1. © 2003 McGraw-Hill Ryerson Limited. Perfect Competition Chapter 11

2. © 2003 McGraw-Hill Ryerson Limited. 11 - 2 Perfect Competition u The concept of competition is used in two ways in economics. l Competition as a process is a rivalry among firms. l Competition as a market structure.

3. © 2003 McGraw-Hill Ryerson Limited. 11 - 3 Competition as a Process u Competition involves one firm trying to take away market share from another firm. u As a process, competition pervades the economy.

4. © 2003 McGraw-Hill Ryerson Limited. 11 - 4 A Perfectly Competitive Market u A perfectly competitive market is one which has highly restrictive assumptions, but which provides us with a reference point we can use in comparing different markets.

5. © 2003 McGraw-Hill Ryerson Limited. 11 - 5 A Perfectly Competitive Market u In a perfectly competitive market: l The number of firms is large. l The firms' products are identical. l There is free entry and exit, that is, there are no barriers to entry. l There is complete information. l Firms are profit maximizers. l Both buyers and sellers are price takers.

6. © 2003 McGraw-Hill Ryerson Limited. 11 - 6 The Necessary Conditions for Perfect Competition u The number of firms is large. l Large number of firms means that any one firm's output is very small when compared with the total market. l What one firm does has no bearing on market quantity or market price.

7. © 2003 McGraw-Hill Ryerson Limited. 11 - 7 The Necessary Conditions for Perfect Competition u Firms' products are identical. l This requirement means that each firm's output is indistinguishable from any other firm’s output. l Firms sell homogeneous product.

8. © 2003 McGraw-Hill Ryerson Limited. 11 - 8 The Necessary Conditions for Perfect Competition u There is free entry and free exit. l Firms are free to enter a market in response to market signals such as price and profit. l Barriers to entry are social, political, or economic impediments that prevent other firms from entering the market.

9. © 2003 McGraw-Hill Ryerson Limited. 11 - 9 The Necessary Conditions for Perfect Competition u There is free entry and free exit. l Technology may prevent some firms from entering the market. l There must also be free exit, without incurring a loss.

10. © 2003 McGraw-Hill Ryerson Limited. 11 - 10 The Necessary Conditions for Perfect Competition u There is complete information. l Firms and consumers know all there is to know about the market – prices, products, and available technology. l Any technological advancement would be instantly known to all in the market.

11. © 2003 McGraw-Hill Ryerson Limited. 11 - 11 The Necessary Conditions for Perfect Competition u Firms are profit maximizers. l The goal of all firms in a perfectly competitive market is profit and only profit. l There is no non-price competition (based on quality, brand name, or the like).

12. © 2003 McGraw-Hill Ryerson Limited. 11 - 12 The Necessary Conditions for Perfect Competition u Both buyers and sellers are price takers. l A price taker is a firm or individual who takes the market price as given. l Neither supplier nor buyer possesses market power.

13. © 2003 McGraw-Hill Ryerson Limited. 11 - 13 The Definition of Supply and Perfect Competition u Supply is a schedule of quantities of goods that will be offered to the market at various prices.

14. © 2003 McGraw-Hill Ryerson Limited. 11 - 14 The Definition of Supply and Perfect Competition u This definition of supply requires the supplier to be a price taker.

15. © 2003 McGraw-Hill Ryerson Limited. 11 - 15 The Definition of Supply and Perfect Competition u Because of the definition of supply, if any of the conditions required for perfect competition are not met, the formal definition of supply disappears.

16. © 2003 McGraw-Hill Ryerson Limited. 11 - 16 The Definition of Supply and Perfect Competition u That the number of suppliers be large means that they do not have the ability to collude (act together with other firms to control price or market share).

17. © 2003 McGraw-Hill Ryerson Limited. 11 - 17 The Definition of Supply and Perfect Competition u Other conditions make it impossible for any firm to forget about the hundreds of other firms waiting to replace their supply. u A firm's goal is specified by the condition of profit maximization.

