Chapter 12: Perfect Competition

Preface
Firms in perfect competition face the maximum amount of competition because
there are many competing firms, each of which produces an identical product.

Firms in perfect competition maximize their profit by producing where MR = MC.

Perfect competition leads to an efficient allocation of resources.

I. What is Perfect Competition?

A. Definition
1. Perfect competition is an industry in which
a). Many firms sell identical products to many buyers
b). There are no restrictions on entry into the industry
c). Established firms have no advantage over existing ones
d). Sellers and buyers are well informed about prices
These characteristics of perfect competition arise when the minimum efficient
scale for a firm is small relative to the size of the entire market.

What markets satisfy the characteristics of perfect competition? The markets that
come closest are agricultural markets, though others such as lawn service,
laundromats, fishing, plumbing, and so on, come close.

If there aren’t really any perfectly competitive markets, what use is studying perfect
competition? 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. Think 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 much fancier model!

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Economists use the model of perfect competition in a similar way to understand our
economic world. Remember 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.

2. Firms operating in perfect competition seek to maximize economic profit,

which is the difference between Total Revenue (the price (P) of the firm’s
output multiplied by the quantity (Q) sold) and its total opportunity cost of
production. That is, TR=P*Q.
3. Firms in perfect competition are price takers, meaning that a firm that
cannot influence the market price and so it sets its own price equal to the
market price.
4. Because the firm is a price taker, its marginal revenue (MR) — which is
the change in total revenue that results in a one-unit increase in the quantity
sold—is equal to the market price and remains constant as output sold
increases (P=MR). The firm’s demand is perfectly elastic and the firm’s
demand curve is a horizontal line at the market price.

II. The Firm’s Output Decision

A. Marginal Analysis and the Supply Decision
1. The firm produces the quantity of output for which the difference between
total revenue and total cost is at its maximum because this difference is its
economic profit.

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2. Marginal analysis can be used to determine the profit maximizing quantity.
The firm compares the marginal revenue (which remains constant with
output) to the marginal cost (which changes with output) of producing
different levels of output.

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 a). When MR > MC, then the extra revenue from selling one more unit
exceeds the extra cost of producing one more unit, so the firm
increases its output to increase its profit.
b). When MR < MC, then the extra cost of producing one more unit
exceeds the extra revenue from selling one more unit, so the firm
decreases its output to increase its profits
c). When MR = MC, then the extra cost of producing one more unit
equals the extra revenue from selling one more unit, so the firm’s
profit is maximized at this level of output.
d). In the figure the firm produces 9 units of output because that is the
quantity that sets the firm’s marginal cost equal to its marginal
revenue, that is, MR = MC. The firm then charges the going market
price of $25 for its product.

B. Temporary Shutdown Decision

1. The firm will temporarily shut down in the short run when price falls below
the shutdown point, which is the output and price that just allows the firm
to cover its total variable cost. The minimum AVC is the lowest price at
which the firm will operate because if it operated with a lower price, the
firm’s loss would be greater than if it shut down. (The loss when the firm
shuts down is equal to its fixed cost.)
2. The firm will continue operating in the short run even if it incurs an
economic loss as long as the price exceeds the minimum AVC.

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3. Three possible cases:
Case 1:

Case 2:

Case 3:

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Why would a restaurant open on days it knows business will be bad? Monday is
typically the slowest day in the restaurant industry. So why do so many restaurants
stay open on Monday? The answer is that even if a restaurant incurs an economic
loss on Monday, it still might increase its total profit by remaining open. The point is
that as long as the restaurant can cover all its variable costs—the cost of the food, the
cost of the servers, and so on—it likely will be able to pay some of its fixed costs
using the revenue left over after paying its variable costs. As long as the restaurant
can pay some of its fixed costs on Monday, its total profit by staying open exceeds
what its total profit would be if it closed. So losing money on Monday might be good
business!

Some people often have a hard time understanding why operating at an economic
loss can be the best action for a firm owner. The key is emphasizing:
 The firm’s short-run decisions are made after some irrevocable commitments
have generated sunk costs.
 The firm considers only avoidable future costs when making decisions.
Unavoidable costs have no impact on the decision (other than to learn from
them).
 For the firm to continue to produce output, the firm needs only to receive
revenues that exceed any avoidable costs, not necessarily all total costs.
Basically the goal of profit maximization does not guarantee that the firm will earn a
positive economic profit in the short run. Sometimes the best the firm can do is to
minimize its economic loss.

C. The Firm’s Supply Curve

1. As long as the firm remains open, it produces where MR = MC. So the
firm’s supply curve is its MC curve above the minimum AVC. At prices
below the minimum AVC, the firm shuts down and supplies zero.

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 2. The figure shows the firm’s supply curve as the heavy dark line.
a). At prices less than the minimum average variable cost, which equals
P in the figure, the firm shuts down and supplies zero.
b). At prices greater than the minimum average variable cost, the firm
supplies along its marginal cost curve. Hence the firm’s marginal cost
curve is its supply, indicated in the figure by the S = MC curve.

