Perfect Competition Chapter 8

A Perfectly Competitive Market A perfectly competitive market is one in which economic forces operate unimpeded.

A Perfectly Competitive Market For a market to be perfectly competitive, six conditions must be met: Both buyers and sellers are price takers – a price taker is a firm or individual who takes the market price as determined by market supply and demand. Since a competitive firm takes the market price as given and beyond its control, its only decision is how much output to produce and sell The number of firms is large – any one firm’s output compared to the market output has no influence on other firms 14-3 3

A Perfectly Competitive Market There are no barriers to entry – barriers to entry are social, political, or economic impediments that prevent firms from entering a market e.g. Patents, technology, lenders Firms’ products are identical – this requirement means that each firm’s output is indistinguishable from any other firm’s output There is complete information – all consumers know all about the market such as prices, products, available technology and profit levels Selling firms are profit-maximizing entrepreneurial firms – firms must seek maximum profit 14-4 4

The Definition of Supply and Perfect Competition These strong six conditions are seldom met simultaneously, but are necessary for a perfectly competitive market to exist 14-5 5

Demand Curves for the Firm and the Industry The demand curves facing the firm is different from the industry demand curve. Individual firms will increase their output in response to an increase in demand even though that will cause the price to fall thus making all firms collectively worse off.

Market Demand Versus Individual Firm Demand Curve 1,000 3,000 Price $10 8 6 4 2 Quantity 10 20 30 Price $10 8 6 4 2 Quantity Supply Demand Individual firm demand Price Equilibrium

Profit Maximisation The goal of every firm is to maximize profits. Profit is the difference between total revenue (money in) and total cost (money out). What happens to profit in response to a change in output is determined by marginal revenue (MR) and marginal cost (MC). A firm maximizes profit when MC = MR. Marginal revenue (MR) – the change in total revenue associated with a change in quantity. Marginal cost (MC) – the change in total cost associated with a change in quantity.

Profit Maximization: MC = MR Profit Maximisation A perfect competitor accepts the market price as given (price taker). As a result, marginal revenue equals price (MR = P). Initially, marginal cost falls and then begins to rise. Profit Maximization: MC = MR To maximize profits, a firm should produce where marginal cost equals marginal revenue.

Profit Maximisation If marginal revenue does not equal marginal cost, a firm can increase profit by changing output. The supplier will continue to produce as long as marginal cost is less than marginal revenue. The supplier will cut back on production if marginal cost is greater than marginal revenue. Thus, the profit-maximizing condition of a competitive firm is MC = MR = P.

Again! MC=MR Profit Maximisation Profit is maximized when MC=MR. If the cost of producing one more unit is less than the revenue it generates, then a profit is available If the cost of producing one more unit is more than the revenue it generates, then increasing production reduces profit.

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 Profit Maximisation Loss P = D = MR Profit B

Measuring Profit Apples per Day Euros 100 200 300 400 500 600 700 800 Economic Profit Apples per Day Euros 100 200 300 400 500 600 700 800 AC MC D = MR = AR €1.00 Profit per apple(€0.20) €0.80-

Moving from Short Run to Long Run: Entry of new firms Firms enter the market for a number of reasons As perfect knowledge exists, everybody knows the profits that are made. Profit is attractive and will therefore bring new firms. There are no barriers to entry.

Moving from Short Run to Long Run: Entry of new firms As we enter long-run, much will change: As number of firms increases, market supply curve will shift rightward causing several things to happen: Market price begins to fall. As market price falls, demand curve facing each firm shifts downward Each firm—striving as always to maximize profit— will slide down its marginal cost curve, decreasing output

Moving from Short Run to Long Run: Entry of new firms Price per apple Market Apples per Year Euros Firm S1 So each firm earns an economic profit. With initial supply curve S1, market price is €1.00… MC A €1.00 €1.00 d1 AC D 900,000 9,000

Moving from Short Run to Long Run: Entry of new firms Market Firm Price per apple Apples per Year Euros S1 S2 MC A A €1.00 €1.00 d1 AC E E €0.25 €0.25 d1 D 900,000 1,200,000 5,000 9,000 Profit attracts entry, shifting the supply curve rightward… ...until market price falls to €0.25 and each firm earns zero economic profit.

Moving from Short Run to Long Run: Entry of new firms Economic Loss Apples per Day Euros 100 200 300 400 500 600 700 800 MC AC €1.00 €0.80 Loss per apple (€0.20) D = MR = AR

From Short-Run Loss to Long-Run Equilibrium What if we begin to make a loss? In a competitive market, economic losses continue to cause exit until losses are reduced to zero When there are no significant barriers to exit, economic loss will eventually drive firms from the industry, raising market price until typical firm breaks even again

Supply curve in Perfect Competition The Supply Curve is the quantity of a good that a firm will produce at each price. In Perfect Competition, a firm always produces where MC=AR The SR supply curve is that part of the MC curve above AVC curve (See P.112) The LR supply curve is that part of the MC curve above AC curve (See P.113)

Advantages of Perfect Competition Consumer not exploited – Consumer buys at the lowest price. This is the lowest price that the seller is willing to make the product. No waste of resources such as advertising. Efficiency is encourages as any firm that cannot produce at the lowest point on the AC goes out of business. Consumer guaranteed to get the same quality and price for the product…everywhere!

Disadvantages of Perfect Competition No choice as goods are identical. No economies of scale as most businesses are small compared to market total. Therefore, higher prices for consumers. Firms only one step away from going out of business which may discourage entrepreneurs from entering the market.

Is Perfect Competition realistic? ANSWER = NO...BUT WHY? There are barriers in every industry (e.g. setting up an airline) Goods are not identical (e.g. Coca Cola and Pepsi, Mac lipstick and L’oreal lipstick) Goods are not always the same price (e.g. petrol) Many business’ in order to get established and become popular will lower prices and undercut competition. Perfect Competition is the economic equivalent of World Peace. It doesn’t exist but is an ideal on which we can compare the real world to.