ECON 101

Chapter 12: Perfect competition

What is market competition?

-A perfect competition is a market in which:

• Many firms sell identical products to many buyers.

• There are no restrictions on entry into the market.
• Established firms have no advantages over new ones.
• Sellers and buyers are well informed about prices.

How perfect competition arises:

-Perfect competition arises if the minimum efficient scale of a single producer is small
relative to the market demand for the good or service.
-A firm’s minimum efficient scale is the smallest output at which long-run average cost
reaches its lowest level.
-Each firm is perceived to produce a good or service that has no unique characteristics, so
consumers don’t care which firm’s good they buy.

Price takers:
-Firms in perfect competition are price takers.
-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.

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Economic profit and revenue:
-A firm’s goal is to → maximize economic profit = total revenue - total cost.
-Total cost: the opportunity cost of production, which includes normal profit.

-A firm’s total revenue = price X quantity.

-Marginal revenue: is the change in total revenue that results from a one-unit increase in
the quantity sold.
-Marginal revenue is calculated by: the change in total revenue / the change in the quantity
sold.

Total revenue:

-Total revenue = the price X the quantity sold.

-The firm’s total revenue curve (TR), which graphs the relationship between total revenue
and the quantity sold.
-The total revenue curve is an upward-sloping straight line.

Marginal revenue:
-Marginal revenue is the change in total revenue that results from one-unit increase in
quantity sold.
-The change in total revenue that results from a one-unit increase in the quantity sold
equals the market price.

-In perfect competition, the firm’s marginal revenue = market price.

Demand for the firm’s product:

-The demand curve for the firm’s product is a horizontal line at the market price, the same
as the firm’s marginal revenue curve.
-A horizontal demand curve illustrates a perfectly elastic demand, so the demand for the
firm’s product is → perfectly elastic.
-The market demand for sweaters is not perfectly elastic.

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The firm’s decisions:

-A perfectly competition firm’s goal is to make maximum economic profit, given the
constraints it faces:

1. How to produce at minimum cost.

2. What quantity to produce.
3. Whether to enter or exit a market.

The firm’s output decision:

-A firm’s cost curve (total cost, average cost, and marginal cost) → describe the relationship
between its output and costs.
-A firm’s revenue curves (total revenue and marginal revenue) → describe the relationship
between its output and revenue.
-We can find the output that maximizes the firm’s economic profit.

-One way to find the profit-maximizing output is to look at the firm’s total revenue and total
cost curves.

-Economic profit = total revenue – total cost.

-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.
-Zero economic profit is called → break-even point.

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Marginal analysis and the supply decision:
-Another way to find the profit maximizing output is to use marginal analysis, which
compares marginal revenue (MR) with marginal cost (MC).
-As output increase → the firm’s marginal revenue is constant but its marginal cost
eventually increases.
-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.
-Economic profit is maximized and either an increase or a decrease in output decrease
economic profit.
-A firm’s profit-maximizing output is its quantity supplied at the market price.

-These profit-maximizing responses to different market prices are the foundation of the law
of supply:
Other things remaining the same, the higher the market price of a good, the greater is the
quantity supplied of that good.

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Temporary shutdown decision:

-A firm maximizes profit by producing the quantity at which marginal revenue (price) equals
marginal cost.

-But suppose that at this quantity, price is less than average total cost.
-In this case, the firm incurs an economic loss.
-Maximum profit is a loss (a minimum loss).
-If the firm expects the loss to be permanent → it goes out of business.
-If it expects the loss to be temporary → the firm must decide whether to shut down
temporarily and produce no output, or to keep producing.

-To make this decision, the firm compares the loss from shutting down with the loss from
producing and takes the action that minimizes its loss.

Loss comparisons:
-The firm’s loss equals total fixed cost (TFC) plus total variable cost (TVC) minus total
revenue (TR).
-Economic loss = TFC + TVC – TR = TFC + (AVC - P) X Q
-If the firm shuts down → it produces no output (Q = 0).

-The firm has no variable costs and no revenue but it must pay its fixed costs, so its
economic loss = TFC.
-This economic loss is the largest that the firm must bear.
-If the firm produces → its economic loss = TFC + TVC -TR.
-If TVC exceeds TR, this loss exceeds TFC and the firm shuts down.
-If AVC exceeds price, this loss exceeds TFC and the firm shuts down.

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The shutdown point:
-A firm’s shutdown point: is the price and quantity at which it is indifferent between
producing the profit-maximizing quantity and shutting down.
-The shutdown point occurs at the price and the quantity at which AVC is minimum.
-At the shutdown point → the firm is minimizing its loss and its loss = TFC.

