11 CHAPTER Perfect Competition

11 CHAPTER Perfect Competition Notes and teaching tips: 4, 6, 17, 26, 30, 34, 36, 62, and 82. To view a full-screen figure during a class, click the red “expand” button. To return to the previous slide, click the red “shrink” button. To advance to the next slide, click anywhere on the full screen figure.

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 in an industry are determined and 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

The Busy Bee The busy bee pollinates plants and beekeepers rent their hives to farmers. Across the United States from Vermont to California, a parasite is killing off bees and the rent farmers pay for hives has more than doubled. How does competition in beekeeping and other industries affect prices and profits? We study a fiercely competitive 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 advances.

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. 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.

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.

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.

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.

Figure 11.1 illustrates a firm’s revenue concepts. Part (a) shows that market demand and market supply determine the market price that the firm must take.

Figure 11.1(b) shows the firm’s total revenue curve (TR)—the relationship between total revenue and quantity sold.

Figure 11.1(c) shows the marginal revenue curve (MR). The firm can sell any quantity it chooses at the market price, so marginal revenue equals price and the demand curve for the firm’s product is horizontal at the market price.

The demand for the firm’s product is perfectly elastic because one of Cindy’s sweaters is a perfect substitute for the sweater of another firm. The market demand is not perfectly elastic because a sweater is a substitute for some other good.

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). The goal of the firm is to make maximum economic profit, given the constraints it faces. So the firm must make four decisions: Two in the short run and two in the long run.

Short-Run Decisions In the short run, the firm must decide: 1. Whether to produce or to shut down temporarily. 2. If the decision is to produce, what quantity to produce. Long-Run Decisions In the long run, the firm must decide: 1. Whether to increase or decrease its plant size. 2. Whether to stay in the industry or leave it.

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.

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 economic profit (or loss), shown by the curve EP in part (b).

At low output levels, the firm incurs an economic loss—it can’t cover its fixed costs. At intermediate output levels, the firm makes an economic profit.

At high output levels, the firm again incurs an economic loss—now the firm faces steeply rising costs because of diminishing returns. The firm maximizes its economic profit when it produces 9 sweaters a day.

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.

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.

Profits and Losses in the Short Run Maximum profit is not always a positive economic profit. To determine whether a firm is making an economic profit or incurring an economic loss, we compare the firm’s average total cost at the profit-maximizing output with the market price. Figure 11.4 on the next slide shows the three possible profit outcomes.

In part (a) price equals average total cost and the firm makes zero economic profit (breaks even). 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 makes 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.

In part (b), price exceeds average total cost and the firm makes a positive economic profit.

In part (c) price is less than average total cost and the firm incurs an economic loss—economic profit is negative. 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 make a positive economic profit in the short run.

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.

Temporary Plant Shutdown If price is less than the minimum average variable cost, the firm shuts down temporarily and incurs an economic loss equal to total fixed cost. This economic loss is the largest that the firm must bear. If the firm were to produce just 1 unit of output at a price below minimum 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.

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.

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.

Short-Run Supply Curve 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.

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.

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.

Figure 11.6 shows the supply curve for an industry that has 1,000 firms like Cindy’s. 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.

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.

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.

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.

Long-Run Adjustments In short-run equilibrium, a firm may make an economic profit, break even, or incur an economic loss. Which of these outcomes occurs determines how the industry adjusts in the long run. In the long run, the firm may: Enter or exit an industry Change its plant size

Entry and Exit New firms enter an industry in which existing firms make 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.

Effects of Entry 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.

The Effects of Exit As firms exit an industry, industry supply decreases. The industry supply curve shifts leftward. The price rises, the quantity decreases, and the economic loss of each firm remaining in the industry decreases.

Changes in Plant Size A firm changes its plant size whenever doing so is profitable. If average total cost exceeds the minimum long-run average cost, the firm changes its plant size to lower average costs and increase economic profit. Figure 11.9 on the next slide shows the effects of changes in plant size.

If the price is $25 a sweater, the firm is making zero economic profit with the current plant.

