1. 12
Perfect Competition
CHAPTER
Notes and teaching tips: 2, 4, 6, 16, 25, 27, 32, 34, 58, and 79.
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2. Sweet Competition
Maple syrup is produced by 12,000 farms in Canada and the United States in a highly competitive market.
We study such a market in this chapter.
We explain the changes in price and output as the firms in perfect competition respond to changes in demand and technological change.

3. 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.
Established firms have no advantages over new ones.
Sellers and buyers are well informed about prices.
The range of market types. Remind the students of what they learned in Chapter 9 about the spectrum of markets that range from perfect competition to monopoly.
The perfect competition model serves as a benchmark and its predictions work in a wide range of real markets. Set the scene for appreciating the power of the perfect competition model with a physical analogy. Explain that physicists often use the model of a “perfect vacuum” to understand our physical world. For example, to predict how long it will take a 50 kilogram steel ball to hit the ground if it is dropped from the top of the Empire State Building, you will be very close to the actual time if you assume a perfect vacuum and use the formula that applies in that case. Friction from the atmosphere is obviously not zero, but assuming it to be zero is not very misleading. In contrast, if you want to predict how long it will take a feather to make the same trip, you need a fancier model!
Economists use the model of “perfect competition” in a similar way to understand our economic world. Emphasize to students that although no real world industry meets the full definition of perfect competition, the behavior of firms in many real world industries and the resulting dynamics of their market prices and quantities can be predicted to a high degree of accuracy by using the model of perfect competition.

4. Competition How Perfect Competition Arises Perfect competition arises
When firm’s minimum efficient scale is small relative to market demand so there is room for many firms in the industry.
And 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.

5. Competition Price Takers
In perfect competition, each firm is a price taker.
A price taker is a firm that cannot influence the price of a good or service.
No single firm can influence the price—it must “take” the equilibrium market price.
Each firm’s output is a perfect substitute for the output of the other firms, so the demand for each firm’s output is perfectly elastic.
Price taking. Be sure to spend a few minutes providing intuition to ensure that your students understand why firms in perfect competition are price takers: They can offer to sell for a lower price, but they’re giving profits away; and they can ask for a higher price, but no one will pay. You might like to note that if the market is not in equilibrium, the firm isn’t a price taker. If there is a shortage, firms can get away with a higher price and they ask for more. That’s how prices rise. If there is a surplus, firms offer a lower price to move their product. That’s how prices fall. But in equilibrium, there is nothing to do but take the going price. And competitive markets get to equilibrium fast.

6. Competition Economic Profit and Revenue
The goal of each firm is to maximize 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, P, multiplied by quantity sold, Q, or P  Q.
A firm’s marginal revenue is the change in total revenue that results from a one-unit increase in the quantity sold.

7. Competition
Figure 11.1(a) shows that market demand and supply determine the price that the firm must take.

8. Competition
Figure 11.1(b) shows the demand curve for the firm’s product, which is also its marginal revenue curve. The firm is a price taker, so marginal revenue equals price.

9. Competition
Figure 11.1(c) shows the firm’s total revenue curve.

10. The Firm’s Decisions in Perfect Competition
A perfectly competitive firm faces two constraints:
1. A market constraint summarized by the market price and the firm’s revenue curves
2. A technology constraint summarized by firm’s product curves and cost curves (like those in Chapter 10)

11. The Firm’s Decisions in Perfect Competition
The competitive firm makes two decisions in the short run:
1. Whether to produce or to shut down.
2. If the decision is to produce, what quantity to produce.
A firm’s long-run decisions are
1. Whether to increase or decrease its plant size.
2. Whether to stay in the industry or leave it.

12. The Firm’s Decisions in Perfect Competition
Profit-Maximizing Output
A perfectly competitive firm chooses the output that maximizes its economic profit.
One way to find the profit-maximizing output is to look at the firm’s the total revenue and total cost curves.
Figure 11.2 on the next slide looks at these curves along with the firm’s total profit curve.
Do firms really choose the output that maximizes profit? It is useful to explain to your students that many big firms routinely make tables using spreadsheets of total revenue, total cost, and economic profit—and make graphs—similar to those in Figure But most firms, and certainly most small firms like Cindy’s sweater knitting firm, don’t make such calculations. Nonetheless, they do make their decisions at the margin. They can figure out how much it will cost to hire one more worker and how much output that worker will produce. So they can figure out their marginal cost—wage rate divided by marginal product. They can compare that number with the price. They are choosing at the margin.

