Economics  Page

WEST HILLS COLLEGE
ECONOMICS

CHAPTER 22

Perfect Competition

We are continuing to look more deeply at supply and demand. Particularly we want to see how suppliers, that is firms, behave and why. This is the stuff of the US economy. So, we begin to delve into the situations the firms face and choices that those firms must make. Chapters 22–24 are about firms facing different types of  MARKET STRUCTURE—the particular environment in which a firm operates—We look to see how market structure affects a firm’s pricing and output decisions. In this chapter, we look at the theory of behavior of a firm operating in one type of market structure called  PERFECT COMPETITION, . We look at optimal short-run behavior for a perfectly competitive firm and optimal long-run behavior of the perfectly competitive firm. We also look at some special issues like employment and racial discrimination and see what kind of insights economists have about it.
 

CHAPTER OBJECTIVES

Upon completing this chapter, you should be able to:

1. Explain why a perfectly competitive firm faces a horizontal (flat, perfectly elastic) demand curve.

2.  Explain why a perfectly competitive firm seeks to produce that quantity of output at which MR = MC.

3.  Identify the condition under which a firm should shut down.

4.  Explain how a market supply curve is derived.

5.  Identify long-run competitive equilibrium.

6.  Explain the process whereby a firm moves from one long-run equilibrium position to another.

7.  Explain why higher costs don’t always mean higher prices.

KEY TERMS

• market structure                                             • long-run competitive equilibrium

• perfect competition                                        •constant-cost industry

• price taker                                                     •long-run (industry) supply curve

• marginal  revenue (MR)                                • increasing-cost industry

• profit-maximization rule                                • decreasing-cost industry

• short-run (firm) supply curve                        • resource allocative efficiency

• short-run market (industry) supply curve      • productive efficiency
 
 

CHAPTER OUTLINE

Review the types of costs Fixed Costs, Variable Costs and Total Costs

Introduce Perfect Competion- Monopoly: the two extremes of market structure.
 

I. THE THEORY OF PERFECT COMPETITION

A.    Basic Assumptions—

First a definition:

A MARKET STRUCTURE is a firm’s particular environment, the characteristics of which influence the firm’s decisions, for example perfect competition.
One of the types of market structure is perfect competition. The definition of and the theory of PERFECT COMPETITION rests on FOUR BASIC ASSUMPTIONS. By that we mean that perfectly competitive firms and the perfectly competitive industry that they operate in will be characterized by four things:
1. There are many sellers and buyers, none of which is large in relation to total sales or purchases— In other words:
        no  single seller or buyer has any power to significantly influence market price.
 2. Each Firm Produces and Sells a Homogeneous Product—
        that is, a product that is indistinguishable from the product of any other firm in the industry.
 3.    Buyers and Sellers Have All Relevant Information about Prices, Product Quality, Sources of Supply, and So Forth.
4.    Firms Have Easy Entry and Exit—New firms can enter the market easily (i.e., there are no prohibitive start-up costs or regulations), and existing firms can exit the market easily.
X. Assumption X - it doesn't get mentioned in the text. This whole analysis holds at full employment. Things   start to break down when there is unemployment.
B.  A Perfectly Competitive Firm Is a Price Taker—
The firm in a competive industry wants to get the best price and maximize profits like firms in every other industry.
Since the perfectly competitive firm has no market power, and offers a product that is indistinguishable from its competition, is subject to new competitors, and does business in a market where all buyers and sellers are well informed, a perfectly competitive firm is said to be a price taker.
 
A PRICE TAKER is a seller that cannot control the price of the product it sells, but must rely on the market to set the price at which its output will be sold.
The prime example would be a small farm selling lettuce or milk. The farmer has no control over the price.
 
C. The Demand Curve for a Perfectly Competitive Firm Is Horizontal—Because of the nature of the perfectly competitive market,
The industry that the firm is in faces a downward-sloping market demand curve ,



 
 
 
 

each individual firm faces a demand curve that is horizontal atthe market price (as is shown above) The reason?
 
