1. Chapter 23
Perfect Competition

2. Introduction
Most gold mines in California ceased operations by the 1960s.
Since 2007, a number of mining companies have modernized some of these gold mines and begun extracting gold once again.
To understand why these gold mines were closed and reopened again, you must learn about the theory of perfect competition—the topic of this chapter.

3. 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

4. Learning Objectives (cont'd)
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

5. Chapter Outline
Characteristics of a Perfectly Competitive Market Structure
The Demand Curve of the Perfect Competitor
How Much Should the Perfect Competitor Produce?
Using Marginal Analysis to Determine the Profit- Maximizing Rate of Production
Short-Run Profits

6. Chapter Outline (cont'd)
The Short-Run Breakeven Price and the Short-Run Shutdown Price
The Supply Curve for a Perfectly Competitive Industry
Price Determination Under Perfect Competition
The Long-Run Industry Situation: Exit and Entry
Long-Run Equilibrium
Competitive Pricing: Marginal Cost Pricing

7. Did You Know That ...
More than 1,600 U.S. auto dealerships closed during 2009?
Ease of exit from an industry is a fundamental characteristic of the theory of perfect competition —the topic of this chapter.

8. 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

9. Characteristics of a Perfectly Competitive Market Structure (cont'd)
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

10. Characteristics of a Perfectly Competitive Market Structure (cont'd)
Price Taker
A competitive firm that must take the price of its product as given because the firm cannot influence its price

11. Characteristics of a Perfectly Competitive Market Structure (cont'd)
Why a perfect competitor is a price taker
Large number of buyers and sellers
Homogenous products are perfect substitutes
Both buyers and sellers have equal access to information
No barriers to entry or exit (any firm can enter or leave the industry without serious impediments)

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

13. The Demand Curve of the Perfect Competitor (cont'd)
The perfectly competitive firm is a price taker, selling a homogenous commodity with perfect substitutes.
Will sell all units for $5
Will not be able to sell at a higher price
Will face a perfectly elastic demand curve at the going market price

14. Figure 23-1 The Demand Curve for a Producer of Titanium Batteries

15. How Much Should the Perfect Competitor Produce?
Perfect competitor accepts price as given
Firm raises price, it sells nothing
Firm lowers its price, it earns less revenues than it otherwise would
Perfect competitor has to decide how much to produce
Firm uses profit-maximization model

16. How Much Should the Perfect Competitor Produce? (cont'd)
The model assumes that firms attempt to maximize their total profits.
The positive difference between total revenues and total costs
The model also assumes firms seek to minimize losses
When total revenues may be less than total costs

17. How Much Should the Perfect Competitor Produce? (cont'd)
Total Revenues
The price per unit times the total quantity sold
The same as total receipts from the sale of output

18. How Much Should the Perfect Competitor Produce? (cont'd)
Profit p = Total revenue (TR) – Total cost (TC)
TR = P x Q
TC = TFC + TVC
P is determined by the market in perfect competition
Q is determined by the producer to maximize profit

19. How Much Should the Perfect Competitor Produce? (cont'd)
For the perfect competitor, price is also equal to average revenue (AR) because
The demand curve is the average revenue curve
AR = = = P TR Q PQ Q

20. Figure 23-2 Profit Maximization, Panel (a)

21. Figure 23-2 Profit Maximization, Panel (b)
Total
Output/
Sales/ Total Market Total Total
day Costs Price Revenue Profit
0 $10 $5 $0 $10
10 8 5 1 1

22. Figure 23-2 Profit Maximization, 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

23. How Much Should the Perfect Competitor Produce? (cont'd)
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

24. Marginal Revenue change in TR MR = change in Q
Using Marginal Analysis to Determine the Profit-Maximizing Rate of Production
Marginal Revenue
The change in total revenues divided by the change in output
MR =
change in TR
change in Q

25. Marginal Cost change in TC MR = change in Q
Using Marginal Analysis to Determine the Profit-Maximizing Rate of Production (cont’d)
Marginal Cost
The change in total cost divided by the change in output
MR =
change in TC
change in Q

26. Profit maximization occurs at the rate of output at which
Using Marginal Analysis to Determine the Profit-Maximizing Rate of Production (cont'd)
Profit maximization occurs at the rate of output at which
marginal revenue equals marginal cost
MR = MC

27. Short-Run Profits
To find out what our competitive individual secure digital cards producer is making in terms of profits in the short run, we have to determine the excess of price above average total cost

28. Short-Run Profits (cont'd)
From Figure 23-2 previously, if we have production and sales of seven Titanium batteries, TR = $35, TC = $30, and profit = $5 per hour.
Now we take info from column 6 in panel (a) and add it to panel (c) to get Figure 23-3.