13. The Firm’s Decisions in Perfect Competition
Part (a) shows the total revenue, TR, curve.
Part (a) also shows the total cost curve, TC, which is like the one in Chapter 10.
Total revenue minus total cost is profit (or loss), shown in part (b).

14. The Firm’s Decisions in Perfect Competition
Profit is maximized when the firm produces 9 sweaters a day.
At low output levels, the firm incurs an economic loss—it can’t cover its fixed costs.

15. The Firm’s Decisions in Perfect Competition
At intermediate output levels, the firm earns an economic profit.
At high output levels, the firm again incurs an economic loss—now it faces steeply rising costs because of diminishing returns.

16. The Firm’s Decisions in Perfect Competition
Marginal Analysis
The firm can use marginal analysis to determine the profit-maximizing output.
Because marginal revenue is constant and marginal cost eventually increases as output increases, profit is maximized by producing the output at which marginal revenue, MR, equals marginal cost, MC.
Figure 11.3 on the next slide shows the marginal analysis that determines the profit-maximizing output.

17. The Firm’s Decisions in Perfect Competition
If MR > MC, economic profit increases if output increases.
If MR < MC, economic profit decreases if output increases.
If MR = MC, economic profit decreases if output changes in either direction, so economic profit is maximized.

18. 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-maximizing output with the market price.
Figure 11.4 on the next slide shows the three possible profit outcomes.

19. The Firm’s Decisions in Perfect Competition
In part (a), price equals ATC and the firm earns zero economic profit (normal profit).
Operating a business at zero economic profit. Students are often skeptical that a zero economic profit is an acceptable outcome for an entrepreneur. The key is to reinforce the meaning of normal profit.
A rational decision is one that is based on a weighing of the full opportunity cost of each alternative against its full benefits—for a firm weighing the total revenue against the opportunity cost for each alternative.
Opportunity cost includes the benefits from forgone opportunities as well as explicit costs. One of these forgone opportunities is that of the entrepreneur pursuing her/his next best activity.
The value of this forgone opportunity is normal profit.
So, when a firm earns zero economic profit, the entrepreneur earns normal profit and enjoys the same benefits as those available in the next best activity. There is no incentive to change to the next best activity.

20. The Firm’s Decisions in Perfect Competition
In part (b), price exceeds ATC and the firm earns a positive economic profit.

21. The Firm’s Decisions in Perfect Competition
In part (c), price is less than ATC and the firm incurs an economic loss—economic profit is negative and the firm does not even earn normal profit.
Operating a business at a loss. Students often have a hard time understanding why operating at an economic loss can be the best action. The key is appreciating that:
The firm’s short-run decisions are made after some irrevocable commitments have generated sunk costs.
The firm considers only avoidable costs when making decisions. Unavoidable costs have no impact on the decision.
So for the firm to produce its revenues need only exceed avoidable costs, not total costs.
The profit maximization goal doesn’t require the firm to earn a positive economic profit in the short run.

22. 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-maximizing 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.

23. 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 a price below average variable cost, it would incur an additional (and avoidable) loss.
Temporary shutdown. In our experience, this topic is the hardest for the students to understand. You can help them with the intuition by pointing out that the rationale for temporary shutdown isn’t confined to perfect competition and that they can see the phenomenon right around the corner. Many restaurants close on Sunday evening and Monday. Many hairdressers close on Sunday and Monday. Why? Your students will easily figure out that total revenue is less than total variable cost and equivalently that price is less than average variable cost.
The mechanics of the shutdown analysis will be a lot easier to explain once the students have thought about these real situations with which they are familiar.

24. 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.

25. 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.
When to increase and when to decrease output. Students need repeated reminders that to determine whether a firm can increase profit by changing output, price, and marginal cost are the only things to consider. Questions that throw average total cost into the mix often cause confusion.

26. The Firm’s Decisions in Perfect Competition
Figure 11.5 shows how the firm’s short-run supply curve is constructed.
If price equals minimum average variable cost, $17 in this example, the firm is indifferent between producing nothing and producing at the shutdown point, T.

27. The Firm’s Decisions in Perfect Competition
If the price is $25, the firm produces 9 sweaters a day, the quantity at which MR = MC.
If the price is $31, the firm produces 10 sweaters a day, the quantity at which MR = MC.
The blue curve in part (b) traces the firm’s short-run supply curve.

28. The Firm’s Decisions in Perfect Competition (skip the rest of chapter #12)
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.