1. Ch. 12: Perfect Competition.
Selection of price and output
Shut down decision in short run.
Entry and exit behavior.
Predicting the effects of a change in demand, technological advance, or change in cost.
Efficiency of perfect competition

2. Perfect Competition Perfect competition is an industry in which:
Many firms sell identical products to many buyers.
No barriers to entry.
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.

3. 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.

4. 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.

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

6. Profit Max. in Perfect Comp.
A perfectly competitive firm faces two constraints:
Market constraint
market price and the firm’s revenue curves
Technology constraint
firm’s product curves and cost curves.

7. 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 stay in the industry or leave it.
Whether to change its capital/labor mix (e.g. increase or decrease its plant size)

8. 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.

9. Profit Max. in Perfect Comp.
Marginal Analysis
Because MR is constant and MC eventually increases as output increases, profit is maximized by producing the output at which
(P=)MR = MC

10. Profit Max. in Perfect Comp.

11. Profit Max. in Perfect Comp.
Profit = (P-ATC)*Q

12. Profit Max. in Perfect Comp.
SR decision to shut down.
P = (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.

13. Profit Max. in Perfect Comp.
The Firm’s Short-Run Supply Curve
shows firm’s profit-maximizing output for different market prices, ceteris paribus
MC curve above minimum of AVC

14. 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.

15. 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.

16. LR adjustments Effect of increase in demand on economic profits in LR
At LR equilibrium
P=MC=ATC
P=0
ATC is at a minimum
Start here 8:30

17. LR equilibrium
Long-run equilibrium occurs in a competitive industry when:
P 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.

18. 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

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

20. LR adjustment to change in demand with decreasing cost industry

21. LR adjustment to change in demand with increasing cost industry

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

23. Changes in Production Technology
Why can’t a firm survive in LR at Q=6?
Why is LR equilibrium at Q where LRATC is minimized?

24. 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)

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

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