Chapter 8 Perfect Competition © 2009 South-Western/ Cengage Learning

22 An Introduction to Perfect Competition Firm’s goal: maximize profit Market structure –# and size of firms –nature of product –entry/exit possibilities in market –forms of competition among firms

Perfectly Competitive Market Structure many, small buyers and sellers homogenous product no barriers to entry/exit perfect information mobile resources no public goods / externalities “price-taking behavior” 3

Demand Under Perfect Competition Market price –determined in market by interaction between S and D Demand curve facing one firm –horizontal line at the market price –perfectly elastic Law of Demand applies to market demand, not the firm’s perceived demand 4

Short Run Profit Maximization Maximize economic profit –Quantity at which TR exceeds TC by the greatest amount Total revenue = TR Total cost = TC Profit = TR – TC If TR > TC: economic profit If TC > TR: economic loss 5

Short Run Profit Maximization Marginal analysis Marginal revenue: MR –MR is the change in total revenue when a firm sells 1 additional unit –MR = ∆TR / ∆q Marginal cost: MC –MC = ∆TC / ∆q (previously defined) 6

Short Run Profit Maximization Maximize economic profit: –Increase production as long as each additional unit increases profit The increase in TR must exceed the increase in TC for the next unit Golden rule –Expand output whenever MR>MC –Stop before MR<MC This is true for all firms in all market structures In Perfect Competition: MR = P 7

Minimizing Short-Run Losses TC = FC+VC in short run a firm must pay fixed cost even if q = 0 If TC<TR there is an economic loss –Produce if TR>VC (P>AVC) Revenue covers variable costs and a portion of fixed cost Loss < fixed cost –Shut down if TR<VC (P<AVC) Loss = FC 8

Maximizing Profit in Short Run Choose q such that –MR = MC Gives us the output level Profit > 0 if P > AC We have our optimal level of q Profit = 0 if P = AC We have our optimal level of q Profit < 0 if P < AC –If P > AVC we have our optimal level of q –If P < AVC shutdown (q = 0) 9

Firm and Industry Short-Run S curves Supply shows the quantities that firm’s will produce at various prices Short-run firm supply curve –Upward sloping portion of MC curve –Above minimum AVC curve Short-run industry supply curve –Horizontal sum of all firms’ short-run supply curves 10

Exhibit 7 Aggregating individual supply to form market supply Quantity per period 0 p p’ Price per unit SASA (a) Firm A 1020 Quantity per period 0 p p’ SBSB (b) Firm B 1020 Quantity per period 0 p p’ SCSC (c) Firm C 3060 Quantity per period 0 p p’ S A + S B + S C = S (d) Industry, or market, supply

Firm Supply and Market Equilibrium Perfect competition in the short run –Market level converges to equilibrium P and Q –Firm level Max profit Min loss Shuts down temporarily All firms in industry are producing where P = MC; Economic profit is positive or zero or negative 12

Perfect Competition in the Long Run Long run –All resources are variable –Firms can enter/exit the market Number of firms can change –Firms adjust scale of operations To maximize long run profits Until average cost is minimized 13

Perfect Competition in the Long Run If we have economic profit in short run –New firms enter market in long run –Existing firms expand in long run –Market S increases (shift right) P decreases Economic profit disappears Firms break even 14

Perfect Competition in the Long Run If we have economic loss in short run –Some firms exit the market in long run –Some firms reduce scale in long run –Market S decreases (shifts left) P increases Economic loss disappears Firms break even 15

Zero Economic Profit in the Long Run In LR firms enter, leave, change scale Market: –S shifts; P changes Firm: –d shifts up and down as P changes –Long run equilibrium MR=MC =ATC=LRAC Normal profit Zero economic profit 16

Long-Run Adjustment to a Change in D Effects of an Increase in Demand –Short run P increases; d increases Firms increase quantity supplied Economic profit exists –Long run New firms enter the market S increases, P decreases Firm’s d decreases Normal profit 17

Long-Run Adjustment to a Change in D Effects of a Decrease in Demand –Short run P decreases; d decreases Firms decrease quantity supplied Economic loss –Long run Firms exit the market S decreases, P increases Firm’s d increases Normal profit 18

The Long-Run Industry Supply Curve Short run –change quantity supplied along MC curve Long run industry supply curve S* –after firms fully adjust to changing prices Constant-cost industry –input prices remain constant as industry output changes LRAC doesn’t shift with output Long run S* curve for industry: horizontal line 19

The Long-Run Industry Supply Curve Increasing Cost Industry –input costs rise as industry output rises average costs increase as output expands Effects of an increase in demand LRAC increases (shifts up) as industry output increases Long run S* curve for industry: upward sloping 20

Perfect Competition and Efficiency Economic Efficiency –State of affairs where it is not possible to make one person better off without making another worse off –Includes productive efficiency and allocative efficiency 21

Perfect Competition and Efficiency Productive efficiency: Making Stuff Right –Produce output at the least possible cost Min point on LRAC curve P = min average cost in long run Allocative efficiency: Making the Right Stuff –Produce output that consumers value most Marginal benefit = P = Marginal cost Cannot reallocate the goods and services to increase welfare to society 22

Perfect Competition and Efficiency In a perfectly competitive equilibrium –the amount the consumer is willing to pay to consume that last unit is just equal to the value (full opportunity costs) of the resources used to produce that last unit –Market price is driven down as low as it can go and still cover the full cost of production 23

What’s So Perfect About Perfect Competition? Consumer surplus –Difference between what the consumer is willing to pay and the market price Producer surplus –Difference between the market price and the marginal cost of producing –Covers FC and profit Gains from voluntary exchange Consumer and producer surplus Productive and allocative efficiency Maximum social welfare 24

Inefficient Production If MB to consumer is not equal to MC to producer we see inefficiency Deadweight loss –Lost consumer surplus or producer surplus (not recovered elsewhere) due to inefficient production 25