-If the price falls below minimum AVC → the firm shuts down temporarily and continues to
incur a loss = TFC.
-At prices above minimum AVC but below ATC → the firm produces the loss-minimizing
output and incurs a loss, but a loss that is less than TFC.

The firm’s supply curve:

-The supply curve is derived from the firm’s marginal cost curve and AVC curves.
-When the price exceeds minimum AVC → the firm maximizes profit by producing the
output at which marginal cost = price.
-If the price rises → the firm increases its output.
-When the price is less than minimum AVC → the firm maximizes profit by temporarily
shutting down and producing no output.

-When the price equals minimum AVC → the firm maximizes profit either by temporarily
shutting down and producing no output or by producing the output at which AVC is
minimum – the shutdown point.

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Output, price, and profit in the short run:
Market supply in the short run:
-The short-run market supply curve: shows the quantity supplied by all the firms in the
market at each price when each firm’s plant and the number of firms remain the same.
-At the shutdown price, some firms will produce the shutdown quantity and others will
produce zero.
-At the price, the market supply curve is horizontal – supply is perfectly elastic.
-As the price rises above the shutdown price, each firm increases its quantity supplied and
the quantity supplied by the market.

Short-run equilibrium:
-Market demand and short-run market supply determine the market price and market
output.
-Each firm takes this price as given and produces its profit-maximizing output.

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Change in demand:
-Change in demand bring changes to short-run market equilibrium.

-An increase in demand brings a rightward shift of the market demand curve → the price
rises and the quantity increases.

-A decrease in demand brings a leftward shift of the market demand curve → the price falls
and the quantity decreases.

Profits and losses in the short run:

-Economic profit (or loss) = (P - ATC) X Q

-If price = ATC → a firm breaks even – the entrepreneur makes normal profit.
-If price exceeds ATC → a firm makes an economic profit.
-If price is less than ATC → a firm incurs an economic loss.

Three possible short-run outcomes:

-Price = ATC → so the firm breaks even (makes zero economic profit).
-Price exceeds ATC → so the firm makes an economic profit.
-The height of the rectangle is profit per item.
-The length is the quantity of item produced.

-Price is less than ATC → so the firm incurs an economic loss.

-If the price dips below than the break even price → the firm temporarily shuts down and
incurs an economic loss = TFC.

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Output, price, and profit in the long run:

-In short-run equilibrium, a firm might make an economic profit, break even, or incur an
economic loss.

-In long-run equilibrium, firms break even because firms can enter or exit the market.

Entry and exit:

-Entry occurs in a market → when new firms come into the market and the number of firms
increases.
-Exit occurs in a market → when existing firms leave a market and the number of firms
decreases.
-Firms respond to economic profit and economic loss by either entering or exiting a market.
-New firms enter a market in which existing firms are making an economic profit.
-Firms exit a market in which they are incurring an economic loss.
-Entry and exit change the market supply, which influences the market price, the quantity
produced by each firm, and its economic profit (or loss).
-If firms enter a market → supply increases and the market supply curve shifts rightward.

-The increase in supply lowers the market price and eventually eliminates economic profit.
-When economic profit reaches zero, entry stops.
-If firms exit a market → supply decreases and the market supply curve shifts leftward.
-The market price rises and economic loss decreases and eventually economic loss is
eliminated and exit stops.

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To summarize:

• New firms enter a market in which existing firms are making economic profit.
• As new firms enter a market, the market price falls and the economic profit of each
firm decreases.
• Firms exit a market in which they are incurring an economic loss.
• As firms leave a market, the market price rises and the economic loss incurring by
the remaining firms decrease.
• Entry and exit stop when firms make zero economic profit.

A closer look at entry:

-As entry takes place, supply increases and the market supply curve shifts rightward.

-As supply increases with no change in demand, the market price gradually falls.
-At this lower price, each firm makes zero economic profit and entry stops.
-Entry results in an increase in market output, but each firm’s output decreases.

A closer look at exit:

-As exit takes place, supply decreases and the market supply curve shifts leftward.
-As supply decreases with no change in demand, the market price gradually rises.
-At this higher price, losses are eliminated, each firm makes zero economic profit, and exit
stops.
-Exit results in a decrease in market output, but each firm’s output increases.

Long-run equilibrium:
-When economic profit and economic loss have been eliminated and entry and exit have
stopped, a competitive market is in long-run equilibrium.
-A competitive market is rarely in a state of long-run equilibrium.

