Chapter 10: Perfect Competition

Objectives After studying this chapter, you will be able to: Define perfect competition Explain how firms make their supply decisions and why they sometimes shut down temporarily and lay off workers Explain how price and output are determined and why firms enter and leave an industry Predict the effects of a change in demand and of a technological advance Explain why perfect competition is efficient .

Rivalry in Personal Computers The personal computer business is a highly competitive business made of such firms as Apple, Dell, Gateway etc competing with hundreds of smaller firms. How do firms operate when they face the fiercest competition from other firms. What determines their production decisions? Why do firms enter or leave the industry? These and other questions about competitive markets will be answered in this chapter

What is Perfect Competition? Perfect competition is an industry in which: Many firms sell identical products to many buyers. There are no restrictions to entry into the industry. Existing firms have no advantages over new ones. Sellers and buyers are well informed about prices.

What is Perfect Competition? How Perfect Competition Arises Perfect competition arises when two conditions are present: A firm’s minimum efficient scale is the smallest quantity of output at which long-run average cost reaches its lowest level. When each firm is perceived to produce a good or service that has no unique characteristics, so consumers don’t care which firm they buy from.

What is Perfect Competition? Price Takers In perfect competition, each firm is a price taker. A price taker is a firm that cannot influence the market price of a good or service. Each firm produces a tiny fraction of the total output and buyers are well informed about the prices of other firms. The firm faces a perfectly elastic demand for its output

What is Perfect Competition? Economic Profit and Revenue The goal of each firm is to maximise economic profit, which equals total revenue minus total cost. Total cost is the opportunity cost of production, which includes normal profit. A firm’s total revenue equals price times quantity sold A firm’s marginal revenue is the change in total revenue that results from a one-unit increase in the quantity sold.

Demand, Price, and Revenue in Perfect Competition Table 10.1 15

Demand, Price, and Revenue in Perfect Competition Figure 10.1 Sam’s demand, average revenue, and marginal revenue Sam’s total revenue T-shirt market TR 50 Demand for Sam’s T-shirts 50 S Price (dollars per T-shirt) Total revenue (dollar per day) Price (dollars per T-shirt) AR= MR 25 225 25 A D 0 9 0 9 0 10 20 Quantity (thousands of T-shirts per day) Quantity (T-shirts per day) Quantity (T-shirts per day) 19

The Firm’s Decisions in Perfect Competition A perfectly competitive firm faces two constraints: A market constraint summarised by the market price and the firm’s revenue curves. A technology constraint summarised by the firm’s product curves and cost curves.

The Firm’s Decisions in Perfect Competition Short-Run Decisions The perfectly competitive firm makes two decisions in the short run: Whether to produce or to temporarily shut down What quantity to produce

The Firm’s Decisions in Perfect Competition Long-Run Decisions A firm’s long-run decisions are: Whether to increase or decrease its plant size Whether to remain in, enter, or leave an industry

The Firm’s Decisions in Perfect Competition Profit-Maximising Output A perfectly competitive firm chooses the output that maximises its economic profit. One way to find the profit maximising output is to look at the firm’s the total revenue and total cost curves.

Total Revenue, Total Cost, and Economic Profit Table 10.2 27

Revenue and Cost TC TR 300 225 183 100 0 4 9 12 Figure 10.2(a) Economic loss Total revenue & total cost (dollars per day) 300 Economic profit = TR - TC 225 183 100 Economic loss 0 4 9 12 Quantity (T-shirts per day) 31

Economic Profit and Loss Figure 10.2(b) Economic profit and loss 42 Profit/loss (dollars per day) Economic profit Economic loss 20 Quantity (T-shirts per day) 4 9 12 Profit maximising quantity -20 Profit/ loss -40 34

The Firm’s Decisions in Perfect Competition Marginal Analysis The firm can use marginal analysis to determine the profit-maximising output. Profit is maximised by producing the output at which marginal revenue, MR, equals marginal cost, MC.

Profit-Maximising Output Table 10.3 41

Profit-Maximizing Output Figure 10.3 MC Profit- maximization point Loss from an extra 10th T-shirt 10 20 30 25 MR Marginal revenue & marginal cost (dollars per T-shirt) Profit from an extra 10th T-shirt 8 9 10 Quantity (T-shirts per day) 45

The Firm’s Decisions in Perfect Competition Profits and Losses in the Short-run Maximum profit is not always a positive economic profit. To determine whether a firm is earning an economic profit or incurring an economic loss, we compare the firm’s average total cost, ATC, at the profit maximising output with the market price.

