Roger LeRoy Miller Economics Today Chapter 23 Perfect Competition

Introduction Few Americans today would say that competition does not exist in the U.S. marketplace. But how much competition is there really? Is the American marketplace truly more competitive today than in years past?

Learning Objectives Identify the characteristics of a perfectly competitive market structure Discuss the process by which a perfectly competitive firm decides how much output to produce Understand how the short-run supply curve for a perfectly competitive firm is determined

Learning Objectives Explain how the equilibrium price is determined in a perfectly competitive market Describe what factors induce firms to enter or exit a perfectly competitive industry Distinguish among constant-, increasing-, and decreasing-cost industries based on the shape of the long-run industry supply curve

Chapter Outline Characteristics of a Perfectly Competitive Market Structure The Demand Curve of the Perfect Competitor How Much Should the Perfect Competitor Produce?

Chapter Outline Using Marginal Analysis to Determine the Profit-Maximizing Rate of Production Short-Run Profits The Short-Run Shutdown Price The Meaning of Zero Economic Profits The Perfect Competitor’s Short-Run Supply Curve

Chapter Outline Competitive Price Determination The Long-Run Industry Situation: Exit and Entry Long-Run Equilibrium Competitive Pricing: Marginal Cost Pricing

Did You Know That... Many firms, such as the tens of thousands of copy shops, video rental stores, and farmers, have no control over the price they receive for their products or services? Such is the world of perfect competition.

Characteristics of a Perfectly Competitive Market Structure Perfect Competition A market structure in which the decisions of individual buyers and sellers have no effect on market price

Characteristics of a Perfectly Competitive Market Structure Perfectly Competitive Firm A firm that is such a small part of the total industry that it cannot affect the price of the product or service that it sells

Characteristics of a Perfectly Competitive Market Structure Price Taker A competitive firm that must take the price of its product as given because the firm cannot influence its price

Characteristics of a Perfectly Competitive Market Structure Scenario A wheat farmer delivers his winter wheat crop to the grain elevator and is offered a price of $3.00/bushel. How many bushels will he sell if he wants $3.01/bushel for his wheat? Can he sell any additional bushels by offering to sell for $2.99/bushel?

Characteristics of a Perfectly Competitive Market Structure Characteristics of perfect competition Large number of buyers and sellers Homogenous products When you buy a head of lettuce do you ask what farm it came from? No barriers to entry or exit Buyers and sellers have equal access to information

International Example: A Common Pricing Denominator in Europe Perfect competition is more likely in an environment where buyers and sellers have equal access to information. In Europe accurate decisions on prices of substitutes was limited by the need to compare prices of goods produced in different countries in different currencies. This should be less of a problem with the establishment of the Euro.

Variability in the Domestic Prices of Selected Products in Nine European Nations Figure 23-1

The Demand Curve of the Perfect Competitor Question If the perfectly competitive firm is a price taker, who or what sets the price?

The Demand Curve for a Minidisk Producer Neither an individual buyer or seller can influence the price S D 5 E The interaction of market supply and demand yields an equilibrium price of $5 and quantity of 25,000 units Price per Minidisk 10,000 20,000 30,000 40,000 50,000 Minidisks per Day

The Demand Curve of the Perfect Competitor The perfectly competitive firm: Is a price taker (i.e., must sell for $5) Will sell all units for $5 Will sell zero units if it wants a higher price Cannot sell more units at a lower price

The Demand Curve for a Minidisk Producer Industry Individual firm S D Price per Minidisk 5 E d 5 10,000 20,000 30,000 40,000 50,000 1 2 3 4 5 Minidisks per Day Minidisks per Day Figure 23-2, Panels (a) and (b)

How Much Should the Perfect Competitor Produce? The firm will produce the level of output that will maximize profits given the market price. Total Revenues The price per unit times the total quantity sold Economic profit = total revenue (TR) - total cost (TC)

How Much Should the Perfect Competitor Produce? Economic profit = total revenue (TR) - total cost (TC) TR = P x Q Average revenue (AR)  TR Q PQ   P P determined by the market in perfect competition Q determined by the producer to maximize profit

How Much Should the Perfect Competitor Produce? Economic profit = total revenue (TR) - total cost (TC) TC  explicit + opportunity cost

Profit Maximization Figure 23-3, Panel (a)

