, a part of Cengage Learning

In the long-run, where is equilibrium? At the market price that enables firms to make a normal profit © 2011 South-Western, a part of Cengage Learning

Exhibit 10 Long-Run Perfectly Competitive Equilibrium SRATC SRMC 105 LRAC 90 75 E Price and cost per unit (dollars) 60 MR 45 30 15 1 2 3 4 5 6 7 8 9 10 Quantity of Output (units per hour) © 2011 South-Western, a part of Cengage Learning

What equality exists at long-run perfectly competitive equilibrium? P=MR=SRMC=SRATC=LRAC © 2011 South-Western, a part of Cengage Learning

What different types of industries can exist in the long-run? Constant-cost Decreasing-cost Increasing-cost © 2011 South-Western, a part of Cengage Learning

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 © 2011 South-Western, a part of Cengage Learning

© 2011 South-Western, a part of Cengage Learning What does the long-run supply curve look like in a constant-cost industry? It is perfectly elastic, which is horizontal © 2011 South-Western, a part of Cengage Learning

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 © 2011 South-Western, a part of Cengage Learning

© 2011 South-Western, a part of Cengage Learning

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 © 2011 South-Western, a part of Cengage Learning

© 2011 South-Western, a part of Cengage Learning What does the long-run supply curve look like in a decreasing-cost industry? It is downward sloping © 2011 South-Western, a part of Cengage Learning

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 © 2011 South-Western, a part of Cengage Learning

© 2011 South-Western, a part of Cengage Learning

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 © 2011 South-Western, a part of Cengage Learning

© 2011 South-Western, a part of Cengage Learning What does the long-run supply curve look like in a increasing-cost industry? It is upward sloping © 2011 South-Western, a part of Cengage Learning

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 © 2011 South-Western, a part of Cengage Learning

© 2011 South-Western, a part of Cengage Learning

END