Three Possible Profit Outcomes in the Short-Run ATC Normal profit Figure 10.4(a) 30.00 MC Break-even point 25.00 Price (dollars per T-shirt) 20.00 AR = MR 15.00 8 10 Quantity (T-shirts per day) 66

Three Possible Profit Outcomes in the Short-Run ATC Economic profit Figure 10.4(b) 30.00 MC 25.00 Economic Profit MR Price (dollars per T-shirt) 20.00 15.00 9 10 Quantity ( T-shirts per day) 68

Three Possible Profit Outcomes in the Short-Run Figure 10.4(c) Economic loss 30.00 ATC MC 25.00 Price (dollars per T-shirt) 20.00 Economic loss 17.00 MR 15.00 10 7 Quantity ( T-shirts per day) 70

The Firm’s Decisions in Perfect Competition Temporary Plant Shutdown If price is less than the minimum average variable cost, the firm shuts down temporarily and incurs a loss equal to total fixed cost. This loss is the largest that the firm must bear. If the firm were to produce just 1 unit of output at price below average variable cost, it would incur an additional (and avoidable) loss.

The Firm’s Decisions in Perfect Competition The Firm’s Short-run Supply Curve A perfectly competitive firm’s short-run supply curve shows how the firm’s profit-maximising output varies as the market price varies, other things remaining the same. Because the firm produces the output at which marginal cost equals marginal revenue, and because marginal revenue equals price, the firm’s supply curve is linked to its marginal cost curve. But there is a price below which the firm produces nothing and shuts down temporarily.

The Firm’s Decisions in Perfect Competition The shutdown point is the output and price at which the firm just covers its total variable cost. This point is where average variable cost is at its minimum. It is also the point at which the marginal cost curve crosses the average variable cost curve. At the shutdown point, the firm is indifferent between producing and shutting down temporarily. It incurs a loss equal to total fixed cost from either action.

The Firm’s Decisions in Perfect Competition If the price exceeds minimum average variable cost, the firm produces the quantity at which marginal cost equals price. Price exceeds average variable cost, and the firm covers all its variable cost and at least part of its fixed cost.

A Firm’s Shutdown Point and Supply Curve Figure 10.5(a) MC AVC 31 MR2 T Shutdown point 25 MR1 Marginal revenue & marginal cost (dollars per T-shirt) 17 MR0 7 9 10 Quantity (T-shirts per day) 53

A Firm’s Supply Curve S 31 25 17 60 70 80 Quantity (T-shirts per day) Figure 10.5(b) 31 Marginal revenue & marginal cost (dollars per T-shirt) 25 T 17 60 70 80 Quantity (T-shirts per day) 54

The Firm’s Decisions in Perfect Competition Short-run Industry Supply Curve The short-run industry supply curve shows the quantity supplied by the industry at each price when the plant size of each firm and the number of firms remain constant. 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.

Industry Supply Curve S1 31 25 20 17 7 8 9 10 Figure 10.6 31 D 25 C Price (dollars per T-shirt) 20 B A 17 7 8 9 10 Quantity (thousands of T-shirts per day) 58

Output, Price, and Profit in Perfect Competition Short-Run Equilibrium Short-run industry supply and industry demand determine the market price and output. A short-run equilibrium occurs at the intersection of the demand and supply curves.

Short-run Equilibrium Figure 10.7(a) 31 D 25 D1 C Price (dollars per T-shirt) 20 B A 17 7 8 9 10 Quantity (thousands of T-shirts per day) 58

Output, Price, and Profit in Perfect Competition A Change in Demand An increase in demand brings a rightward shift of the industry demand curve: the price rises and the quantity increases. A decrease in demand brings a leftward shift of the industry demand curve: the price falls and the quantity decreases.

Short-Run Equilibrium Figure 10.4(b) Increase in demand: price rises and firms increase production 31 S D2 Price (dollars per T-shirt) 25 Decrease in demand: price falls and firms decrease production D3 20 17 Instructor notes 1) When demand decreases to D3, the price falls to $17 and each firm decreases its output to 7 sweaters a day. 2) Industry output is 7,000 sweaters a day. D1 6 7 8 9 10 Quantity (thousands of T-shirts per day) 62

Output, Price, and Profit in Perfect Competition Long-Run Adjustments In short-run equilibrium, a firm may earn an economic profit, earn normal profit, or incur an economic loss and which of these states exists determines the further decisions the firm makes in the long run. In the long run, the firm may: Enter or exit an industry Change its plant size

Output, Price, and Profit in Perfect Competition Entry and Exit New firms enter an industry in which existing firms earn an economic profit. Firms exit an industry in which they incur an economic loss. Entry and exit of new firms shifts the industry supply curve.

Entry and Exit Entry increases supply Figure 10.8 31 S2 S1 S0 Price (dollars per T-shirt) Exit decreases supply 23 20 17 D1 7 8 9 10 Quantity (thousands of T-shirts per day) 79

Output, Price, and Profit in Perfect Competition Changes in Plant Size Firms change their plant size whenever doing so is profitable. If average total cost exceeds the minimum long-run average cost, firms change their plant size to lower costs and increase profits. Figure 10.9 on the next slide shows the effects of changes in plant size.