29. Figure 23-3 Measuring Total Profits
Profits are maximized where MR = MC
This occurs at Q = 7.5 units

30. Short-Run Profits (cont'd)
Graphical depiction of maximum profits and graphical depiction of minimum losses
The height of the rectangular box in the previous figure represents profits per unit
The length represents the amount of units produced
When we multiply these two quantities, we get total economic profits

31. Short-Run Profits (cont'd)
Short-run average profits are determined by comparing ATC with P = MR = AR at the profit-maximizing Q
In the short run, the perfectly competitive firm can make either economic profits or economic losses

32. Figure 23-4 Minimization of Short-Run Losses
Losses are minimized where MR = MC
This occurs at Q = 5.5 units

33. Short-Run Profits (cont’d)
We see in the previous Figure 23-4 that the marginal revenue (d2) curve is intersected (from below) by the marginal cost curve at an output rate of 5 batteries per hour
The firm is clearly not making profits because average total costs at that output rate are greater than the price of $3 per battery.
The losses are shown in the shaded area.

34. The Short-Run Break-Even Price and 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?

35. The Short-Run Break-Even Price and the Short-Run Shutdown Price (cont'd)
As long as the loss from staying in business is less than the loss from shutting down, the firm will continue to produce.
A firm goes out of business when the owners sell its assets; a firm temporarily shuts down when it stops producing, but is still in business.

36. The Short-Run Break-Even Price and the Short-Run Shutdown Price (cont'd)
As long as the price per unit sold exceeds the average variable cost per unit produced, the earnings of the firm’s owners will be higher if it continues to produce in the short run than if it shuts down.

37. Short-Run Break-Even Price
The Short-Run Break-Even Price and the Short-Run Shutdown Price (cont'd)
Short-Run Break-Even Price
The price at which a firm’s total revenues equal its total costs
At the break-even price, the firm is just making a normal rate of return on its capital investment (it’s covering its explicit and implicit costs).
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.

38. Figure 23-5 Short-Run Break-Even and Shutdown Prices

39. The meaning of zero economic profits Question Answer
The Short-Run Break-Even Price and the Short-Run Shutdown Price (cont'd)
The meaning of zero economic profits
Question
Why produce if you are not making a profit?
Answer
Distinguish between economic profits and accounting profits
Remember when economic profits are zero a firm can still have positive accounting profits

40. Example: Why Firms Stubbornly Produced Aluminum in the Late 2000s
Between the summer of 2008 and the end of the winter of 2009, the market clearing price of aluminum fell by more than 50 percent.
Meanwhile, almost all aluminum firms maintained their production operations until early in the spring of 2009.
They did so because, even though the equilibrium price fell below the short-run break-even price, for several months the price remained above the short-run shutdown price.

41. The Supply Curve for a Perfectly Competitive Industry
Question
What does the short-run supply curve for the individual firm look like?
Answer
The firm’s short-run supply curve in a competitive industry is its marginal cost curve at and above the point of intersection with the average variable cost curve

42. Figure 23-6 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

43. The Supply Curve for a Perfectly Competitive Industry (cont'd)
The Industry Supply Curve
The locus of points showing the minimum prices at which given quantities will be forthcoming
Also called the market supply curve

44. Figure 23-7 Deriving the Industry Supply Curve

45. The Supply Curve for a Perfectly Competitive Industry (cont'd)
Factors that influence the industry supply curve (determinants of supply)
Firm’s productivity
Factor costs (wages, prices of raw materials)
Taxes and subsidies
Number of sellers

46. Price Determination Under Perfect Competition
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 (consumers)

47. Price Determination Under Perfect Competition (cont'd)
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 supply curves of the individual firms

48. Figure 23-8 Industry Demand and Supply Curves and the Individual Firm Demand Curve, Panel (a)
Pe is the price
the firm must take
Pe and Qe determined by the interaction of the industry S and market D

49. Figure 23-8 Industry Demand and Supply Curves and the Individual Firm Demand Curve, Panel (b)
Given Pe, firm produces qe where MC = MR
If AC = AC1, break-even
If AC = AC2, losses
If AC = AC3, economic profit

50. 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

51. The Long-Run Industry Situation: Exit and Entry (cont'd)
Signals
Compact ways of conveying to economic decision makers information needed to make decisions
An effective signal not only conveys information but also provides the incentive to react appropriately

52. The Long-Run Industry Situation: Exit and Entry (cont'd)
Exit and entry of firms
Economic profits
Signal resources to enter the market
Economic losses
Signal resources to exit the market

53. The Long-Run Industry Situation: Exit and Entry (cont'd)
Allocation of capital and market signals
Price system allocates capital according to the relative expected rates of return on alternative investments.
Investors and other suppliers of resources respond to market signals about their highest- valued opportunities.

