1. Perfect Competition

2. Assumptions of Perfect Competition
Homogeneous or identical products – every seller’s product is the same as every other seller’s product.
Many small independent firms
Easy entry & exit into the industry – all resources are perfectly mobile.
Firms, consumers, & resource owners have perfect knowledge of relevant economic & technical data.

3. The perfectly competitive firm is a price taker that sells its product at the market price. Why?
If the firm tried to charge more than the market price, it would lose all its business to its competitors who sell the identical product.
The firm can sell as much as it wants at the market price, since it is very small relative to the market. The firm, therefore, has no incentive to charge less than the market price.

4. Since the perfectly competitive firm always sells its product for the market price, the demand curve for its product is horizontal at the market price. P D Q

5. Total Variable Cost (TVC)
Consider a perfectly competitive firm whose product sells for $10. The firm’s costs are as shown below.
Quantity of output (Q)
Price (P)
Total Revenue (TR)
Total Fixed Cost (TFC)
Total Variable Cost (TVC)
Total Cost (TC)
Total Profit ()
Marginal Revenue (MR)
Marginal Cost (MC) 10 12 1 2 3 5 4 8 13 6 23 7 38 69

6. Total Variable Cost (TVC)
Total Revenue is TR = PQ
Quantity of output (Q)
Price (P)
Total Revenue (TR)
Total Fixed Cost (TFC)
Total Variable Cost (TVC)
Total Cost (TC)
Total Profit ()
Marginal Revenue (MR)
Marginal Cost (MC) 10 12 1 2 20 3 30 5 4 40 8 50 13 6 60 23 7 70 38 80 69

7. Total Cost is TC = TFC + TVC.
Quantity of output (Q)
Price (P)
Total Revenue (TR)
Total Fixed Cost (TFC)
Total Variable Cost (TVC)
Total Cost (TC)
Total Profit ()
Marginal Revenue (MR)
Marginal Cost (MC) 10 12 1 2 14 20 3 15 30 5 17 4 40 8 50 13 25 6 60 23 35 7 70 38 80 69 81

8. Total Variable Cost (TVC)
Profit is  = TR –TC
Quantity of output (Q)
Price (P)
Total Revenue (TR)
Total Fixed Cost (TFC)
Total Variable Cost (TVC)
Total Cost (TC)
Total Profit ()
Marginal Revenue (MR)
Marginal Cost (MC) 10 12
-12 1 2 14 -4 20 3 15 5 30 17 13 4 40 8 50 25 6 60 23 35 7 70 38 80 69 81 -1

9. Marginal Revenue is MR =ΔTR/ΔQ .
For a perfectly competitive firm, MR is constant & equal to the price of the product.
Quantity of output (Q)
Price (P)
Total Revenue (TR)
Total Fixed Cost (TFC)
Total Variable Cost (TVC)
Total Cost (TC)
Total Profit ()
Marginal Revenue (MR)
Marginal Cost (MC) 10 12
-12
--- 1 2 14 -4 20 3 15 5 30 17 13 4 40 8 50 25 6 60 23 35 7 70 38 80 69 81 -1

10. Marginal Cost is MC =ΔTC/ΔQ
Quantity of output
Price
Total Revenue
Total Fixed Cost
Total Variable Cost
Total Cost
Total Profit
Marginal Revenue
Marginal Cost 10 12
-12
--- 1 2 14 -4 20 3 15 5 30 17 13 4 40 8 50 25 6 60 23 35 7 70 38 80 69 81 -1 31

11. Notice that when Q = 6, MR=MC
and profit is at its maximum.
Quantity of output
Price
Total Revenue
Total Fixed Cost
Total Variable Cost
Total Cost
Total Profit
Marginal Revenue
Marginal Cost 10 12
-12
--- 1 2 14 -4 20 3 15 5 30 17 13 4 40 8 50 25 6 60 23 35 7 70 38 80 69 81 -1 31

12. Notice also that at that profit-maximizing output, price is equal to marginal cost P=MC
Quantity of output
Price
Total Revenue
Total Fixed Cost
Total Variable Cost
Total Cost
Total Profit
Marginal Revenue
Marginal Cost 10 12
-12
--- 1 2 14 -4 20 3 15 5 30 17 13 4 40 8 50 25 6 60 23 35 7 70 38 80 69 81 -1 31

13. P = MC because for the perfectly competitive firm, P = MR & for the profit-maximizing firm, MR = MC.
Quantity of output
Price
Total Revenue
Total Fixed Cost
Total Variable Cost
Total Cost
Total Profit
Marginal Revenue
Marginal Cost 10 12
-12
--- 1 2 14 -4 20 3 15 5 30 17 13 4 40 8 50 25 6 60 23 35 7 70 38 80 69 81 -1 31

14. On a graph, the perfectly competitive firm making a positive economic profit looks like this. The horizontal demand curve lies above the minimum of the ATC curve. MC
ATC $ P
D = MR Q*
Quantity