18. © 2003 McGraw-Hill Ryerson Limited. 11 - 18 The Definition of Supply and Perfect Competition u Even if the conditions for a perfectly competitive market are not met, supply forces are still strong and many of the insights of the competitive model can be applied to firm behavior in other market structures.

19. © 2003 McGraw-Hill Ryerson Limited. 11 - 19 Demand Curves for the Firm and the Industry u The demand curve facing the firm is different from the industry demand curve. u A perfectly competitive firm’s demand is horizontal (perfectly elastic), even though the demand curve for the industry is downward sloping.

20. © 2003 McGraw-Hill Ryerson Limited. 11 - 20 Demand Curves for the Firm and the Industry u Each firm in a competitive industry is so small that it does not need to lower its price in order to sell additional output.

21. © 2003 McGraw-Hill Ryerson Limited. 11 - 21 Market supply Market demand 1,0003,000 Price $10 8 6 4 2 0 Quantity MarketFirm Individual firm demand Market Demand Curve Versus Individual Firm Demand Curve, Fig 11-1(a and b), p 236 102030 Price $10 8 6 4 2 0 Quantity ABC

22. © 2003 McGraw-Hill Ryerson Limited. 11 - 22 The Profit-Maximizing Level of Output u The goal of the firm is to maximize profits. u When it decides what quantity to produce it continually asks how changes in quantity would affect its profit.

23. © 2003 McGraw-Hill Ryerson Limited. 11 - 23 Profit-Maximizing Level of Output u Since profit is the difference between total revenue and total cost, what happens to profit in response to a change in output is determined by marginal revenue (MR) and marginal cost (MC). u A firm maximizes profit when MC = MR.

24. © 2003 McGraw-Hill Ryerson Limited. 11 - 24 Profit-Maximizing Level of Output u Marginal revenue (MR) is the change in total revenue associated with a change in quantity. u Marginal cost (MC) is the change in total cost associated with a one unit change in quantity.

25. © 2003 McGraw-Hill Ryerson Limited. 11 - 25 Marginal Revenue u Since a perfect competitor accepts the market price as given, for a perfectly competitive firm marginal revenue is equal to price (MR = P).

26. © 2003 McGraw-Hill Ryerson Limited. 11 - 26 Marginal Cost u Initially, marginal cost falls and then begins to rise.

27. © 2003 McGraw-Hill Ryerson Limited. 11 - 27 How to Maximize Profit u To maximize profits, a firm should produce where marginal cost equals marginal revenue.

28. © 2003 McGraw-Hill Ryerson Limited. 11 - 28 How to Maximize Profit u If marginal revenue does not equal marginal cost, a firm can increase profit by changing output. u The supplier will continue to produce as long as marginal cost is less than marginal revenue.

29. © 2003 McGraw-Hill Ryerson Limited. 11 - 29 How to Maximize Profit u The supplier will cut back on production if marginal cost is greater than marginal revenue. u Thus, the profit-maximizing condition of a competitive firm is MC = MR = P.

30. © 2003 McGraw-Hill Ryerson Limited. 11 - 30 Marginal Cost, Marginal Revenue, and Price Fig. 11-2a, p. 237 Price = MRQuantityTotal CostMarginal Cost 35040 28 35168 20 35288 16 353104 14 354118 12 355130 17 356147 22 357169 30 358199 40 359239 54 3510293

31. © 2003 McGraw-Hill Ryerson Limited. 11 - 31 B C Area 1 P = D = MR Costs 12345678910Quantity 60 50 40 30 20 10 0 A MC Marginal Cost, Marginal Revenue, and Price, Fig. 11-2b, p. 237 Area 2

32. © 2003 McGraw-Hill Ryerson Limited. 11 - 32 The Marginal Cost Curve Is the Supply Curve u The marginal cost curve, above the point where price exceeds average variable cost, is the firm's supply curve

33. © 2003 McGraw-Hill Ryerson Limited. 11 - 33 The Marginal Cost Curve Is the Supply Curve u The MC curve tells the competitive firm how much it should produce at a given price. u The firm can do no better than producing the quantity at which marginal cost equals price which in turn equals marginal revenue.

