1. The Firm and the Industry Under Perfect Competition5
The Firm and the Industry Under Perfect Competition

2. Outline Types of Market Structure Perfect Competition Defined
The Competitive Firm
The Competitive Industry
Perfect Competition and Economic Efficiency

3. Types of Market Structure
A market is a set of buyers and sellers whose behavior affects P at which a good is sold.
E.g., Cisco stock sold in CA and WI is considered to take place in the same market, so markets don't necessarily refer to a geographical area.

4. Types of Market Structure
Economists describe different types of markets by:
the number of firms
whether the products of different firms are identical or different
how easy it is for new firms to enter the market

5. Types of Market Structure
The 4 major types of markets can be viewed on a continuum.
Perfect Competition
(many small firms selling identical products)
Monopolistic Competition
(many small firms producing slightly diff. products)
Oligopoly
(few large firms)
Pure Monopoly
(single firm)

6. Perfect Competition Defined
4 conditions required for perfect competition:
Numerous small firms and customers –individual buyers and sellers do not impact P.
Homogeneity of product –products are identical.
Freedom of entry and exit –no barriers to enter, such as advertising costs or large sunk costs. Freedom to exit, so firms can leave the industry if it proves unprofitable.
Perfect information –each firm and customer is well informed about P. They know if 1 firm is selling at a lower P.

7. Perfect Competition Defined
These 4 conditions are rarely met.
E.g., Ford stock –millions of buyers and sellers; shares are identical; entry into market is easy; and info about stock is available. Or fishing and farming.
If perfect competition is so rare, then why study it?
Standard by which all other markets are judged.
Most efficient market because industry produces what society wants using scarce resources most effectively.
Understand what an ideally functioning market can accomplish. See how far monopolist deviates.

8. The Competitive Firm
Firm is a P taker –it can produce as much or as little as it likes without affecting market P.
Firm must match P offered by its competitors because products are identical. Otherwise, consumers shift their purchases to another firm.
Industry, which is comprised of all the individual firms, can impact P through the forces of S and D.

9. The Competitive Firm Firm’s D Curve under Perfect Competition:
Horizontal demand
Cannot impact market price
E.g., Farmer Jones can double or triple Q and it has no effect on P corn. Jones is insignificant to the market exchange in Chicago, so she must accept P that a broker quotes her.

10. FIGURE 1. Demand Curve for a Firm under Perfect Competition
Industry
supply
curve S
Price per Bushel
in Chicago C B A E
Industry
demand
curve $8 $8
Firm’s demand
curve 1 2 3 4
100
200
300
400
Truckloads of Corn
Sold by Farmer Jones
per Year
Total Sales in Chicago
in Thousands of Truckloads
per Year
(a)
(b)

11. The Competitive Firm
Short-Run Equilibrium for the Perfectly Competitive Firm:
Profit-max Q is where MR = MC.
D (or AR curve) is horizontal. So D is the MR curve or MR = P.
If a firm ↑Q by 1 unit, it still receives the same P.
At an optimum Q: MR = P = MC → P = MC.

12. TABLE 1. Revenues, Costs, and Profits of a Competitive Firm
Quantity
(1,000's
of bushels)
Total Revenue
($1,000's)
Marginal Revenue
Total Cost
Marginal Cost
Total Profit
------ 10 80 85 -5 20
160
150 65 30
240
180 60 40
320
230 50 90
400
300 70
100
480
450
560
700
250
-140

13. FIGURE 2. Short-Run Equilibrium of the Perfectly Competitive FirmMC AC
Revenue and Cost per Bushel B A $8 D
= MR = AR = P $6 4
50,000
Bushels of Corn per Year

14. Short-Run Profit: Graphic Representation
To measure profit graphically, compare height of D curve with height of AC curve.
Recall: Profit = TR - TC
TR = P x Q
TC = AC x Q
Since Q is identical, we can graphically compare P and AC to see if firm earns SR profits or losses.
If P > AC → firm earns profits or if P < AC → firm incurs losses.

15. Short-Run Profit: Graphic Representation
Profit per unit = revenue per unit (P) - cost per unit (AC). If P > AC → firm makes a profit on each unit.
E.g., AC = TC/Q = $300,000/50,000 = $6 and P = $8, so the profit per unit is $2 or vertical distance between points B and A in Fig. 2.
Total profit = profit per unit (P-AC) x Q
$100,000 = $2 x 50,000 = area labeled $8 $6 A B.
MR = MC indicates profit-max Q but it doesn't show whether the firm earns profits or incurs losses. We must compare P and AC to determine this.

16. Short-Run Losses: Graphic Representation
If D is weak or costs are high, the firm’s most profitable option may lead to a loss.
Assume P is $4 per bushel and relevant data in Table 2.
Jones still produces Q at P = MR = MC to min. losses.
Q = 30,000 where MR  MC.
Total loss is $5,000 = per unit loss (AC - P) of $0.167 x Q of 30,000. Losses are shown by area $4 $4.16 C D in Fig. 3 below.

