© 2006 McGraw-Hill Ryerson Limited. All rights reserved.1 Chapter 10: Perfect Competition Prepared by: Kevin Richter, Douglas College Charlene Richter, British Columbia Institute of Technology

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 2 Perfect Competition The concept of competition is used in two ways in economics.  Competition as a process is a rivalry among firms.  Competition as a market structure.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 3 Competition as a Process Competition involves one firm trying to take away market share from another firm. As a process, competition pervades the economy.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 4 Perfectly Competitive Market A perfectly competitive market is one in which economic forces operate unimpeded. It has highly restrictive assumptions which provide us with a reference point we can use in comparing different markets.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 5 Perfectly Competitive Market In a perfectly competitive market:  The number of firms is large.  The firms' products are identical.  There is free entry and exit, that is, there are no barriers to entry.  There is complete information.  Firms are profit maximizers.  Both buyers and sellers are price takers.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 6 Necessary Conditions for Perfect Competition Firms' products are identical.  This requirement means that each firm's output is indistinguishable from any other firm’s output.  Firms sell homogeneous product.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 7 Necessary Conditions for Perfect Competition There is free entry and free exit.  Firms are free to enter a market in response to market signals such as price and profit. Barriers to entry are social, political, or economic impediments that prevent other firms from entering the market.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 8 Necessary Conditions for Perfect Competition There are no barriers to entry.  Barriers sometimes take the form of patents granted to produce a certain good.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 9 Necessary Conditions for Perfect Competition There are no barriers to entry.  Technology may prevent some firms from entering the market.  Social forces such as bankers only lending to certain people may create barriers.  There must also be free exit, without incurring a loss.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 10 Necessary Conditions for Perfect Competition There is complete information.  Firms and consumers know all there is to know about the market – prices, products, and available technology.  Any technological breakthrough would be instantly known to all in the market.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 11 Necessary Conditions for Perfect Competition Firms are profit maximizers.  The goal of all firms in a perfectly competitive market is profit and only profit.  The only compensation firm owners receive is profit, not salaries.  There is no non-price competition (based on quality, brand name, or the like).

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 12 Necessary Conditions for Perfect Competition Both buyers and sellers are price takers. A price taker is a firm or individual who takes the market price as given.  Neither supplier nor buyer possesses market power.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 13 Definition of Supply and Perfect Competition If all the necessary conditions for perfect competition exist, we can talk formally about the supply of a produced good.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 14 Definition of Supply and Perfect Competition Supply is a schedule of quantities of goods that will be offered to the market at various prices.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 15 Definition of Supply and Perfect Competition When a firm operates in a perfectly competitive market, its supply curve is that portion of its short-run marginal cost curve above average variable cost.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 16 Definition of Supply and Perfect Competition That the number of suppliers be large means that they do not have the ability to collude (act together with other firms to control price or market share).

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 17 Definition of Supply and Perfect Competition Other conditions make it impossible for any firm to forget about the hundreds of other firms waiting to replace their supply. A firm's goal is specified by the condition of profit maximization.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 18 Definition of Supply and Perfect Competition Even if the conditions for a perfectly competitive market are not met, supply forces are still strong and many of the insights of the competitive model can be applied to firm behaviour in other market structures.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 19 Demand Curves for the Firm and the Industry The demand curve facing the firm is different from the industry demand curve. A perfectly competitive firm’s demand schedule is perfectly elastic even though the demand curve for the market is downward sloping.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 20 Demand Curves for the Firm and the Industry 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. Each firm in a competitive industry is so small that it does not need to lower its price in order to sell additional output.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 21 Market supply Market demand 1,0003,000 Price $ Quantity MarketFirm Individual firm demand Market Demand Curve Versus Individual Firm Demand Curve Price $ Quantity A BC

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 22 Profit-Maximizing Level of Output The goal of the firm is to maximize profits. Profit is the difference between total revenue and total cost.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 23 Profit-Maximizing Level of Output When it decides what quantity to produce it continually asks how changes in quantity would affect its profit.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 24 Profit-Maximizing Level of Output 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.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 25 Profit-Maximizing Level of Output Marginal revenue (MR) – the change in total revenue associated with a one-unit change in quantity. Marginal cost (MC) – the change in total cost associated with a one-unit change in quantity.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 26 Marginal Revenue A perfect competitor accepts the market price as given. As a result, marginal revenue is equal to price (MR = P).

