Perfect Competition 14 Perfect Competition There’s no resting place for an enterprise in a competitive economy. — Alfred P. Sloan CHAPTER 14 Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Perfect Competition 14 Chapter Goals Discuss the six conditions for a perfectly competitive market Demonstrate why the marginal cost curve is the supply curve for a perfectly competitive firm Explain why producing an output at which marginal cost equals price maximizes total profit for a perfect competitor Determine the output and profit of a perfect competitor graphically and numerically 14-2

Perfect Competition 14 Chapter Goals Construct a market supply curve by adding together individual firms’ marginal cost curves Explain why perfectly competitive firms make zero economic profit in the long run Explain the adjustment process from short-run equilibrium to long-run equilibrium 14-3

Perfect Competition 14 A Perfectly Competitive Market For a market to be perfectly competitive, six conditions must be met: 1.Both buyers and sellers are price takers – a price taker is a firm or individual who takes the price determined by market supply and demand as given 2.The number of firms is large – any one firm’s output compared to the market output is imperceptible and what one firm does has no influence on other firms A perfectly competitive market is a market in which economic forces operate unimpeded 14-4

Perfect Competition 14 A Perfectly Competitive Market 3.There are no barriers to entry – barriers to entry are social, political, or economic impediments that prevent firms from entering a market 4.Firms’ products are identical – this requirement means that each firm’s output is indistinguishable from any other firm’s output 5.There is complete information – all consumers know all about the market such as prices, products, and available technology 6.Selling firms are profit-maximizing entrepreneurial firms – firms must seek maximum profit and only profit 14-5

Perfect Competition 14 The Definition of Supply and Perfect Competition When a firm operates in a perfectly competitive market, its supply curve is its short-run marginal cost curve above average variable cost Supply is a schedule of quantities of goods that will be offered to the market at various prices These strong six conditions are seldom met simultaneously, but are necessary for a perfectly competitive market to exist 14-6

Perfect Competition 14 Demand Curves for the Firm and the Industry P Q Market demand is downward sloping Market Supply Firm demand is perfectly elastic (horizontal) P0P0 Market Demand P Q P0P0 Firm Demand P = D = MR Q1Q1 Q2Q2 Q3Q3 14-7

Perfect Competition 14 Profit Maximizing Level of Output Marginal revenue (MR) is the change in total revenue associated with a change in quantity A firm maximizes profit when marginal revenue equals marginal cost The goal of the firm is to maximize profits, the difference between total revenue and total cost Marginal cost (MC) is the change in total cost associated with a change in quantity 14-8

Perfect Competition 14 Profit Maximizing Level of Output If MR < MC, a firm can increase profit by decreasing its output If MR > MC, a firm can increase profit by increasing output The profit-maximizing condition of a competitive firm is: MR = MC For a competitive firm, MR = P A firm maximizes total profit, not profit per unit 14-9

Perfect Competition 14 Marginal Cost, Marginal Revenue, and Price Table Price = MR ($)QMarginal Cost ($) If MC < P, increase production Profit maximizing quantity is where MC = P If MC > P, decrease production The profit-maximizing condition of a competitive firm is: MC = MR = P 14-10

Perfect Competition 14 Marginal Cost, Marginal Revenue, and Price Graph P Q Marginal Cost $35 P = D = MR MC < P, increase output to increase total profit MC = P at 8 units, total profit is maximized MC > P, decrease output to increase total profit MC = P 14-11

Perfect Competition 14 The Marginal Cost Curve is the Supply Curve Because the marginal cost curve tells us how much of a good a firm will supply at a given price, the marginal cost curve is the firm’s supply curve P Marginal Cost $35 Q $19.50 $ Firm’s Supply Curve = 14-12

Perfect Competition 14 Profit Maximization using Total Revenue and Total Cost Total cost is the cumulative sum of the marginal costs, plus the fixed costs An alternative method to determine the profit-maximizing level of output is to look at the total and total cost curves Total profit is the difference between total revenue and total cost curves 14-13

Perfect Competition 14 Total Revenue and Total Cost Table QTotal Revenue ($)Total Cost ($)Total Profit ($) Total profit is maximized at 8 units of output 14-14

Perfect Competition 14 Total Revenue and Total Cost Table Total Cost, Total Revenue TC $175 Q $130 $ TR The total revenue curve is a straight line The total cost curve is bowed upward at most quantities reflecting increasing marginal cost Max profit = $81 at 8 units of output 3 Losses Profits Profits are maximized when the vertical distance between TR and TC is greatest 14-15

Perfect Competition 14 Determining Profits Graphically: A Firm with Profit AVC MC Q P ATC Find output where MC = MR, this is the profit maximizing Q P = D = MR MC = MR Q profit max Find profit per unit where the profit max Q intersects ATC ATC at Q profit max P ATC Profits Since P>ATC at the profit maximizing quantity, this firm is earning profits 14-16