Profit Maximization Figure 23-3, Panel (b) Total Output/ Sales/ Total Market Total Total day Costs Price Revenue Profit 0 $10 $5 $0 $10 1 15 5 5 10 2 18 5 10 8 3 20 5 15 5 4 21 5 20 1 5 23 5 25 2 6 26 5 30 4 7 30 5 35 5 8 35 5 40 5 9 41 5 45 4 10 48 5 50 2 11 56 5 55 1 Figure 23-3, Panel (b)

How Much Should the Perfect Competitor Produce? Profit-maximizing rate of production The rate of production that maximizes total profits, or the difference between total revenues and total costs Also, the rate of production at which marginal revenue equals marginal cost

Profit Maximization Figure 23-3, Panel (c) Total Output/ Sales/ Market Marginal Marginal day Price Cost Revenue 0 $5 1 5 2 5 3 5 4 5 5 5 6 5 7 5 8 5 9 5 10 5 11 5 $5 $5 3 5 2 5 1 5 4 5 5 5 6 5 7 5 8 5 Figure 23-3, Panel (c)

Marginal revenue (MR)  Using Marginal Analysis to Determine the Profit-Maximizing Rate of Production Marginal revenue (MR)  ∆TR ∆output Marginal cost (MC)  ∆TC ∆output

Using Marginal Analysis to Determine the Profit-Maximizing Rate of Production Between zero output and MC = MR output, MR > MC and TR is increasing more than TC and profits are increasing MR > MC

Using Marginal Analysis to Determine the Profit-Maximizing Rate of Production Beyond MC = MR output, MC > MR and TC is increasing more than TR and profits are decreasing. MR > MC MC > MR

Profit Maximization Total Output/ Sales/ Total Market Total Total Marginal Marginal day Costs Price Revenue Profit Cost Revenue 0 $10 $5 $0 $10 1 15 5 5 10 2 18 5 10 8 3 20 5 15 5 4 21 5 20 1 5 23 5 25 2 6 26 5 30 4 7 30 5 35 5 8 35 5 40 5 9 41 5 45 4 10 48 5 50 2 11 56 5 55 1 $5 $5 3 5 2 5 1 5 4 5 5 5 6 5 7 5 8 5 MR > MC MR = MC MR < MC

Using Marginal Analysis to Determine the Profit-Maximizing Rate of Production Profit maximization—a review Economic profits = TR  TC Profit-maximizing output occurs at the unit that MC = MR For a perfectly competitive firm, this is at the intersection of the firms demand schedule and its marginal cost curve

Short-Run Profits To find out what our competitive individual minidisk producer is making in terms of profits in the short run, we have to add the average total cost curve to Panel (c) of Figure 23-3.

Price and Cost per Unit ($) Short-Run Profits 14 13 12 11 10 • Recall: Profits are maximized at 7.5 units where MC = MR. • How do we measure profits? 9 Price and Cost per Unit ($) 8 7 6 5 4 3 2 1 3 5 7 9 11 1 4 6 8 10 2 12 Minidisks per Day

Price and Cost per Unit ($) Short-Run Profits 14 • Profit is maximized where MR = MC • ATC = TC/output • TC = ATC  output • TR = P  output • Profit = (P - ATC)  output 13 12 11 MC 10 9 Price and Cost per Unit ($) 8 7 Profits ATC 6 d 5 P = MR = AR 4 3 2 1 3 5 7 9 11 1 4 6 8 10 2 12 Figure 23-4 Minidisks per Day

Price and Cost per Unit ($) Short-Run Profits 14 • At P = $5, ATC = 4.33 • Output = 5 units • TR = $5  7.5 = 37.5 • TC = $4.33  7.5 = 32.5 • Profit = 37.5 - 32.5 = $5 or ($5 - 4.33)  7.5 = $5 13 12 11 MC 10 9 Price and Cost per Unit ($) 8 7 Profits ATC 6 d 5 P = MR = AR 4 3 2 1 3 5 7 9 11 1 4 6 8 10 2 12 Minidisks per Day

Minimization of Short-Run Profits 14 • Losses are minimized where MR = MC • Loss = ($3 - 4.35)  5.5 or $7.43 13 12 11 MC 10 9 Price and Cost per Unit ($) 8 7 ATC 6 Losses d1 5 4 d2 3 P = MR = AR 2 1 3 5 7 9 11 1 4 6 8 10 2 12 Figure 23-5 Minidisks per Day

Short-Run Profits Short-run average profits or average losses are determined by comparing average total costs with price (average revenue) at the profit-maximizing rate of output. In the short run, the perfectly competitive firm can make economic profits or economic losses.