 

Since the firm is a price taker, it may sell all of the output it is capable of producing at or below the market price, but it will not be able to sell anything at a price higher than the market price.

D.    The Marginal Revenue Curve of the Perfectly Competitive Firm Is the Same as its Demand Curve—

MARGINAL REVENUE(MR): The change in total revenue as output increases

Marginal revenue = dTotal revenue/dQuantity

or,

MR = dTR/dQ

For a perfectly competitive firm, price equals marginal revenue, since price will not change as output changes.

Since P = MR, it follows that

the marginal revenue curve for the perfectly competitive firm is the same as the firm’s demand curve.

E. Theory and Real-World Markets—

Theoretically, For markets to behave in a perfectly competitive manner, the four assumptions given at the beginning of this chapter must hold true.

But, if these assumptions do not hold, then those markets may still approximate the behavior of perfectly competitive markets.
 

II.    PERFECT COMPETITION IN THE SHORT RUN

A.    What Level of Output Does the Profit Maximizing Firm Produce?—Consider the graph below

    1. Any profit-seeking firm will continue to increase production as long as Marginal Revenue is greater than Marginal Cost.

    2. Any profit-seeking firm will decrease production if Marginal Cost is greater than Marginal Revenue.
    3. There is one output level at which Marginal Revenue equals Marginal Cost, and at that output level, the firm is maximizing profits (or minimizing losses).

 

The PROFIT-MAXIMIZATION RULE for the firm says the firm will maximize its profits or minimize its losses by producing the quantity at which Marginal Revenue equals Marginal Cost.
 

 

 

THIS RULE HOLDS TRUE NO MATTER WHAT MARKET STRUCTURE PREVAILS:

(Perfect Competition or Monopolies which we discuss in the next chapter)

 
Specifically for the perfectly competitive firm, the rule for profit maximization may be restated  as :
 Price equals Marginal Revenue equals Marginal Cost
Here is an important thing to note:  To say that a firm is maximizing profit, is not to say that it is making a profit. It may mean that the firm is just breaking even or even taking a loss. To say that it is setting marginal cost equal to marginal revenue and price is just to say that it is as doing as well as it can. it may be making a profit, or breaking even or even taking the smallest  loss possible.

So if entrepeneurs are maximizing their profit by producing until Marginal Cost equals Marginal Revenue, they may be making or losing money and they must still answer a crucial question:

B.    Question for the entrepeneur : IN THE SHORT RUN, SHOULD THE FIRM OPERATE?:

In other words, should the firm produce or not produce: How does the entrepeneur decide—

There are three possible situations for the perfectly competitive firm.

For each of them, the entrepenuer must apply the profit-maximizing rule AND do a cost analysis:
        1.Case 1: Price Is Above Average Total Cost— ie Total Revenue greater than Total Cost  Look at Exhibit 4.
For Graph, See Text
 
 
 
If market price exceeds the firm’s ATC at the level of output where MR = MC, then the firm will maximize profits by producing at the quantity where Marginal Revenue equals Marginal Cost.
At that point the firm will make an economic profit.
2.Case 2: Price Is Below Average Variable Cost (same as)  Total Revenue is less than Total Variable Costs. (THE SHUTDOWN POINT)
The business can do better by reducing output (Q) to 0 and eliminating all of the variable costs.
That means shutting down. The firm still has to cover fixed costs even if it shuts down in the short run.


 
 


 
 
 
If market price is less than average variable costs, the firm would do better by shutting down than by continuing to produce. Because if it shuts down it will reduce its variable costs to 0.
In this situation if the firm shuts down, it only has to pay off fixed costs. Variable costs will fall to 0.
If the firm continues to produce, it will lose not only its fixed costs, but part of its total variable costs as well.
So if the firm follows the profit maximization rule (MR=MC), it will shut down.
        3.  Case 3: Price Is Below Average Total Cost but Above Average Variable Cost—
 
For a graph see the text .
 