34. © 2003 McGraw-Hill Ryerson Limited. 11 - 34 The Marginal Cost Curve Is the Firm’s Supply Curve, Fig. 11-3, p. 239 A C Marginal cost $70 60 50 40 30 20 10 0 1Quantity2345678910 B Cost, Price

35. © 2003 McGraw-Hill Ryerson Limited. 11 - 35 Firms Maximize Total Profit u Firms maximize total profit, not profit per unit. u As long as an increase in output yields even a small amount of additional profit, a profit-maximizing firm will increase output.

36. © 2003 McGraw-Hill Ryerson Limited. 11 - 36 Profit Maximization Using Total Revenue and Total Cost u Profit is maximized where the vertical distance between total revenue and total cost is greatest. u At that output, MR (the slope of the total revenue curve) and MC (the slope of the total cost curve) are equal.

37. © 2003 McGraw-Hill Ryerson Limited. 11 - 37 TCTR 0 $385 350 315 280 245 210 175 140 105 70 35 Quantity 123456789 Profit Determination by Total Cost and Revenue Curves, Fig. 11-4b, p 240 Maximum profit =$81 $130 Loss Profit Total cost, revenue

38. © 2003 McGraw-Hill Ryerson Limited. 11 - 38 Total Profit at the Profit- Maximizing Level of Output u While the P = MR = MC condition tells us how much output a competitive firm should produce to maximize profit, it does not tell us the profit the firm makes.

39. © 2003 McGraw-Hill Ryerson Limited. 11 - 39 Determining Profit and Loss From a Table of Costs u Profit can be calculated from a table of costs and revenues. u Profit is determined by total revenue minus total cost.

40. © 2003 McGraw-Hill Ryerson Limited. 11 - 40 Determining Profit and Loss From a Table of Costs u The profit-maximizing output choice is not necessarily a position that minimizes either average variable cost or average total cost. u It is only the choice that maximizes total profit.

41. © 2003 McGraw-Hill Ryerson Limited. 11 - 41 Costs Relevant to a Firm, Table 11-1, p 241

42. © 2003 McGraw-Hill Ryerson Limited. 11 - 42 Costs Relevant to a Firm, Table 11-1, p 241

43. © 2003 McGraw-Hill Ryerson Limited. 11 - 43 Determining Profit and Loss From a Graph u Find output where MC = MR. u The intersection of MC = MR (P) determines the quantity the firm will produce if it wishes to maximize profits.

44. © 2003 McGraw-Hill Ryerson Limited. 11 - 44 Determining Profit and Loss From a Graph u Find profit per unit where MC = MR. u To determine maximum profit, you must first determine what output the firm will choose to produce. u See where MC equals MR, and then draw a line down to the ATC curve. u This is the profit per unit.

45. (a) Positive economic profit(b) Zero economic profit(c) Economic loss Determining Profits Graphically, Fig. 11-5, p 243 Quantity Price 65 60 55 50 45 40 35 30 25 20 15 10 5 0 65 60 55 50 45 40 35 30 25 20 15 10 5 0 123456789 12 1234567891012 D MC AP = MR B ATC AVC E Profit C MC ATC AVC MC ATC AVC Loss 65 60 55 50 45 40 35 30 25 20 15 10 5 0 123456789 12 P = MR Price © The McGraw-Hill Companies, Inc., 2000

46. © 2003 McGraw-Hill Ryerson Limited. 11 - 46 Zero Profit or Loss Where MC=MR u Firms can also earn zero profit or even a loss where MC = MR. u Even though economic profit is zero, all resources, including entrepreneurs, are being paid their opportunity costs.

47. © 2003 McGraw-Hill Ryerson Limited. 11 - 47 Zero Profit or Loss Where MC=MR u In all three cases (profit, loss, zero profit), determining the profit-maximizing output level does not depend on fixed cost or average total cost, but only where marginal cost equals price.