15. Sometimes the best the firm can do is break even (make zero economic profits). This occurs when the price (& the demand curve) are at the minimum of the ATC curve. MC
ATC $
AVC P
D = MR
Quantity

16. What if the demand curve lies below the minimum of the ATC curve but above the minimum of the AVC curve? MC
ATC $
AVC P
D = MR
Quantity

17. Then the firm will have an economic loss.
However, the firm will still operate.
If the firm were to shut down & produce nothing, its loss would equal its fixed cost.
But since the price is greater than the variable costs per unit (AVC), by operating the firm will be able to cover its variable costs & part of its fixed costs.
So its loss would be smaller than the amount of fixed cost.
So it pays to operate, as long as the price is above the minimum of the average variable cost.

18. Mathematically, the situation works like this:
P > AVC
So, PQ > AVC (Q),
[Now since AVC = TVC / Q ,
AVC (Q) = TVC.]
So, PQ > TVC
TR > TVC
TR – TC > TVC – TC
 > TVC – TC
 > – TC + TVC
 > -1(TC – TVC)
 > – TFC
If the firm produced nothing,  = TR – TC
= TR – (TVC+TFC )
= 0 – (0+TFC)
= – TFC
So the firm does better by operating than by shutting down.

19. If the price equals the minimum value of the AVC curve, the firm will lose the same amount if it shuts down or if it operates. MC
ATC $
AVC P
D = MR
Quantity

20. However, if the price is below the minimum of the AVC curve,
the firm is unable to cover even the variable costs, & it should shut down.
It would lose more by operating than by shutting down.
Consequently, the minimum of the AVC curve is called the shutdown point.

21. Graphically, the firm’s horizontal demand curve lies below the minimum of the AVC curve:MC
ATC $
AVC P
D = MR
Quantity

22. So we have these five possible cases:
Positive economic profits
Break even
Operate at a loss
Lose same amount if operate or shutdown
Shutdown MC
ATC $
AVC P1 P2 P3 P4 P5
Quantity

23. Using this information and the fact that the firm maximizes profits by producing where MR = MC, we can determine the firm’s short run supply curve.

24. ATC MC $ AVC D1 = MR1 Quantity
If the price is P1, the firm produces output Q1, where MR = MC. (The numbering of the prices in the upcoming slides does not correspond to the numbering in our 5 case discussion.)
ATC MC $
AVC
D1 = MR1 P1 Q1
Quantity

25. If the price is P2, the firm produces output Q2 .
ATC MC $
AVC
D2= MR2 P2 Q2
Quantity

26. If the price is P3, the firm produces output Q3.MC
ATC $
AVC P3
D3 = MR3 Q3
Quantity

27. If the price is P4, the firm produces output Q4.MC
ATC $
AVC P4
D4 = MR4 Q4
Quantity

28. MC ATC $ AVC D5 = MR5 Quantity
If the price is P5, the firm produces output Q5 (or shuts down – it loses the same amount either way). MC
ATC $
AVC P5
D5 = MR5 Q5
Quantity

29. So in determining the quantity the firm would supply at each price, we have actually traced out the points of the MC curve above the minimum of the AVC curve. MC
ATC $
AVC
Quantity

30. So this is the firm’s short run supply curve.
Price
Quantity

31. To determine the industry or market short run supply curve, horizontal sum the individual firms’ supply curves.
Price
Industry supply curve S1 S2 S3 S4 S5
Quantity

32. That means that for each price, we add the amounts all the firms are willing to supply.
For example, if there are five firms who at a price of $25 will supply 10, 20, 30, 40, & 50 units each, the total supplied by the industry at that price is = 150 .
Price
Industry supply curve S1 S2 S3 S4 S5 25
Quantity

33. How do perfectly competitive firms & industries adjust to changes in demand conditions & what are the implications for the long run market supply curve?
Let’s start with the simplest case, which is the constant cost industry.

34. Constant Cost Industry
an industry in which costs of production remain constant as industry output expands

35. Start with the market.
Market P S P0 D Q* Q

36. Put in a typical firm in long run equilibrium (zero profits).
Market
Firm q* q MC
ATC
D= MR P0 P P S P0 D Q* Q

37. Suppose demand increases.
Firm
Market MC P
ATC S
D= MR P0 P0 D’ D Q* Q q* q

38. Price rises and profits are made.
Firm
Market MC P
ATC S P1
D1= MR1 P1
D= MR P0 P0 D’ D
Q* Q1 Q
q* q1 q

39. New firms enter the industry, increasing supply.
Market MC P
ATC S S’ P1
D1= MR1 P1
D= MR P0 P0 D’ D
Q*Q1 Q
q* q1 q

40. Price falls to original level, & profits return to zero.
Firm
Market MC P
ATC S S’ P1
D1= MR1 P1
D= MR P0 P0 D’ D
Q* Q1 Q2 Q q* q

41. The Long Run Supply Curve
The initial market point and the final one are long run equilibrium points and therefore are on the long run supply curve for this industry.
(The middle point - the black one - is not on the long run supply curve, since it is not a long run equilibrium point.)
For a constant cost industry, the long run supply curve is a horizontal line.