But if the LRAC curve is sloping downward at the current output, the firm can increase profit by expanding the plant.

As the plant size increases, the firm’s short-run supply increases, the average total cost falls, and its economic profit increases.

As all firms in the industry change their plant size, industry supply increases, the market price falls, and economic profit decreases.

Long-run equilibrium occurs when each firm is producing at minimum long-run average cost and is making zero economic profit.

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 market demand curve leftward. The price falls and the quantity decreases. Figure illustrates the effects of a permanent decrease in demand when the industry is in long-run equilibrium. 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 shifts the industry demand curve leftward. The market price falls, and each firm decreases the quantity it produces.

The market price is now below each firm’s minimum average total cost, so firms incur economic losses.

Economic losses induce some firms to exit, which decreases the industry supply and the price starts to rise.

As the price rises, the quantity produced by the industry continues to decrease as more firms exit, but each firm remaining in the industry starts to increase its quantity.

A new long-run equilibrium occurs when the price has risen to equal minimum average total cost. Firms do not incur economic losses, and firms no longer exit the industry.

The main difference between the initial and new long-run equilibrium is the number of firms in the industry. Fewer firms produce the equilibrium quantity.

A permanent increase in demand has the opposite effects to those just described and shown in Figure 11.9. 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.

With a falling price, each firm decreases production in a movement along the firm’s marginal cost curve (short-run supply curve). A new long-run equilibrium occurs when the price has fallen to equal minimum average total cost so that firms do not make economic profits, and firms no longer enter the industry. The main difference between the initial and new long-run equilibrium is the number of firms in the industry. In the new equilibrium, a larger number of firms produce the equilibrium quantity.

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.

In the absence of external economies or external diseconomies, a firm’s costs remain constant as industry output changes. Figure illustrates the three possible cases and shows the long-run industry supply curve. The 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 the number of firms in the industry.

Figure 11.11(a) shows that in the absence of external economies or external diseconomies, an increase in demand does not change the price in the long run. The long-run industry supply curve LSA is horizontal.

Figure 11.11(b) shows that when external diseconomies are present, an increase in demand brings a higher price in the long run. The long-run industry supply curve LSB is upward sloping.

Figure 11.11(c) shows that when external economies are present, an increase in demand brings a lower price in the long run. The long-run industry supply curve LSC is downward sloping.

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

New-technology firms enter and old-technology firms either exit or adopt the new technology. 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 firms use the new technology, the price equals minimum average total cost, and each firm makes zero economic profit.

Competition and Efficiency
Efficient Use of Resources Resources are used efficiently when no one can be made better off without making someone else worse off. This situation arises when marginal social benefit equals marginal social 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. Emphasize 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.

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. Choices A consumer’s demand curve shows how the best budget allocation changes as the price of a good changes. So consumers get the most value out of their resources at all points along their demand curves. With no external benefits, the market demand curve is the marginal social benefit curve.

A competitive firm’s supply curve shows how the profit-maximizing quantity changes as the price of a good changes. So firms get the most value out of their resources at all points along their supply curves. With no external cost, the market supply curve is the marginal social cost curve.

Equilibrium and Efficiency In competitive equilibrium, resources are used efficiently—the quantity demanded equals the quantity supplied, so marginal social benefit equals marginal social cost. The gains from trade for consumers is measured by consumer surplus. The gains from trade for producers is measured by producer surplus. Total gains from trade equal total surplus, and in long-run equilibrium total surplus is maximized.

Figure illustrates an efficient allocation of resources in a perfectly competitive industry. In part (a), each firm is producing at the lowest possible long-run average total cost at the price P* and the quantity q*.

Figure 11.12(b) shows the market. Along the market demand curve D = MSB, consumers are efficient. Along the market supply curve S = MSC, producers are efficient.

The quantity Q* and price P* are the competitive equilibrium values. So competitive equilibrium is efficient. Total surplus, the sum of consumer surplus and producer surplus is maximized.

THE END

11 CHAPTER Perfect Competition

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