Ch. 11: Perfect Competition.  Explain how price and output are determined in perfect competition  Explain why firms sometimes shut down temporarily and lay off workers  Explain why firms enter and leave the industry  Predict the effects of a change in demand or a technological advance  Explain why perfect competition is efficient

Perfect Competition  Perfect competition is an industry in which:  Many firms sell identical products to many buyers.  no restrictions to entry into the industry.  Established firms have no advantages over new ones.  Sellers and buyers are well informed about prices.  Perfect competition arises when  When firm’s minimum efficient scale is small relative to market demand  Homogeneous products – only price matters to buyers.

Perfect Competition In perfect competition, each firm is a price taker.  No single firm can influence the price  Each firm’s output is a perfect substitute for the output of the other firms,  Demand for each firm’s output is perfectly elastic.

Perfect Competition Firms’s goal: maximize economic profit.  = TR – TC TR=PXQ TC=opportunity costs of production, including normal profit for the owner.

Perfect Competition – Market demand and supply determine the price that the firm must take. – A firm’s marginal revenue is the change in TR resulting from a one-unit increase in the quantity sold. – In perfect competition, MR=P.

Profit Max. in Perfect Comp. A perfectly competitive firm faces two constraints:  A market constraint summarized by the market price and the firm’s revenue curves  A technology constraint summarized by firm’s product curves and cost curves.

Profit Max. in Perfect Comp. 2 decisions in the short run:  Whether to produce or to shut down.  If the decision is to produce, what quantity to produce. A firm’s long-run decisions are:  Whether to increase or decrease its plant size.  Whether to stay in the industry or leave it.

Profit Max. in Perfect Comp. At low output levels, the firm incurs an economic loss—it can’t cover its fixed costs. Profits maximized at 9 units of output.

Profit Max. in Perfect Comp. Marginal Analysis – The firm can use marginal analysis to determine the profit-maximizing output. – Because MR is constant and MC eventually increases as output increases, profit is maximized by producing the output at which (P=)MR = MC

Profit Max. in Perfect Comp.

Profit = (P-ATC)*Q

Profit Max. in Perfect Comp. The Firm’s Short-Run Supply Curve  shows how the firm’s profit-maximizing output varies as the market price varies, other things remaining the same.  linked to its MC curve.  but there is a price below which the firm produces nothing and shuts down temporarily.

Profit Max. in Perfect Comp. SR decision to shut down.   = (P-ATC)*Q  = (P-AVC)*Q –TFC  If P < minimum of AVC, the firm shuts down temporarily and incurs a loss equal to TFC.  If P> minimum of AVC, the firm produces the quantity at which P=MC, even if profits are negative.

Graphic representation of firm’s profit maximizing output for various prices

Use the diagram below to answer the next 4 questions.

What is the profit maximizing level of output? None of the above

At the profit maximizing output, what are profits? 1.$7 2.-$7 3.$ $109

The price that would result in zero economic profits is: 1.$11 2.$16 3.$22 4.$23

This firm would produce nothing in the short run if and only if the price falls below ____ 1.$23 2.$22 3.$16 4.$11

SR Industry Supply Curve – The quantity supplied by the industry at any given price is the sum of the quantities supplied by all the firms in the industry at that price. – Entry of new firms shifts industry supply curve to the right – Exit of old firms shifts industry supply curve to the left.

LR adjustments In SR, economic profits could be positive, negative or zero. In the LR, – Firms enter if economic profits are positive – Firms exit if economic profits are negative. – No entry or exit if economic profits are zero.

Changes in Plant Size – Firms change their plant size whenever doing so is profitable. – If ATC exceeds the minimum of LRATC, firms change their plant size to lower costs and increase profits. – Suppose a new technology emerges that reduces LRATC at a higher level than previously.

Changes in Plant Size – Why can’t a firm survive in LR at Q=6? – Why is LR equilibrium at Q where LRATC is minimized?

LR adjustments Effect of entry/exit on economic profits in LR At LR equilibrium  P=MC=ATC   =0  ATC is at a minimum

LR adjustments Effect of increase in demand on economic profits in LR At LR equilibrium  P=MC=ATC   =0  ATC is at a minimum

SR vs. LR Adjustments Summary of effects of an increase in demand when starting from a LR equilibrium. SR effectLR effect Price Firm output Industry output Number of firms Profits ATC

LR equilibrium Long-run equilibrium occurs in a competitive industry when:   is zero, so firms have no incentive to enter or exit the industry.  LRATC is at its minimum, so firms can’t reduce costs by changing plant size.

Use the diagram below to answer the questions that folllow

Given the starting price of $16, in the long run this industry should have 1.Firms exit and prices rise. 2.Firms exit and prices fall. 3.Firms enter and prices rise. 4.Firms enter and prices fall.

External Economies and Diseconomies Constant cost industry – Industry output has no effect on a given firm’s ATC External economies – decreasing cost industry – Firm’s costs fall as industry output rises External diseconomies – Increasing cost industry – Firm’s costs rise as industry output rises

External Economics and Diseconomies LR supply curve reflects how change in industry output affects ATC. – External economies  LR supply upward sloping – External diseconomies  LR supply downward sloping – Constant cost industry  LR supply horizontal.

LR adjustment to change in demand with Constant cost industry

LR adjustment to change in demand with decreasing cost industry

LR adjustment to change in demand with increasing cost industry

Refer to the diagram below to answer the questions that follow.

If the industry is at a long run equilibrium, the price must be: 1.$8 2.$10 3.$12 4.$16

Suppose that the industry was initially at a long run equilibrium, if demand for the product increases, in the short run, profits should ____, and output should _____ 1.Rise; not change 2.Rise; rise 3.Fall; not change 4.Fall; fall.

Suppose that the industry was initially at a long run equilibrium and demand for the product increases. If this is a constant cost industry, in the long run the price should settle 1.Above the original price. 2.Below the original price. 3.At the original price.

Suppose that the industry was initially at a long run equilibrium and demand for the product increases. If this is an increasing cost industry, in the long run the price should settle 1.Above the original price. 2.Below the original price. 3.At the original price.

Technological Advances New-technology firms enter and old-technology firms either exit or adopt the new technology. Optimal sized firm could be either larger or smaller Industry supply increases and the industry supply curve shifts rightward. The price falls and the quantity increases. Eventually, a new long-run equilibrium emerges in which  all the firms use the new technology  the price has fallen to the minimum average total cost,  each firm earns normal profit (zero economic profit)

Competition and Efficiency Competitive equilibrium is efficient only if there are no external benefits or costs. – Positive externalities. – Negative externalities.

Applications Effect of barriers to entry on competitive market SR versus LR effect of increase in variable input price SR versus LR effect of commodity taxes