54. The Long-Run Industry Situation: Exit and Entry (cont'd)
Tendency toward equilibrium (note that firms are adjusting all of the time)
At break-even, resources will not enter or exit the market
In competitive long-run equilibrium, firms will make zero economic profits

55. The Long-Run Industry Situation: Exit and Entry (cont'd)
Long-Run Industry Supply Curve
A market supply curve showing the relationship between prices and quantities after firms have been allowed time to enter or exit from an industry, depending on whether there have been positive or negative economic profits

56. The Long-Run Industry Situation: Exit and Entry (cont'd)
Constant-Cost Industry
An industry whose total output can be increased without an increase in long-run per- unit costs
Its long-run supply curve is horizontal.

57. Figure 23-9 Constant-Cost, Increasing-Cost, and Decreasing-Cost Industries, Panel (a)

58. The Long-Run Industry Situation: Exit and Entry (cont'd)
Increasing-Cost Industry
An industry in which an increase in industry output is accompanied by an increase in long- run per unit costs
Its long-run industry supply curve slopes upward

59. Figure 23-9 Constant-Cost, Increasing-Cost, and Decreasing-Cost Industries, Panel (b)

60. The Long-Run Industry Situation: Exit and Entry (cont'd)
Decreasing-Cost Industry
An industry in which an increase in industry output leads to a reduction in long-run per-unit costs
Its long-run industry supply curve slopes downward.

61. Figure 23-9 Constant-Cost, Increasing-Cost, and Decreasing-Cost Industries, Panel (c)

62. Long-Run Equilibrium
In the long run, the firm can change the scale of its plant, adjusting its plant size in such a way that it has no further incentive to change; it will do so until profits are maximized
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

63. Figure 23-10 Long-Run Firm Competitive Equilibrium

64. Why Not … eliminate economic profits entirely?
If companies were prohibited from earning more than zero economic profits, entrepreneurs would have little incentive to try new ways of doing things in an effort to reduce costs and gain profits.
There would also be no incentive for new firms to enter an industry experiencing growing demand.
Thus, society benefits from the market signals created when firms experience positive short-run economic profits.

65. 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
The opportunity cost is the marginal cost to society.

66. Competitive Pricing: Marginal Cost Pricing (cont'd)
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

67. You Are There: The Coal Mining Industry Confronts a Changing Cost Structure
In past decades, coal mining was a decreasing- cost industry and the market clearing price of coal steadily declined relative to other goods and services.
Today, coal mining has become an increasing-cost industry as miners have to dig deeper and move more earth to extract coals from aging mines.
So, in the long run, the equilibrium price will rise as the demand for coal increases.

68. Issues & Applications: A Higher Price Sets Off a New California Gold Rush
Since 2000, both the current dollar and the inflation-adjusted price of gold have more than tripled.
As the theory of perfect competition predicts, the increase in the price of gold has touched off renewed interest by mining firms in trying to extract gold from California mines abandoned decades ago.

69. Issues & Applications: A Higher Price Sets Off a New California Gold Rush (cont’d)
The gold mining industry satisfies the key characteristics of perfect competition:
Units of each type of gold are homogeneous, even though it has different qualities
Many mining firms have the technology to extract gold from earth
The potential output of each mining firm is small relative to total gold production
It is easy to enter or leave the industry

70. Figure 23-11 Index Measures of the Current-Dollar and Inflation-Adjusted Prices of Gold

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

72. Summary Discussion of Learning Objectives (cont'd)
How a perfectly competitive firm decides how much to produce
Economic profits are maximized when marginal cost equals marginal revenue as long as the market price is not below the short-run shutdown price, where the marginal cost curve crosses the average variable cost curve

73. Summary Discussion of Learning Objectives (cont'd)
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

74. Summary Discussion of Learning Objectives (cont'd)
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

75. Summary Discussion of Learning Objectives (cont'd)
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
Upward-sloping long-run supply curve
Decreasing-cost industry
Downward-sloping long-run supply curve