Perfect Competition 14 Determining Profits Graphically: A Firm with Zero Profit or Losses AVC MC Q P ATC MC = MR Q profit max ATC at Q profit max P =ATC P = D = MR Since P=ATC at the profit maximizing quantity, this firm is earning zero profit or loss Find output where MC = MR, this is the profit maximizing Q Find profit per unit where the profit max Q intersects ATC 14-17

Perfect Competition 14 Determining Profits Graphically: A Firm with Losses AVC MC Q P ATC MC = MR Q profit max ATC at Q profit max P ATC P = D = MR Since P<ATC at the profit maximizing quantity, this firm is earning losses Find output where MC = MR, this is the profit maximizing Q Find profit per unit where the profit max Q intersects ATC Losses 14-18

Perfect Competition 14 Determining Profits Graphically: The Shutdown Decision AVC MC Q P ATC Q profit max P Shut down P = D = MR The shutdown point is the point below which the firm will be better off if it shuts down than it will if it stays in business If P>min of AVC, then the firm will still produce, but earn a loss If P<min of AVC, the firm will shut down If a firm shuts down, it still has to pay its fixed costs 14-19

Perfect Competition 14 Short-Run Market Supply and Demand The market (industry) supply curve is the horizontal sum of all the firms’ marginal cost curves While the firm’s demand curve is perfectly elastic, the industry’s demand curve is downward sloping The market supply curve takes into account any changes in input prices that might occur 14-20

Perfect Competition 14 ATC Profits Short-Run Market Supply and Demand Graph P Q Market Supply P Market Demand P Q P P = D = MR MC ATC Q profit max MarketFirm 14-21

Perfect Competition 14 Long-Run Competitive Equilibrium Profits create incentives for new firms to enter, market supply will increase, and the price will fall until zero profits are made At long run equilibrium, economic profits are zero The existence of losses will cause firms to leave the industry, market supply will decrease, and the price will increase until losses are zero 14-22

Perfect Competition 14 Long-Run Competitive Equilibrium Normal profit is the amount the owners would have received in their next best alternative Zero profit does not mean that the entrepreneur does not get anything for his efforts Economic profits are profits above normal profits 14-23

Perfect Competition 14 Long-Run Competitive Equilibrium Graph P Q P = D = MR MC SRATC LRATC At long-run equilibrium, economic profits are zero 14-24

Perfect Competition 14 SR Profits Market Response to an Increase in Demand Graph P Q S 0(SR) P0P0 D0D0 P Q P0P0 MC ATC Q 0,2 MarketFirm S 1(SR) D1D1 P1P1 1 P1P1 11 Q1Q Q0Q0 Q1Q1 Q2Q S (LR) 14-25

Perfect Competition 14 Long-Run Market Supply If the long-run industry supply curve is upward sloping, the market is an increasing-cost industry If the long-run industry supply curve is perfectly elastic, the market is a constant-cost industry If the long-run industry supply curve is downward sloping, the market is a decreasing-cost industry In the short run, the price does more of the adjusting, and in the long run, more of the adjustment is done by quantity 14-26

Perfect Competition 14 Application: Kmart After 2 years of losses, Kmart realized that the decrease in demand was permanent Although Kmart was making losses, Kmart decided to keep 300 stores open because P>AVC They moved from the short run to the long run and closed the stores because prices had fallen below their long-run average costs 14-27

Perfect Competition 14 Chapter Summary The necessary conditions for perfect competition are: 1.Buyers and sellers are price takers 2.The number of firms is large 3.There are no barriers to entry 4.Firms’ products are identical 5.There is complete information 6.Sellers are profit-maximizing entrepreneurial firms 14-28

Perfect Competition 14 Chapter Summary Competitive firms maximize profit where MR = MC Profit is (P – ATC)(Q) at the profit-maximizing level of output Perfectly competitive firms shut down if P < AVC The supply curve of a competitive firm is its MC curve above minimum AVC The short-run market supply curve is the horizontal sum of the MC curves above AVC for all the firms in the market 14-29

Perfect Competition 14 Chapter Summary In the short run, competitive firms can make a profit or loss. In the long run they make zero profits. If there are profits: Firms enter the industry Supply increases Price decreases, eliminating profit If there are losses: Firms leave the industry Supply decreases Price increases, eliminating losses 14-30

Perfect Competition 14 Chapter Summary The long-run industry supply curve is a schedule of quantities supplied where firms are making zero profit Constant-cost industries have horizontal long-run supply curves Increasing-cost industries have upward sloping long-run supply curves Decreasing-cost industries have downward sloping supply curves The slope of the long-run supply curve depends on what happens to factor costs when output increases 14-31

Perfect Competition 14 Preview of Chapter 15: Monopoly Summarize how and why the decisions facing a monopolist differ from the collective decisions of competing firms Determine a monopolist’s price, output, and profit graphically and numerically Explain why MR = MC maximizes total profit for a monopolist Show graphically the welfare loss from monopoly Explain why a price-discriminating monopolist will earn more profit than a normal monopolist Explain why there would be no monopoly without barriers to entry Discuss three normative arguments against monopoly 14-32