Plant Size and Long-Run Equilibrium LRAC Plant Size and Long-Run Equilibrium MC0 MC1 SRAC0 SRAC1 Figure 10.9 Short-run profit maximizing point 25 Price (dollars per T-shirt) MR0 MR1 20 M Long-run competitive equilibrium 6 8 Quantity (T-shirts per day) 84

Output, Price, and Profit in Perfect Competition Long-Run Equilibrium Long-run equilibrium occurs in a competitive industry when: Economic profit is zero, so firms neither enter nor exit the industry. Long-run average cost is at its minimum, so firms don’t change their plant size.

Changing Tastes and Advancing Technology A Permanent Change in Demand A decrease in demand shifts the demand curve leftward. The price falls and the quantity decreases. Economic losses induce exit, which decreases short-run supply and shifts the short-run industry supply curve leftward. Watching the work of the invisible hand. The power of the market to make firms respond to consumers’ changing demands become visible to the student in this section. When you teach this material, do the analysis with a specific (and current/recent) example with which the students can identify. Computers and ISPs are good for an increase in demand. Audio tapes are good for a decrease in demand.

A Decrease in Demand Industry Firm MC S1 S0 D0 D1 Q2 Q1 Q0 Figure 10.10 Industry Firm MC S1 S0 Price D0 Price and Cost ATC D1 P0 MR0 P0 Q2 MR1 P1 P1 q1 Instructor Notes: This is a summary slide of all the events. Q1 Q0 Quantity q0 Quantity 96

Changing Tastes and Advancing Technology Increase in Demand An increase in demand shifts the demand curve rightward. The price rises and the quantity increases. Economic profit induces entry, which increases short-run supply and shifts the short-run industry supply curve rightward. As industry supply increases, the price falls and the market quantity continues to increase.

Changing Tastes and Advancing Technology External Economics and Diseconomies The change in the long-run equilibrium price following a permanent change in demand depends on external economies and external diseconomies. External economies are factors beyond the control of an individual firm that lower the firm’s costs as the industry output increases. External diseconomies are factors beyond the control of a firm that raise the firm’s costs as industry output increases.

Changing Tastes and Advancing Technology A long-run industry supply curve shows how the quantity supplied by an industry varies as the market price varies, after all the possible adjustments have been made, including changes in plant size and changes in the number of firms in the industry

Long-Run Changes in Price and Quantity Figure 10.11 Constant-cost industry Increasing-cost industry Decreasing-cost industry Price Price Price D1 S1 S0 S2 D1 S0 D1 S0 Ps Ps LSB Ps S3 Qs P2 Qs Qs P0 LSA P0 P0 Q2 LSC Q1 P3 Q3 D0 D0 D0 Q0 Q0 Q0 Quantity Quantity Quantity 110

Changing Tastes and Advancing Technology Technological Change New technologies are constantly discovered that lower costs. A new technology enables firms to produce at a lower average cost and lower marginal cost—firms’ cost curves shift downward. Firms that adopt the new technology earn an economic profit.

Competition and Efficiency Efficient Use of Resources Resource use is efficient when we produce the goods and services that people value most highly If someone can become better off without anyone else becoming worse off, resources are not being used efficiently. In other words, resource use is efficient when marginal benefit equals marginal cost. Pulling it all together In this section, you can show your students what they’ve learned and pull together the entire course to date. Begin by reiterating the two primary goals of this chapter and then note that you are now dealing with the second goal. Emphasise that the pressures of competition force self-interested firms to produce incredible long run results: Each firm produces at the lowest possible average total cost –at the minimum point of the long run average cost curve, Consumers pay the lowest possible price that keeps firms in business—P = minimum ATC. Each firm uses the least-cost technology, Firms produce the efficient quantity—price, which equals marginal benefit equals marginal cost. The forces of competition, which Adam Smith called an invisible hand, guide firms to produce output and charge prices that maximize the value of our scarce resources.

Competition and Efficiency Choices, Equilibrium, and Efficiency We can describe an efficient use of resources in terms of the choices of consumers and firms coordinated in market equilibrium. Consumers allocate their resources to get the most value possible out of them Consumers get the most value possible out of their resources at all points along their demand curves, which are also their marginal benefit curves.

Competition and Efficiency In competitive equilibrium, the quantity demanded equals the quantity supplied. This means that the consumer’s marginal benefit equals the producer’s marginal cost. The gains from trade — consumer surplus plus producer surplus — are maximised. 114

Efficiency of Competition A Single Firm A Market Quantity Price S D=MSB q* P* MC Consumer surplus Price and cost SRAC LRAC Efficient allocation P* MR Long-run Competitive equilibrium Producer surplus q* Quantity 116

END CHAPTER 10