48. © 2003 McGraw-Hill Ryerson Limited. 11 - 48 The Role of Profits as Market Signals, Table 11-2, p 243 Profit Calculation Type of ProfitMarket Signal  > 0 Positive economic profit, or Economic profit Entry. Resources are drawn into the industry.  = 0 Zero economic profit, Zero profit, or Normal profit Static. The industry is in long run equilibrium.  < 0 Economic lossExit. Resources leave the industry.

49. © 2003 McGraw-Hill Ryerson Limited. 11 - 49 The Shutdown Point u The firm will shut down if it cannot cover variable costs. l A firm should continue to produce as long as price is greater than average variable cost. l Once price falls below that point it will be cheaper to shut down temporarily and save the variable costs.

50. © 2003 McGraw-Hill Ryerson Limited. 11 - 50 The Shutdown Point u The shutdown point is the point at which the firm will be better off by shutting down than it will if it stays in business.

51. © 2003 McGraw-Hill Ryerson Limited. 11 - 51 The Shutdown Point u As long as total revenue is more than total variable cost, temporarily producing at a loss is the firm’s best strategy since it is taking less of a loss than it would by shutting down (loss minimization).

52. © 2003 McGraw-Hill Ryerson Limited. 11 - 52 MC P = MR 2468Quantity Price 60 50 40 30 20 10 0 ATC AVC Loss A $17.80 The Shutdown Decision, Fig.11-6a, p 245

53. © 2003 McGraw-Hill Ryerson Limited. 11 - 53 Long-Run Competitive Equilibrium, Fig.11-6b, p 245 MC P = MR 0 60 50 40 30 20 10 Price 2468Quantity SRATC LRATC

54. © 2003 McGraw-Hill Ryerson Limited. 11 - 54 Short-Run Market Supply and Demand u While the firm's demand curve is perfectly elastic, the industry demand is downward sloping. u Industry supply is the sum of all firms’ supply curves.

55. © 2003 McGraw-Hill Ryerson Limited. 11 - 55 Short-Run Market Supply and Demand u In the short run when the number of firms in the market is fixed, the market supply curve is just the horizontal sum of all the firms' marginal cost curves.

56. © 2003 McGraw-Hill Ryerson Limited. 11 - 56 Short-Run Market Supply and Demand u Since all firms have identical marginal cost curves, a quick way of summing the quantities is to multiply the quantities from the marginal cost curve of a representative firm by the number of firms in the market.

57. © 2003 McGraw-Hill Ryerson Limited. 11 - 57 The market supply u In the long run, the number of firms may change in response to market signals, such as price and profit. u As firms enter the market in response to economic profits being made, the market supply shifts to the right. u As economic losses force some firms to exit, the market supply shifts to the left.

58. © 2003 McGraw-Hill Ryerson Limited. 11 - 58 Long-Run Competitive Equilibrium u Profits and losses are inconsistent with long-run equilibrium. u Profits create incentives for new firms to enter, output will increase, and the price will fall until zero economic profits are made. u Only zero economic profit will stop entry.

59. © 2003 McGraw-Hill Ryerson Limited. 11 - 59 Long-Run Competitive Equilibrium u The existence of losses will cause some firms to leave the industry. u In a long run equilibrium firms make no economic profit (the zero profit condition).

60. © 2003 McGraw-Hill Ryerson Limited. 11 - 60 Long-Run Competitive Equilibrium u Zero profit does not mean that the entrepreneur does not get anything for his efforts.

61. © 2003 McGraw-Hill Ryerson Limited. 11 - 61 Long-Run Competitive Equilibrium u In order to stay in business the entrepreneur must receive his opportunity cost or normal profits (the amount the owners of business would have received in the next-best alternative).

62. © 2003 McGraw-Hill Ryerson Limited. 11 - 62 Long-Run Competitive Equilibrium u Normal profits are included as a cost. Economic profits are profits above normal profits.

63. © 2003 McGraw-Hill Ryerson Limited. 11 - 63 Long-Run Competitive Equilibrium u Even if some firm has super efficient workers or machines that produce rent, it will not take long for competitors to match these efficiencies and drive down the price, until all economic profits are eliminated.