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Changes in demand and supply as technology advances:
An increase in demand:

-The equilibrium price of a component rises and producers make economic profits.
-New firms start to enter the market.
-Supply increases and the price stops rising and then begins to falls.
-Eventually, enough firms have entered for the supply and the increased demand to be in
balance at a price that enables the firms in the market to return to zero economic profit.
-Market demand increases and the demand curve shift rightward. The price rises, and the
quantity supplied increases as the market moves up along its short-run supply curve.

A decrease in demand:
-A decrease in demand brings a lower price, economic losses, and exit.

-Exit decreases supply, which raises the price to its original level and economic profit returns
to zero in a new long-run equilibrium.

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Technological advances change supply:
-New technologies also lower production costs.
-Starting from a long-run equilibrium, when a new technology becomes available that
lowers production costs, the first firms to use it make economic profit.
-But as more firms begin to use the new technology, market supply increases and the price
falls.

-The old technology incur economic losses.

-They were making zero economic profit and now with the lower price they incur economic
losses. So old-technology firms exit.
-Eventually, all the old-technology firms have exited and enough new-technology firms have
entered to increase the market supply to a level that lowers the price to equal the minimum
ATC using the new technology. In this situation, firms are making zero economic profit.
-Economic profit is zero and firms are producing at minimum ATC on the curve ATC old.
-When a new technology becomes available, ATC and MC of production fall.
-With price below P0, old-technology firms incur an economic loss and exit.
-With price above P1, new-technology firms make an economic profit and enter.

-Technological change brings only temporary gains to producers.

-But the lower prices and better products that technological advances bring are permanent
gains for consumers.

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Competition and efficiency:
Efficient use of resources:
-Resources use is efficient when we produce the goods and services that people value most
highly.
-If it is possible to make someone better without anyone else becoming worse off, resources
are not being used efficiently.

-We can test whether resources are allocated efficiently by comparing MSB and MSC.

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, at all points along their demand curves, consumers get the most value out of their
resources.
-If the people who consume the good are the only ones who benefit from the good, market
demand curve is the MSB curve.
-A competition firm’s supply curve shows how the profit-maximizing quantity changes as the
price of a good changes.
-So, at all points along their supply curves, firms get the most value out their resources.
-If the firm that produce the good bear all the costs of producing it, then the market supply
curve is the MSC curve.

-Demand → for social benefit.

-Supply → for social cost.

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Equilibrium and efficiency:
-In competitive equilibrium, resources are used efficiently – the quantity demanded = the
quantity supplied, so MSB = MSC.
-The gain from trade for consumers is measured by → consumer surplus.
-The gain from trade for producers is measured by → producer surplus.

-Total gains from trade = total surplus.

-In long-run equilibrium, total surplus is maximized.
-Along the market demand curve D = MSB, consumers are efficient.
-Along the market supply curve S = MSC, producers are efficient.
-At the market equilibrium, MSB = MSC.

-Resources are allocated efficiently

-Total surplus is maximized.
-Each firm in the market has the plant that enables it to produce at the lowest possible ATC.
-Consumers are as well off as possible because the good cannot be produced at a lower cost
and the price equals that least possible cost.

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Notes from class:

-The shutdown rule.

-Price = Marginal revenue = Demand.
-The supply curve is the marginal cost.
-At several intersections is the new marginal cost curve.

-At the minimum AVC → the firm will be indifferent.

-Horizontal line → the firm is indifferent.
-At the market → the price is constant but quantity changes.
-The economic profit/ loss→ is the rectangular.
-Break even point → when the firm is making zero economic profit.
-When there is a profit → a new firm will enter the market. As the supply increase (shifts to
the right) the market price decrease, so it goes back to the break-even point.

-When there is a loss → a firm will exit the market. As the supply decrease (shifts to the left)
the market price increase, so it goes back to the break-even point.

-At equilibrium, the firm will make zero economic profit.

-In the long-run, whether its profit or loss, it goes back to the break-even point (zero
economic profit).
-Shifting the market demand to the left → shifts the supply curve to the left (Technology
advances). Some firms exit the market, results in higher price in both market and firm, but
produces lower quantities in the market, and higher quantities in the firm.
-When the market supply curve shifts to the right:

• In old-technology firm → it makes losses.

• In new-technology firm → it used to make profit, but it will make zero economic
profit (break-even point).

-Total surplus is maximized – both consumer and producer surplus (No deadweight loss).
-At the market equilibrium → MSB = MSC.

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