III. Output, Price, and Profit in the Short Run

1. 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 number of
firms remain the same. The quantity supplied in the industry at any price is
the summation of all quantities supplied by each firm at that price, so the
short-run industry supply curve is the horizontal summation of all the firms’
supply curves.

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2. Changes in market demand influence the output and the entry or exit
decisions made by firms. An increase in market demand shifts the demand
curve rightward and raises the market price. Each firm in the industry
responds by increasing its quantity supplied.
3. The higher price now exceeds each firm’s minimum ATC and the firms in
the industry earn an economic profit. The figure illustrates a perfectly
competitive firm earning an economic profit. The firm’s economic profit is
equal to the area of the darkened rectangle.
4. In the short run there are three possible profit outcomes—an economic
profit, zero economic profit, and an economic loss.
a). If the price exceeds the ATC, the firm earns an economic profit (as
illustrated in the figure).

b). If the price equals the ATC, the firm “breaks even” by earning zero
economic profit. In this case, the firm earns a normal profit. At the
profit maximizing level of output, q, the price, P, equals the ATC.

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 c). If the price is less than the ATC, the firm incurs an economic loss.

IV. Output, Price, and Profit in the Long Run

1. Economic profit motivates firms to enter the industry, thereby increasing
the market supply.

2. When the market supply curve shifts rightward, the market price falls.
Eventually the price falls to equal the minimum ATC for each firm in the
industry and firms have adjusted their plant size so they are producing at
the minimum long-run average cost. At this price, firms in the industry no
longer earn an economic profit and so firms no longer enter the industry.
The figure illustrates this long-run equilibrium. In the figure, LRAC is the
long-run average cost curve and SRAC is the short-run average cost curve.

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3. One difference between the old and new market equilibriums is that the
number of firms in the industry has risen and total quantity produced in the
industry has increased.
4. The effects of a decrease in market demand are the opposite of those
outlined above.
(a) At the beginning, the market price is lower than the firm’s minimum
ATC

(b) Some firms exit due to economic loss

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 5. In the long run, competitive firms earn zero economic profit (price =
average total cost).

Profit as a “signal”: When demand for a good increases so that the existing firms
in an industry earn an economic profit, the economic profit indicates that consumers
are willing to pay a higher price for the good than they were willing to pay before the
demand increased. The economic profit for the firms is a signal from the consumers
to the owners of firms in other industries that society now values the availability of
the good more highly than the availability of goods from those other industries.
These self-interested firm owners choose to enter the industry in order to earn an
economic profit. Their self-interested decisions promote the social interest by using
more resources to produce those goods that are more highly valued by society. The
dynamic behavior of a perfectly competitive market characterizes the “invisible
hand” coined by Adam Smith.

Why would a firm stay in business if profit is zero? Remember that the profit we’re
measuring is economic profit. Zero economic profit doesn’t necessarily mean that the
firm isn’t making any money. Rather, zero economic profit means that the revenue
the firm is earning is exactly the same as the value of the firm’s best alternative. If
the firm were to move to its best alternative, it would make the same amount of
profit. If a firm is making zero profit, there isn’t any incentive to go anywhere else as
there isn’t any place that would generate a higher return for the firm. You may need
to continue reminding your students of this throughout this chapter.

V. Competition and Efficiency

A. Efficient Use of Resources
Resource allocation in a market is efficient when society values no other use
of the resources more highly. Resource use is efficient when production is
such that the marginal social benefit of the good equals the marginal social
cost of the good.

B. Choices, Equilibrium, and Efficiency

1. Consumers allocate their budgets to get the most value out of them.
Because consumers get the most value out of their budget, a consumer’s

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 individual demand curve for a good is the consumer’s marginal benefit
curve for the good. If no one else benefits from the good other than the
consumers, then as shown in the figure the market demand curve for a good
is the marginal social benefit curve.
2. Firms maximize their profits in order to get the most value out of their
resources. Firms make choices across all possible allocations of their
resources. A firm’s supply curve for a good is its marginal cost curve. If all
the costs of production of the good are paid by the producers, then as shown
in the figure the market supply curve for a good is the marginal social cost
curve.

3. In a competitive equilibrium, the quantity demanded equals the quantity

supplied. If there are no externalities, the demand curve is the same as the
marginal social benefit curve and the supply curve is the same as the
marginal social cost curve, so at the competitive equilibrium, the marginal
social benefit equals the marginal social cost. Resource use is efficient.
Because resources are used efficiently, at the competitive equilibrium there
is no other allocation of resources that will generate greater net benefits to
society. The figure shows this outcome, where resource use is efficient at
the equilibrium quantity of 3,000 units.

Watching the work of the invisible hand: The power of the market to make firms
respond to consumers’ changing demands becomes visible to the student in this
chapter. When you teach the dynamics of firm entry and exit, do the analysis with a
specific (and current) example with which the students can identify. Computers, cell
phones and internet ISPs are good examples for an increase in demand. Audio

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cassette tapes and analog video cameras are good examples for a decrease in demand.