42. The Long Run Supply Curve
Market P S S’ P1
long run supply curve P0 D’ D
Q* Q1 Q2 Q

43. Increasing Cost Industry
an industry in which costs of production increase as industry output expands

44. Start with the market.
Market P S P0 D Q* Q

45. Put in a typical firm in long run equilibrium (zero profits).
Market MC P P
ATC S
D= MR P0 P0 D Q* Q q* q

46. Suppose demand increases.
Market
Firm MC P
ATC S
D= MR P0 P0 D’ D Q* Q q* q

47. Price rises and profits are made.
Firm
Market MC P
ATC S P1
D1= MR1 P1
D= MR P0 P0 D’ D
Q* Q1 Q
q* q1 q

48. New firms enter the industry, increasing supply.
Market MC P
ATC S S’ P1
D1= MR1 P1
D= MR P0 P0 D’ D
Q*Q1 Q
q* q1 q

49. However, as industry output expands, demand for the inputs rises
However, as industry output expands, demand for the inputs rises. The prices of the inputs increase, and therefore production costs increase.
So we see an upward shift in the cost curves.

50. Cost curves shift upward.
Firm
Market
MC1
ATC1 P
ATC S S’ P1
D1= MR1 P1
D= MR P0 P0 MC D’ D
Q*Q1 Q
q* q1 q

51. The market supply curve shifts to the right just enough, so that the equilibrium price will be at the minimum of the new ATC curve and we have zero profits.
So the price rises and then falls but not to the original price level.

52. The new long run equilibrium price is higher than the original price.
Firm
Market
MC1
ATC1 P
ATC S S’
D1= MR1 P1 P1
D2 =MR2 P2 P2
D= MR P0 P0 MC D’ D
Q*Q1 Q q
q2 q* q1

53. The Long Run Supply Curve
The initial market point and the final one are long run equilibrium points and therefore are on the long run supply curve for this industry.
For a increasing cost industry, the long run supply curve is upward sloping.

54. The Long Run Supply Curve
Market P
long run supply curve S S’ P1 P2 P0 D’ D
Q*Q1 Q

55. Decreasing Cost Industry
an industry in which costs of production fall as industry output expands

56. Start with the market.
Market P P0 S D Q* Q

57. Put in a typical firm in long run equilibrium (zero profits).
Market MC P P
ATC
D= MR P0 P0 S D Q* Q q* q

58. Suppose demand increases.
Firm
Market MC P
ATC
D= MR P0 P0 S D’ D Q* Q q* q

59. Price rises and profits are made.
Firm
Market MC P
ATC P1
D1= MR1 P1
D= MR P0 P0 S D’ D
Q* Q1 Q
q* q1 q

60. New firms enter the industry, increasing supply.
Market MC P
ATC P1
D1= MR1 P1
D= MR P0 P0 S D’ S’ D
Q*Q1 Q
q* q1 q

61. As industry output expands, area infrastructure (such as roads and bridges) improves and therefore costs of transporting inputs and outputs decrease.
So we see an downward shift in the cost curves.

62. Cost curves shift downward.
Firm
Market MC P
ATC P1
D1= MR1 P1
D= MR P0 P0 S D’ S’ D
Q*Q1 Q
q* q1 q

63. The market supply curve shifts to the right just enough, so that the equilibrium price will be at the minimum of the new ATC curve and we have zero profits.
So the price rises and then falls to below the original price level.

64. The new long run equilibrium price is lower than the original price.
Firm
Market MC P
ATC P1
D1= MR1 P1
D= MR P0 P0
D2= MR2 P2 P2 S D’ S’ D
Q*Q1 Q
q* q1 q2 q

65. The Long Run Supply Curve
The initial market point and the final one are long run equilibrium points and therefore are on the long run supply curve for this industry.
For a decreasing cost industry, the long run supply curve is downward sloping.

66. The Long Run Supply Curve
Market P P1 P0
long run supply curve P2 S D’ S’ D
Q*Q Q2 Q

67. We have seen that in long run equilibrium, the perfectly competitive firm always operates at the minimum of its SR ATC curve.
In LR equilibrium, it will also be at the minimum of its LR ATC. Why?
When the firm is maximizing LR profits, MR = LR MC.
Since for a perfectly competitive firm, P=MR, P = LR MC.
But since the firm has zero economic profits,
P = LR ATC.
So LR MC must equal LR ATC. Where does that occur?
At the minimum of the LR ATC.

68. So in LR equilibrium, a perfectly competitive firm operates at the minimum of both the SR & LR ATC curves, where those curves intersect the LR & SR MC curves. q* q
LR MC
LR ATC
D= MR P0 P
SR ATC
SR MC