17. TABLE 2. Revenues, Costs, and Losses of a Competitive Firm
Quantity
(1,000's bushels)
Total Revenue
($1,000's)
Marginal Revenue
Total Cost
Marginal Cost
Total Profit
------ 45
-45 10 40 65 20
-25 80 90 25
-10 30
120
125 35 -5
160
170 50
200
220
-20 60
240
275 55
-35 70
280
335
-55

18. FIGURE 3. Short-Run Equilibrium of Competitive Firm with Losses
Revenue and Cost
per Bushel MC AC C D
$4.16
4.00
D = MR = AR = P
30,000
Bushels of Corn per Year

19. Shutdown and Break-Even Analysis
Firms can't endure a loss forever.
Sunk costs = costs that cannot be escaped in SR.
E.g., restaurant owner has signed a one-year lease on a building.
If firm shuts down → TR = 0 and TVC = 0, but TFC (or sunk costs) remain. Sometimes it is better to remain in operation until the sunk costs expire.

20. Shutdown and Break-Even Analysis
2 rules that govern the shutdown decision:
If TR > TC → firm earns positive profits and should remain open in SR and LR.
Firm should operate in SR if TR > TVC, but should plan to close in LR if TR < TC.
Proof:
Loss if the firm stays open = TC - TR
Loss if the firm shuts down = TFC = TC - TVC
So stay open in SR if: TC - TR < TC - TVC
or TR > TVC.

21. TABLE 3. The Shutdown Decision
Firm A
Firm B TR
100
TVC 80
130
Sunk Cost 60 TC
140
190
Loss if firm closes
Loss if the firm stays open 40 90

22. Shutdown and Break-Even Analysis
In Table 3, both firms have the same TR and TFC, but differ in their TVC.
Both firms should close in LR because TC > TR.
Yet, firm A should remain open in SR because it earns $20,000 in TR above TVC, which can go toward TFC.
Firm B should close now. By operating in SR, it adds $30,000 in TVC above TR, which can be avoided by closing.

23. FIGURE 4. Shutdown AnalysisMC AC
AVC P 3 A B P 2
Price P 1
Quantity Supplied

24. Shutdown and Break-Even Analysis
This firm operates at a loss whether P is P1, P2, or P3.
Lowest P to keep the firm open in SR is where P  AVC.
Stay open in SR if: TR > TVC
P x Q > AVC x Q
Since Q is equal, P > AVC.
Firm will shut down immediately if P < AVC.

25. Shutdown and Break-Even Analysis
At P = P1 → shutdown; firm cannot cover TVC.
At P = P3 → firm earns revenues above TVC so stay open in SR and produce at pt A where P3 = MC. But, firm will close in LR as TR < TC.
At P = P2 → firm is indifferent between remaining open and closing since TR just covers TVC. If firm stays open it will produce at pt B where P2 = MC. P2 is lowest P which Q > 0 and it’s the min pt on AVC curve.

26. The Competitive Firm’s Short-run Supply Curve
SR S curve for competitive firm = portion of MC curve that lies above the min pt on AVC curve.
Supply tells us how much output is produced at different prices.
In SR: (1) If P > AVC → produce where P = MC. So for any P above pt B, MC tells us the Qs.
(2) If P < AVC then Qs = 0.

27. The Competitive Industry’s Short-run Supply Curve
SR for industry: too brief a period of time for new firms to enter or old firms to leave. Number of firms is fixed.
LR for industry: long enough period of time for any firm that so chooses to enter or leave. Also, each firm can adjust its Q to fit LR costs.
SR industry S curve is horizontal summation of the individual firm's S curves.
SR industry S curve has (+) slope because individual firms have MC curves that slope upward.

28. FIGURE 5. Derivation of the Industry Supply Curve
Typical Corn Farmer
Corn Industry s S e E
$8.00
$8.00
Price per Bushel
Price per Bushel c C
6.00
6.00 45 50 45 50
Quantity Supplied in
Thousands of Bushels
Quantity Supplied in
Millions of Bushels
(a)
(b)

29. The Competitive Industry’s Short-run Supply Curve
In Fig. 5, if 1,000 identical firms each supplied 45,000 when P = $6 → industry Qs is 45,000 x 1,000 = 45 million. Repeating this process for every P derives industry S curve.
Entry of new firms shifts SR industry S curve out.
Exit of old firms shifts SR industry S curve in.

30. The Competitive Industry
Industry S and market D determine equilibrium P and Q.
Individual firms face horizontal D curves because they are so small. If 1 firm doubled its Q, market P is unchanged. But if every firm in industry doubled their Q, ↓P to induce consumers to purchase the add. Q.
In Fig. 6, equilibrium → P = $8 and Q = 50 million.
Recall: if P = $6 → shortage = 27. ↑P toward E as frustrated buyers bid up prices.