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 27 Marginal Cost Initially, marginal cost falls and then begins to rise. Marginal concepts are best defined between the numbers.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 28 Profit Maximization: MC = MR To maximize profits, a firm should produce where marginal cost equals marginal revenue.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 29 How to Maximize Profit If marginal revenue does not equal marginal cost, a firm can increase profit by changing output. The supplier will continue to produce more as long as marginal cost is less than marginal revenue.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 30 How to Maximize Profit 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.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 31 Price = MRQuantityTotal CostMarginal Cost

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 32 B C Area 1 P = D = MR Costs Quantity A MC Marginal Cost, Marginal Revenue, and Price Area 2

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 33 C A P = D = MR Costs Quantity A B MC Marginal Cost, Marginal Revenue, and Price $ Price = MR Quantity Produced Marginal Cost $

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 34 Marginal Cost Curve Is the Firm’s Supply Curve The marginal cost curve, above the point where price exceeds average variable cost, is the firm's supply curve.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 35 Marginal Cost Curve Is the Firm’s Supply Curve The MC curve tells the competitive firm how much it should produce at a given price. The firm can do no better than produce the quantity at which marginal cost equals marginal revenue which in turn equals price.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 36 Marginal Cost Curve Is the Firm’s Supply Curve A B C Marginal cost Cost, Price $ Quantity

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 37 Firms Maximize Total Profit Firms seek to maximize total profit, not profit per unit.  Firms do not care about profit per unit.  As long as an increase in output yields even a small amount of additional profit, a profit- maximizing firm will increase output.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 38 Profit Maximization Using Total Revenue and Total Cost Profit is maximized where the vertical distance between total revenue and total cost is greatest. At that output, MR (the slope of the total revenue curve) and MC (the slope of the total cost curve) are equal.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 39 TCTR 0 Total cost, revenue $ Quantity Maximum profit =$81 $130 Loss Profit Profit =$45 Profit Maximization Using Total Revenue and Total Cost

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 40 Total Profit at the Profit-Maximizing Level of Output The P = MR = MC condition tells us how much output a competitive firm should produce to maximize profit. It does not tell us how much profit the firm makes.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 41 Determine Profit and Loss From a Table of Costs Profit can be calculated from a table of costs and revenues. Profit is determined by total revenue minus total cost.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 42 Determine Profit and Loss From a Table of Costs The profit-maximizing output choice is not necessarily a position that minimizes either average variable cost or average total cost. It is only the choice that maximizes total profit.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 43 Costs Relevant to a Firm

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 44 Costs Relevant to a Firm

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 45 Determine Profit From a Graph Find output where MC = MR. The intersection of MC = MR (P) determines the quantity the firm will produce if it wishes to maximize profits.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 46 Determine Profit From a Graph Find profit per unit where MC = MR. To determine maximum profit, you must first determine what output the firm will choose to produce. See where MC equals MR, and then draw a line down to the ATC curve. This is the profit per unit.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 47 Determine Profit and Loss From a Graph The firm makes a profit when the ATC curve is below the MR curve. The firm incurs a loss when the ATC curve is above the MR curve.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 48 Determine Profit and Loss From a Graph Zero economic profit or loss occurs where MC=MR. Firms can earn zero economic profit or even a loss where MC = MR at the relevant output. Even though economic profit is zero, all resources, including entrepreneurs, are being paid their opportunity costs at the relevant output.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 49 (a) Economic Profit(b) Zero economic profit(c) Loss Determine Profits Graphically Quantity Price D MC AP = MR B ATC AVC E Profit C MC ATC AVC MC ATC AVC Loss P = MR Price

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 50 Shutdown Point The firm will shut down if it cannot cover its variable costs.  A firm should continue to produce as long as price is greater than average variable cost.  If price falls below that point it makes sense to shut down temporarily and save the variable costs.  The firm still pays fixed costs.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 51 Shutdown Point The shutdown point is the point at which the firm will be better off if it shuts down than if it stays in business.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 52 Shutdown Point If total revenue is more than total variable cost, the firm’s best strategy is to temporarily produce at a loss. It is taking less of a loss than it would by shutting down.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 53 MC P = MR 2468Quantity Price ATC AVC Loss A $17.80 Shutdown Decision