 
If price is higher than the average variable costs, then the firm is better off producing than it is  shutting down, because producing will provide it with the opportunity to cover all of its total variable costs and part of its fixed costs.
In this situation where P>AVC but P<ATC the firm will minimize short-run losses by producing at the quantity where MR = MC;
however, over a longer period of time, the firm willeither need to alter its production costs or leave the market because over time it must cover all of its costs.
 

Why do restaurants who charge high prices for dinner stay open and  charge low prices for lunches?
Because they know people won't spend a lot at lunch (no girl friend to impress) and if the vrestaurants can cover their variable costs and some of their fixed costs they can make their real money at night.
 
 
 

C. The Perfectly Competitive Firm’s Short Run Supply Curve— The firm produces in the short run if Price is greater than Average Variable Costs , so
THE SHORT-RUN SUPPLY CURVE OF THE FIRM is that portion of its marginal cost curve that lies above the average variable cost curve.

 


 
 

D. Understanding the shape of the Market (Industry) Supply Curve— Once we know each firm’s short-run supply curves,

The THE SHORT-RUN MARKET SUPPLY CURVE:  is the horizontal sum the individual firm’s supply curves, in much the same manner as we derived the market demand curve in Chapter 3.

E. Now we can understand,   why is the Market Supply Curve upward sloping?

Because of the law of diminishing marginal returns, marginal cost curves are upward sloping. If the the supply curves of all of the individual firms (their marginal cost curves) are upward sloping, the market supply curve will also slope upwards!

III.  PERFECT COMPETITION IN THE LONG RUN


 
 
 
 
 
 
 
 
 
 
 

A.    The Conditions of Long-Run Competitive Equilibrium—The following conditions characterize LONG-RUN COMPETITIVE EQUILIBRIUM:
 

1.    There is no incentive for firms to enter or exit the industry.
2.    There is no incentive for firms to produce more or less output.
3.    There is no incentive for firms to change plant size.
 
Looking at this more technically:
1. For long-run competitive equilibrium to exist, there must be no incentive for firms to enter or exit the market.
 
       2.   Firms Are Producing the Quantity of Output at Which Price Is Equal to Marginal Cost—Firms naturally move toward the profit-maximizing level of output. At that level of output, MR = MC, and as shown earlier, since P = MR, P = MC.
3.    Finally, no firm must have an incentive to change its plant size.   Each firm is just breaking even in the short and long run.
We may summarize the three points with the statement: Long-run competitive equilibrium exists when price equals marginal cost and average cost  in the short  and long run.


P = MC = SRATC = LRATC



 
 
 
 
 
 
 
 
 

 

B.    Industry Adjustment to an Increase in Demand—Suppose we start at long-run competitive equilibrium. What happens if demand increases?
 

figure 22g or For Graph, See Text


 
 
 

First, equilibrium price will rise, shifting the individual firm’s demand curve upward.

Second, existing firms will increase output, since P = MC is now at a higher level of output (since P has increased).

As a result, existing firms will enjoy additional profits in the short run.

Over time, new firms will enter the industry in search of economic profits.

This will, in turn, shift the industry supply curve outward (rightward), lowering equilibrium price.

Entry will continue until long-run competitive equilibrium (specifically, zero economic profit) is re-established.

Where will the new long-run equilibrium price be? Higher than the old one? Lower than the old one? The same as the old one?

The answer depends upon the industry.
 

1.    CONSTANT COST INDUSTRY—an industry in which average total costs do not change as (industry) output increases or decreases in the long run.
If market demand increases for a good produced by firms in a constant-cost industry,
then price will initially rise and then fall, eventually reaching its original level.

 

figure 22h or For Graph, See Text
 

2.  INCREASING-COST INDUSTRY—an industry in which average total costs rise as output increases and fall as output decreases.

If market demand increases for a good produced by firms in an increasing-cost industry, price will initially rise and then fall, eventually settling at a price above the original equilibrium price.

figure 22i For Graph, See Text

3.  DECREASING-COST INDUSTRY—an industry in which average total costs fall as output increases and rise as output decreases.

