1. 11
PERFECT COMPETITION
CHAPTER

2. Objectives After studying this chapter, you will able to
Define perfect competition
Explain how price and output are determined in perfect competition
Explain why firms sometimes shut down temporarily and lay off workers
Explain why firms enter and leave the industry
Predict the effects of a change in demand and of a technological advance
Explain why perfect competition is efficient
Students find this topic challenging. Part of their problem is that it builds on the cost curves of the previous chapter and many of them still have only a shaky grasp of that material. So emphasize the cumulative nature of economics and remind the students of the huge payoff from mastering material a bite at a time.
You can help your students by emphasizing the two primary goals of this chapter: (1) To derive the market supply curve in a competitive industry and (2) to deepen your students’ understanding of how competition among self-interested consumers and producers moves resources from where they are less valued to where they are more valued and to an efficient allocation.
Explain that although Chapter 3 (Demand and Supply) and Chapter 5 (Efficiency and Equity) covered these same topics, they did so at a level that is one step removed from the decision makers. Remind the students that they’ve seen how consumer decisions lead to the best use of a household’s income. Point out that they are now going see how producer decisions are made and how they interact with consumer decisions.
You might like to use the metaphor that the chapter strips away more of the veil that hides the invisible hand.

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 pound 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.

7. Competition
A firm’s marginal revenue is the change in total revenue that results from a one-unit increase in the quantity sold.
Figure 11.1 illustrates a firm’s revenue curves.

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

9. Competition
Figure 11.1(b) shows the demand curve for the firm’s product, which is also its marginal revenue curve.

10. Competition
Because in perfect competition the price remains the same as the quantity sold changes, marginal revenue equals price.

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

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

13. The Firm’s Decisions in Perfect Competition
The perfectly competitive firm makes two 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 increase or decrease its plant size.
Whether to stay in the industry or leave it.

14. 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.

15. 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).

16. 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.

17. 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.

18. 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.

19. 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.

20. 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.

21. 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.

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

23. 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.

24. 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.

25. 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.
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.

26. 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.

27. 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.

28. 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.

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

30. 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.

31. The Firm’s Decisions in Perfect Competition
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.

32. The Firm’s Decisions in Perfect Competition
At a price equal to minimum average variable cost - the shutdown price - the industry supply curve is perfectly elastic because some firms will produce the shutdown quantity and others will produces zero.

33. Output, Price, and Profit in Perfect Competition
Short-Run Equilibrium
Short-run industry supply and industry demand determine the market price and output.
Figure 11.7 shows a short-run equilibrium at the intersection of the demand and supply curves.

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

35. 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

36. 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.
Figure 11.8 on the next slide shows the effects of entry and exit.

37. Output, Price, and Profit in Perfect Competition
As new firms enter an industry, industry supply increases.
The industry supply curve shifts rightward.
The price falls, the quantity increases, and the economic profit of each firm decreases.

38. Output, Price, and Profit in Perfect Competition
As firms exit an industry, industry supply decreases.
The industry supply curve shifts leftward.
The price rises, the quantity decreases, and the economic profit of each firm increases.

39. 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 11.9 on the next slide shows the effects of changes in plant size.

40. Output, Price, and Profit in Perfect Competition
If the price is $25, firms earn zero economic profit with the current plant.

41. Output, Price, and Profit in Perfect Competition
But if the LRAC curve is sloping downward at the current output, the firm can increase profit by expanding the plant.

42. Output, Price, and Profit in Perfect Competition
As the plant size increases, short-run supply increases, the price falls, and economic profit decreases.

43. Output, Price, and Profit in Perfect Competition
Long-run equilibrium occurs when the firm is producing at the minimum long-run average cost and earning zero economic profit.

44. 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.