一些關於完全競爭市場補充的說明

這裡主在說明由理論的角度出發，在一個完全競爭市場的架構下，市場均衡價
格、均衡交易量、每個消費者的購買量與每個生產者的供給量是如何決定的。
在這個例子中，你將看到消費者與生產者都必須是價格接受者的情形下，經濟
理論是如何描述市場運作來達到均衡的。為簡化分析，我們假設這個完全競爭
市場中，消費者與供給者都各僅有兩位，但你應可將這個例子擴展到多個生產
者與消費者的情形。

假設社會上僅有兩個消費者，一個是 Lisa 另一個是 Nick，Lisa 根據他自己的偏

好，畫出了一條他自己對於 Pizza 的邊際利益曲線（或需求線）如圖下，Nick
也畫出了他自己對於 Pizza 的邊際利益曲線（或需求線），因此將兩人的需求線
相加，我們就可以得到整個社會對於 Pizza 的需求線。例如在 Pizza 價格是$1
時，Lisa 想買 30 單位的 Pizza，而 Nick 想買 10 單位的 Pizza，故在 Pizza 是$1
時，整個社會對於 Pizza 的總需求是 40 單位(=30+10)，以此類推，當 Pizza 的
價格是$0.5 時， Lisa 想買 40 單位的 Pizza，而 Nick 想買 20 單位的 Pizza，故
在 Pizza 是$0.5 時，整個社會對於 Pizza 的總需求是 60 單位(=40+20)。

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根據圖上資訊 Lisa 的需求線方程式為 20P+Q=50

Nick 的需求線方程式為 20P+Q=30
當 P 大於 1.5 時，整個市場的需求線方程式為 20P+Q=50
當 P 小於 1.5 時，整個市場的需求線方程式為 Q=80-40P

同樣的，下圖假設社會上僅有兩個生產者，一個是 Peter，另一個是 John，Peter

根據他自己的生產技術與成本，畫出了一條他自己對於 Pizza 的邊際成本曲線

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（或供給線），John 也畫出了他自己對於 Pizza 的邊際成本曲線（或供給線），
因此將兩人的供給線相加，我們就可以得到整個社會對於 Pizza 的供給線。例
如在 Pizza 價格是$1 時，Peter 想提供 40/3 單位的 Pizza，而 John 想提供 20/3
單位的 Pizza，故在 Pizza 是$1 時，整個社會對於 Pizza 的總供給是 20 單位
(=40/3+20/3)，以此類推，當 Pizza 的價格是$2 時， Peter 想提供 40 單位的
Pizza，而 John 想提供 20 單位的 Pizza，故在 Pizza 是$2 時，整個社會對於
Pizza 的總供給是 60 單位(=40+20)。

(a) Peter’s supply (b) John’s supply (c) Market supply

根據圖上資訊 Peter 的供給線方程式為 40P-1.5Q=20

John 的供給線方程式為 20P-1.5Q=10
整個市場的供給線方程式為 Q=40P-20

將市場的供給線與需求線方程式進行聯立求解，則可得

Market S=MSC

1.25

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整體社會均衡價格 P*是 1.25，均衡交易量 Q*是 30。
在瞭解上述的數字與圖形後，我們開始說明由理論的角度出發，市場是如何運
作且均衡是如何達成的。首先，這兩位消費者獻出了他們如上所描述的需求
線，兩位供給者也同時獻出了如上所描述的供給線，市場那隻看不見的手接著
發揮了力量，將這些線條加總並求出了整個市場供給線與需求線的方程式，同
時也解出了均衡的價格 1.25，再來，這個價格資訊傳送到了所有人手中，當所
有人都必須是價格的接受者下，各消費者乖乖的回頭去看在 1.25 的價格下，他
應當買多少的 PIZZA 才能讓總效用極大（CHAPTER 9），而各生產者也乖乖的
回頭去看在 1.25 的價格下，他應當生產多少的 PIZZA，才能讓利潤極大
（CHAPTER 12）。根據上述我們對於消費者與生產者的設定，NICK 將消費 5
單位的 PIZZA，而 LISA 將消費 25 單位的 PIZZA；PETER 將生產 20 單位的
PIZZA，而 JOHN 將生產 10 單位的 PIZZA。將 NICK 與 LISA 的消費量加總可
得社會的總需求量是 30，將 PETER 與 JOHN 的生產量加總，我們亦可得社會
的總供給量也是 30，總供給量等於總需求量，均衡就是這樣達成的。

至於為何當大家都接受的價格均是 1.25 時，NICK 與 LISA 的消費量加總恰等

於 PETER 與 JOHN 的生產量加總，也等同於前頁最後一行解聯立方程式所得
出的 30？其實這個結果並不令人意外，因為整個社會的總需求或是總供給都是
加總個別生產者與消費者的資訊得到的。

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