The Short-Run Shutdown Price What do you think? Would you continue to produce if you were incurring a loss? In the short run? In the long run?

Short-Run Shutdown and Break-Even Price Short-run break-even point Short-run shutdown point Figure 23-6

The Short-Run Shutdown Price What do you think? Would you continue to produce if you were incurring a loss? In the short run? In the long run?

The Short-Run Shutdown Price As long as the price per unit sold exceeds the average variable cost per unit produced, the firm will be covering at least part of the opportunity cost of the investment in the business— that is, part of its fixed costs.

The Short-Run Shutdown Price Short-Run Break-Even Price The price at which a firm’s total revenues equal its costs At the break-even price, the firm is just making a normal rate of return on its capital investment Short-Run Shutdown Price The price that just covers average variable costs It occurs just below the intersection of the marginal cost curve and the average variable cost curve

The Meaning of Zero Economic Profits Why produce if you are not making a profit? Hint: Distinguish between economic profits and accounting profits When economic profits are zero, accounting profits are positive

The Perfect Competitor’s Short-Run Supply Curve Question What does the supply curve for the individual firm look like? Answer In Figure 23-7, the firm’s supply curve is the marginal cost curve above the short-run shutdown point. Thus, the definition of the individual firm’s short-run supply curve in a competitive industry is its marginal costs curve equal to and above the point of intersection with the average variable cost curve.

The Individual Firm’s Short-Run Supply Curve • Given the price, the quantity is determined where MC = MR • Short-run supply = MC above minimum AVC Figure 23-7

The Perfect Competitor’s Short-Run Supply Curve The Industry Supply Curve The locus of points showing the minimum prices at which given quantities will be forthcoming

Deriving the Industry Supply Curve Figure 23-8, Panels (a), (b), and (c)

The Perfect Competitor’s Short-Run Supply Curve Factors that influence the industry supply curve (determinants of supply) Firm’s productivity Factor costs Taxes and subsidies Number of firms

Competitive Price Determination Question How is the market, or “going,” price established in a competitive market? Answer This price is established by the interaction of all the suppliers (firms) and all the demanders.

Competitive Price Determination The competitive price is determined by the intersection of the market demand curve and the market supply curve The market supply curve is equal to the horizontal summation of the portions of the individual marginal cost curves above their respective minimum average variable costs

Competitive Price Determination Pe is the price the firm must take Pe and Qe determined by the interaction of the industry S and market D Figure 23-9, Panel (a)

Competitive Price Determination -Given Pe firm produces qe where MC = MR -If AC = AC1, break-even -If AC = AC2, losses -If AC = AC3, economic profit Figure 23-9, Panel (b)

The Long-Run Industry Situation: Exit and Entry Profits and losses act as signals for resources to enter an industry or to leave an industry.

The Long-Run Industry Situation: Exit and Entry Signals Compact ways of conveying to economic decision makers information needed to make decisions A true signal not only conveys information but also provides the incentive to react appropriately

The Long-Run Industry Situation: Exit and Entry The profit signal—entry (assumptions) A perfectly competitive market (wheat) characterized by a normal rate of return (i.e., break-even) A European crop failure increases the demand for U.S. wheat

The Long-Run Industry Situation: Exit and Entry The profit signal—entry (assumptions) The increase in demand creates shortages in the U.S. market, the price of wheat increases and economic profits exist The profits signal for new resources to enter the market The market returns to a normal rate of return

The Adjustment Graphically Initial market conditions MC S D ATC Price of Wheat ($) Pe Qe d = MR qe Break-even Quantity of Wheat (industry) Quantity of Wheat (firm)

The Adjustment Graphically European crop failure increases U.S. Demand MC D2 S1 ATC Q1 P2 d2 q2 Higher price creates economic profit Price of Wheat ($) P1 d1 D1 Q1 q1 Quantity of Wheat (industry) Quantity of Wheat (firm)

The Adjustment Graphically Economic profit attracts new firms Price fall to break-even MC S1 S2 ATC Price of Wheat ($) P1 d1 D2 D1 Q1 q1 Quantity of Wheat (industry) Quantity of Wheat (firm)

The Adjustment Graphically Reaction to losses MC S D ATC qe ATC Price of Wheat ($) Pe Qe d = MR Quantity of Wheat (industry) Quantity of Wheat (firm)