64. © 2003 McGraw-Hill Ryerson Limited. 11 - 64 Long-Run Competitive Equilibrium u The zero profit condition is enormously powerful. u As long as there is free entry and exit, price will be pushed down to the average total cost of production.

65. © 2003 McGraw-Hill Ryerson Limited. 11 - 65 Adjustment from the Short Run to the Long Run u Industry supply and demand curves come together to lead to long-run equilibrium.

66. © 2003 McGraw-Hill Ryerson Limited. 11 - 66 An Increase in Demand u An increase in demand leads to higher prices and higher profits. u Existing firms increase output and new firms will enter the market, increasing industry output still more, price will fall until all profit is competed away.

67. © 2003 McGraw-Hill Ryerson Limited. 11 - 67 An Increase in Demand u If the the market is a constant-cost industry, the new equilibrium will be at the original price but with a higher market output. u A market is a constant-cost industry if the long-run industry supply curve is perfectly elastic (horizontal).

68. © 2003 McGraw-Hill Ryerson Limited. 11 - 68 An Increase in Demand u The original firms return to their original output but since there are more firms in the market, the total market output increases.

69. © 2003 McGraw-Hill Ryerson Limited. 11 - 69 An Increase in Demand u In the short run, the price does more of the adjusting. u In the long run, more of the adjustment is done by quantity.

70. © 2003 McGraw-Hill Ryerson Limited. 11 - 70 Profit $9 10 12 0 Firm Price Quantity B A Market Response to an Increase in Demand, Fig. 11-7, p 248 Market Quantity Price 0 B A C MC AC S LR S 0SR D0D0 7 700 $9 840 1,200 D1D1 S 1SR 7

71. © 2003 McGraw-Hill Ryerson Limited. 11 - 71 Long-Run Market Supply u Two other possibilities exist: l Increasing-cost industry – factor prices rise as new firms enter the market and existing firms expand capacity. l Decreasing-cost industry – factor prices fall as industry output expands.

72. © 2003 McGraw-Hill Ryerson Limited. 11 - 72 An Increasing-Cost Industry u If inputs are specialized, factor prices are likely to rise when the increase in the industry-wide demand for inputs to production increases.

73. © 2003 McGraw-Hill Ryerson Limited. 11 - 73 An Increasing-Cost Industry u This rise in factor costs would raise costs for each firm in the industry and increase the price at which firms earn zero profit (break even).

74. © 2003 McGraw-Hill Ryerson Limited. 11 - 74 An Increasing-Cost Industry u Therefore, in increasing-cost industries, the long-run supply curve is upward sloping.

75. © 2003 McGraw-Hill Ryerson Limited. 11 - 75 A Decreasing-Cost Industry u If input prices decline when industry output expands, individual firms' cost curves shift down. u The price at which firms break even now decreases, and the long-run market supply curve is downward sloping.

76. © 2003 McGraw-Hill Ryerson Limited. 11 - 76 An Example: Canadian Retail Industry u During the 1990s the Canadian retail industry illustrated how a competitive market adjusts to changing market conditions.

77. © 2003 McGraw-Hill Ryerson Limited. 11 - 77 An Example: Canadian Retail Industry u Many retailers were lost or absorbed by competitors: Eaton’s, Bretton’s, Pascal’s, Robinson’s, K-Mart and many others. u Initially, these firms saw their losses as the temporary result of reduced demand in a slowing economy.

78. © 2003 McGraw-Hill Ryerson Limited. 11 - 78 An Example: Canadian Retail Industry u As prices fell, P=MR fell below their ATC. u But since price remained above the AVC, many firms closed their less profitable locations and continued to operate.

79. © 2003 McGraw-Hill Ryerson Limited. 11 - 79 An Example: Canadian Retail Industry u When demand did not recover, firms ran out of options. u Many firms realized as they moved into the long run that they have to exit the Canadian retail industry.

80. © 2003 McGraw-Hill Ryerson Limited. 11 - 80 Price Quantity MC ATC AVC P = MR Loss An Example: A Shutdown Decision, Fig. 11-8, p 250

81. © 2003 McGraw-Hill Ryerson Limited. Perfect Competition End of Chapter 11