Microeconomics
Chapter 11 – Perfect Competition
Features of a market with perfect competition
● Many firms sell identical products to many buyers
● There are no restrictions on entry into the market
● Established firms have no advantage over new ones
● Sellers and buyers are well informed about prices
Minimum efficient scale: Smallest output at which the LRAC curve reaches its lowest
level.
Perfect competition arises if the minimum efficient scale of a single producer is small
relative to the market demand for the good or service.
● In perfect competition, each firm produces a good that has no unique
characteristics, so consumers don’t care which firm’s goods they buy
Price taker: A firm that cannot influence the market price because its production is an
insignificant part of the total market.
● Firms in perfect competition are price takers
A firm’s goal is to maximize economic profit.
Economic profit = TR – TC
Total cost is the opportunity cost of production, which includes normal profit.
Total revenue: Price X Quantity
Marginal revenue: Change in total revenue that results from a one-unit increase in the
quantity sold.
In perfect competition, the firm’s marginal revenue equals the market price.
To achieve maximum economic profit, a firm must decide:
● How to produce at minimum cost
● What quantity to produce
● Whether to enter or exit a market
A way to find the maximum economic profit is to compare the differences between the
TR and TC curves. The locations where TR is greater than TC and the point with the
greatest separation, will give you the areas where economic profit is positive and the
location at which it is maximized.
Another way to find the profit-maximizing output is to use marginal analysis, which
compares MR with MC.
Economic profit is maximized when MR = MC.
Economic loss = TFC + (AVC – P) x Q
If the firm shuts down then the only costs they incur are their fixed costs.
If the firm produces, then in addition to its fixed costs, it incurs variable costs, but it also
receives revenue.
● Economic loss if operating: (TFC + TVC) – TR
● If total variable cost exceeds total revenue, then loss exceeds total fixed cost and
the firm shuts down
● If average variable cost exceeds the price, this loss exceeds total fixed cost and
the firm shuts down
Shutdown point: The price and quantity at which a firm is indifferent to shutting down.
● Shutdown point occurs at the price and the quantity at which average variable
cost is at its minimum
● At the shutdown point, the firm is minimizing its loss and its loss equals total fixed
cost
● At prices above the minimum average variable cost but below average total cost,
the firm produces the loss-minimizing output and incurs a loss, but a loss that is
less than total fixed cost
A firm’s supply curve can be derived from their marginal cost curve and average
variable cost curves.
The firm produces zero output at all prices below minimum average variable cost.
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.
At the shutdown point, the economic loss incurred is equal to the total fixed cost
because firms are not able to cover that cost.
Economic profit or loss in the short-run = (P – ATC) x Q
If price equals average total cost, then a firm breaks even – the entrepreneur makes a
normal profit.
If price exceeds average total cost, then a firm makes an economic profit.
If price is less than average total cost, a firm incurs an economic loss.
In the long-run, firms can enter or exit the market.
● Firms respond to economic profit and economic loss by either entering or exiting
the market
● Temporary economic profit or loss does not trigger an entry or exit
o Consistent economic profit or loss triggers an entry or exit
If firms enter the market, then 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 the market, then supply decreases and the supply curve shifts leftward. The
market price rises and economic loss decreases. Eventually this loss is eliminated and
exit stops.
Entry results in an increase in market output, but each firm’s output decreases. Because
the price falls, each firm moves down its supply curve and produces less.
Exit results in a decrease in economic output, but each firm’s output increases. Because
the price rises, each firm moves up its supply curve and produces more.
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
● It is constantly evolving toward long-run equilibrium, but the market is constantly
bombarded with events that change the constraints firms face
When technological advancement occurs, markets disadvantaged by this advancement
will incur an economic loss and firms will exit until this loss is eliminated.
An increase in demand in a market brings a higher price, economic profits, and
increased firm entry.
● Entry will then increase the supply, which lowers the price to its original level, and
economic profit returns to zero
When a technological advancement occurs, all of the old-technology firms will
eventually exit the market and enough new technology firms enter the market to
increase the market supply to a level that lowers the price to equal the minimum
average total cost using the new technology.
Technological advancement only brings temporary gains for the producers, though it
brings permanent gains for the consumers.