The Adjustment Graphically Losses signal for resources to leave the market Supply falls and price increases to break-even MC S2 S1 ATC P2 d = MR Price of Wheat ($) P1 Break-even D Q1 q1 Quantity of Wheat (industry) Quantity of Wheat (firm)

The Long-Run Industry Situation: Exit and Entry Summary Economic profits Signal resources to enter the market and the price falls to the break-even price Economic losses Signal resources to exit the market and the price increases to the break-even level

The Long-Run Industry Situation: Exit and Entry Summary At break-even Resources will not enter or exit because the market is yielding a normal rate of return In the long run, the perfectly competitive firms will make zero economic profits (normal rate of return)

The Long-Run Industry Situation: Exit and Entry Long-Run Industry Supply Curve A market supply curve showing the relationship between price and quantities forthcoming after firms have been allowed time to enter or exit from an industry

The Long-Run Industry Situation: Exit and Entry Constant-Cost Industry An industry whose total output can be increased without an increase in long-run per-unit costs

Constant-Cost Industry Figure 23-10, Panel (a)

The Long-Run Industry Situation: Exit and Entry Increasing-Cost Industry An industry in which an increase in industry output is accompanied by an increase in long-run per unit costs

Increasing-Cost Industry Figure 23-10, Panel (b)

The Long-Run Industry Situation: Exit and Entry Decreasing-Cost Industry An industry in which an increase in industry output leads to a reduction in long-run per unit costs

Decreasing-Cost Industry Figure 23-10, Panel (c)

Long-Run Equilibrium Firms will adjust plant size until it has no further incentive to change.

Long-Run Firm Competitive Equilibrium Figure 23-11

Long-Run Equilibrium In the long run, a competitive firm produces where price, marginal revenue, marginal cost, short-run minimum average cost, and long-run minimum average cost are equal.

Competitive Pricing: Marginal Cost Pricing A system of pricing in which the price charged is equal to the opportunity cost to society of producing one more unit of the good or service in question

Competitive Pricing: Marginal Cost Pricing Market Failure A situation in which an unrestrained market operation leads to either too few or too many resources going to a specific economic activity

Policy Example: Can the Government Cure Market Failure Due to Asymmetric Information, or Are Lemons Here to Stay? Lemons Problem The situation in which consumers, who do not know details about the quality of a product, are willing to pay no more than the price of a low-quality product, even if a higher quality product at a higher price exists

Lemons will tend to be overpriced. Policy Example: Can the Government Cure Market Failure Due to Asymmetric Information, or Are Lemons Here to Stay? Lemons will tend to be overpriced. Quality used cars will be underpriced.

Issues and Applications: Has the U.S. Economy Become More Competitive? Groundwork for greater competition: deregulation in the 1970s and 1980s Trying to measure overall competition A competition index shows the U.S. economy to be becoming more competitive

Issues and Applications: Have “Greedy” Companies Been Able to Avoid Serious Competition? Source: John Duca and David BanHoose, “Has Greater Competition Restrained Inflation?” Southern Economic Journal, January 2000. Figure 23-12

Web Links The following Web link appears in the margin of this chapter in the textbook: http://www.cbo.gov

Summary Discussion of Learning Objectives The characteristics of a perfectly competitive market structure Large number of buyers and sellers Homogeneous product No barriers to entry and exit Buyers and sellers have equal access to information

Summary Discussion of Learning Objectives How a perfectly competitive firm decides how much to produce Economic profits are maximized when marginal cost equals marginal revenue above minimum average variable cost

Summary Discussion of Learning Objectives The short-run supply curve of a perfectly competitive firm The rising part of the marginal cost curve above minimum average variable cost The equilibrium price in a perfectly competitive market A price at which the total amount of output supplied by all firms is equal to the total amount of output demanded by all buyers

Summary Discussion of Learning Objectives Incentives to enter or exit a perfectly competitive industry Economic profits induce entry of new firms Economic losses will induce firms to exit the industry

Summary Discussion of Learning Objectives The long-run industry supply curve and constant-, increasing-, and decreasing-cost industries The relationship between price and quantity after firms have been able to enter or exit the industry Constant-cost industry Horizontal long-run supply curve Increasing-cost industry Upwards-sloping long-run supply curve Decreasing-cost industry Downward-sloping long-run supply curve

End of Chapter Chapter 23 Perfect Competition