31. FIGURE 6. Supply-Demand Equilibrium of a Competitive Industry
$10.00 E
Price per Bushel
8.00 A C
6.00 45 50 72
Quantity of Corn in
Millions of Bushels

32. Industry and Firm Equilibrium in the Long Run
LR equilibrium may differ from SR equilibrium because:
number of firms may differ
firms can vary their plant size in LR
Thus, firm and industry cost curves differ in LR.
Firms enter or exit based on Π earned in industry.
SR profits → new firms enter
SR losses → existing firms exit
If firms earn high profits in an industry then new firms enter, forcing ↓P as SR industry S curve shifts out.

33. FIGURE 7. Entry of Firms into the Competitive Industry
Typical Firm
Industry MC S
(1,000 firms) AC D S 1
(1,600 firms)
Price per Bushel e
Price per Bushel E
$8.00 D
$8.00 a A
6.00 D 1
6.00 b 40 45 50 50 72
Quantity of Corn in
Thousands of Bushels
Quantity of Corn in
Millions of Bushels
(a)
(b)
Typical firm earns profits at point e which encourages the entry of 600 new firms. This shifts industry S curve out and lowers P.

34. Entry of Firms into the Competitive Industry
SR profits (point e in Fig. 7) encourages 600 firms to enter which shifts industry S out and pushes P down to $6 (new SR equilibrium point A).
Existing firms react to ↓P by setting new P = MC and lowering their Q to 45,000.
At P = $6 → 1,600 firms produce 45,000 each so industry Qs = 72M.
Point A is another SR equilibrium as typical firm earns profits. Note: P > AC and per unit profits = a – b.

35. FIGURE 8. LR Equilibrium of the Competitive Firm and Industry
Typical Firm
Industry MC D AC
(2,075 firms) S 2
Price per Bushel
Price per Bushel m M
$5.00 D 2
$5.00 40 83
Quantity of Corn in
Thousands of Bushels
Quantity of Corn in
Millions of Bushels
(a)
(b)
Point m is a LR equilibrium where typical firm earns zero profits and produces where P = AC = MC.

36. Entry of Firms into the Competitive Industry
Entry continues until all profits are competed away. SR Industry S will shift out until P = min AC.
LR equilibrium (point m in Fig. 8) is where typical firm earns zero profits and produces where P = AC = MC.
There are no profits in LR.
SR profits → firms enter and ↓P until all profits end.
SR losses → firms leave and ↑P until all losses end.

37. Zero Economic Profit
Why do firms stay in the industry if profits are zero in LR?
Recall: economist's definition of profit includes opportunity cost of any K or L supplied by firm's owners. 0 economic Π → (+) accounting Π
E.g., if investors can earn 15% on their funds elsewhere → firm must earn 15% to cover opportunity cost of its K. If not, funds will not be given to the firm because investors will go elsewhere.

38. Zero Economic Profit
Zero economic profit indicates firms are earning the normal economy-wide rate of profit (in the accounting sense).
An industry whose K earns a higher rate of return than K invested elsewhere attracts K into the industry. This shifts SR industry S curve out and ↓P until econ Π = 0.
If K invested in an industry earns a lower return than K invested elsewhere, funds dry up in the industry. This shifts SR industry S curve in and ↑P until econ Π = 0.

39. The LR Industry Supply Curve
LR industry S curve reflects:
Entry and exit of firms → shifts SR industry S curve toward its LR position.
Each firm is freed of its sunk cost commitments → each firm is operating on its LR AC curve.
LR industry S curve = Industry’s LR AC curve because LR Π = 0, so industry P = industry LR AC.
If P > LRAC → firms enter, attracted by profits
If P < LRAC → firms exit, due to losses

40. FIGURE 9. SR Industry Supply and LR Industry Average Cost
If LR P = $4 and current P = $7→ firms earn $3 in economic Π on each bushel they sell → entry of new firms → S shifts out to LRAC. S
LRAC B
$7.00
Price, Average Cost per Bushel
4.00 A 70
Output in Millions of Bushels of Corn

41. Perfect Competition and Economic Efficiency
Perfect competition leads to great efficiency in LR as firms must produce where P = min LR AC curve. Thus, output of competitive industries is produced at lowest possible cost to society.
In Table 4, industry produces 12 million bushels by having 120 firms produce 100,000.
Total industry cost = AC x industry output, so total industry cost is lowest by having each firm produce at lowest AC possible.

42. TABLE 4. AC for the Firm and Total Cost for the Industry
Firm's Q
Firm's AC
Number of firms
Industry
Output
Industry Total Cost
60,000
$0.90
200
12,000,000
$10,800,000
100,000
0.70
120
8,400,000
120,000
0.80
100
9,600,000