If the market demand increases for a good produced by firms in a decreasing-cost industry, price will initially rise and then fall, settling at a price below the original equilibrium price.

figure 22j For Graph, See Text

C.What Happens as Firms Enter an Industry In Search of Profits?—The prices of computers, videocassette recorders, and other goods have fallen dramatically in the past.
One reason for this is the entry of new firms into those industries. These firms’ actions shifted the industry supply curve outward, causing the equilibrium price to decline.
eg. Amazon.Com

 
 

D.    Industry Adjustment to a Decrease in Demand— Starting at long-run competitive equilibrium, suppose that market demand decreases. What happens?

First, equilibrium price will fall, shifting the individual firm’s demand curve down.
Second, existing firms will decrease output, since P = MC is now at a lower level of output (since P has decreased).
As a result, existing firms will suffer losses in the short run.
Over time, firms will exit the industry until losses “dry up.” This will, in turn, shift the industry supply curve inward (left), raising equilibrium price.
Exit will continue until long-run competitive equilibrium (specifically, zero economic profit) is re-established.
 

E. Profits in Agriculture

What happens if one farmer’s land is more profitable than another—If one farmer’s land is more productive than another farmer’s land. he will be able to sell or rent his land for a higher price.
The new owner will now have higher total costs, and the ATC curve will shift up to reflect this fact.
The profitability of the land has been incorporated in the price of the land.
 

F.    Profit and Discrimination— Workers from other countries and discrimination:

A firm in a perfectly competitive market that discriminates because of a worker’s race, religion, or gender will see an increase in its total costs, making the firm less competitive.
It is argued that competition and free markets will tend to eliminate racial discrimation.
 

 

But what happens if there is unemployment? What happens if there are a large group of workers who must work to live and for whom there are no jobs?

Then can the employer hire only the prefered group at the minimum wage rate? Can the employers leave the undesireable   jobs for people with brown skin or undesireable political views?
That is one of the reasons for labor unions- to protect workers from unfair demands such as sexual favors in exchange for employment during times of high unemployment?
IV.    TOPICS FOR ANALYSIS WITHIN THE THEORY OF PERFECT COMPETITION
 
A.    Do Higher Costs Mean Higher Prices?—
To what extent are cost increases passed on to consumers?
If the cost increase is experienced by just one firm (or even a handful), it will not result in a higher price, because the market price is based upon the cost conditions prevailing in the entire market.
On the other hand, if there is a widespread cost increase, then the market supply curve will shift, and consumers will have to pay higher prices.
 
B.    Will the Perfectly Competitive Firm Advertise?
The main point of advertising is to differentiate your product from that of your (nearest) competitors’. In a perfectly competitive market there are two problems.
First, there are too many competitors to advertise “against.” Second, everyone’s product is the same; thus, there is no basis for product differentiation.
The only advertising that is rational is advertising by the entire industry, aimed at pulling customers away from a competing industry.
 
C.    Supplier-Set Price versus Market-Determined Price: Collusion or Competition?
Why do airlines frequently charge the same prices?
If all the firms in an industry charge the same price, is this evidence of collusion?
Not necessarily. It could be that all the firms are price takers.

 
 

V.    RESOURCE ALLOCATIVE EFFICIENCY AND PRODUCTIVE EFFICIENCY

A.    RESOURCE ALLOCATIVE EFFICIENCY—Resources are allocated efficiently when the value of the resources to demanders equals the opportunity cost of the resources. Since the price represents the value of the resources to the demanders of the goods made from those resources, and Marginal Cost represents the cost to suppliers of hiring (purchasing) resources to make their goods, then P = MC fulfills the condition for resource allocative efficiency.
 
 

B.    Productive Efficiency—A     firm that produces its output at the lowest possible per-unit cost (lowest ATC) is said to exhibit PRODUCTIVE EFFICIENCY.
 
 



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