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 54 Short-Run Market Supply and Demand While the firm's demand curve is perfectly elastic, the industry demand is downward sloping. Industry supply is the sum of all firms’ supply curves.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 55 Short-Run Market Supply and Demand In the short run when the number of firms in the market is fixed, the market supply curve is just the horizontal sum of all the firms' marginal cost curves.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 56 Short-Run Market Supply and Demand Since all firms have identical marginal cost curves, a quick way of summing the quantities is to multiply the quantities from the marginal cost curve of a representative firm by the number of firms in the market.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 57 Market Supply In the long run, the number of firms may change in response to market signals, such as price and profit. As firms enter the market in response to economic profits being made, the market supply shifts to the right. As economic losses force some firms to exit, the market supply shifts to the left.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 58 Profits as Signals

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 59 Long-Run Competitive Equilibrium Profits and losses are inconsistent with long- run equilibrium. Profits create incentives for new firms to enter, output will increase, and the price will fall until economic profits fall to zero. The existence of losses will cause firms to leave the industry.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 60 Long-Run Competitive Equilibrium Only at zero profit will entry and exit stop. The zero profit condition defines the long-run equilibrium of a competitive industry.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 61 Long-Run Competitive Equilibrium MC P = MR Price 2468Quantity SRAC LRAC

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 62 Long-Run Competitive Equilibrium Zero profit does not mean that the entrepreneur does not get anything for his efforts.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 63 Long-Run Competitive Equilibrium In order to stay in business the entrepreneur must receive his opportunity cost or normal profits (the amount the owners of business would have received in the next-best alternative).

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 64 Long-Run Competitive Equilibrium Normal profits are included as a cost. Economic profits are profits above normal profits.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 65 Long-Run Competitive Equilibrium Firms with super-efficient workers or machines will find that the price of these specialized inputs will rise. Rent is the income received by those specialized factors of production.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 66 Long-Run Competitive Equilibrium The zero profit condition is enormously powerful. As long as there is free entry and exit, price will be pushed down to the average total cost of production.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 67 Increase in Demand An increase in demand leads to higher prices and higher profits.  Existing firms increase output.  New firms enter the market, increasing output still more.  Price falls until all profit is competed away.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 68 Increase in Demand If input prices remain constant, the market is a constant-cost industry, and the new equilibrium will be at the original price but with a higher output.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 69 Increase in Demand If the the market is a constant-cost industry, the new equilibrium will be at the original price but with a higher market output. A market is a constant-cost industry if the long-run industry supply curve is perfectly elastic (horizontal).

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 70 Increase in Demand The original firms return to their original output but since there are more firms in the market, the total market output increases.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 71 Increase in Demand In the short run, the price does more of the adjusting. In the long run, more of the adjustment is done by quantity.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 72 Profit $ Firm Price Quantity B A Market Response to an Increase in Demand Market Quantity Price 0 B A C MC AC S LR S 0SR D0D $ ,200 D1D1 S 1SR 7

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 73 Long-Run Market Supply In the long run firms earn zero profits. If the long-run industry supply curve is perfectly elastic, the market is a constant- cost industry.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 74 Long-Run Market Supply Two other possibilities exist: Increasing-cost industry – factor prices rise as new firms enter the market and existing firms expand capacity. Decreasing-cost industry – factor prices fall as industry output expands.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 75 Increasing-Cost Industry If inputs are specialized, factor prices are likely to rise in response to the increase in the industry-wide demand for inputs to production increases.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 76 Increasing-Cost Industry This rise in factor costs would force costs up for each firm in the industry and increases the price at which firms earn zero profit. Therefore, in increasing-cost industries, the long-run supply curve is upward sloping.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 77 Decreasing-Cost Industry If input prices decline when industry output expands, individual firms' cost curves shift down. The price at which firms break even now decreases, and the long-run market supply curve is downward sloping.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 78 Canadian Retail Industry During the 1990s the Canadian retail industry illustrated how a competitive market adjusts to changing market conditions.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 79 Many retailers were lost or absorbed by competitors: Eaton’s, Bretton’s, Pascal’s, Robinson’s, K-Mart and many others. Initially, these firms saw their losses as the temporary result of reduced demand in a slowing economy. Canadian Retail Industry

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 80 As prices fell, P=MR fell below their ATC. But since price remained above the AVC, many firms closed their less profitable locations and continued to operate. Canadian Retail Industry

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 81 When demand did not recover, firms ran out of options. Many firms realized as they moved into the long run that they have to exit the Canadian retail industry. Canadian Retail Industry

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 82 Price Quantity MC ATC AVC P = MR Loss Shutdown Decision

© 2006 McGraw-Hill Ryerson Limited. All rights reserved.83 Perfect Competition End of Chapter 10