1. Chapter 22 Perfect Competition Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. 22-1

2. 22-2 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter Objectives The characteristics of perfect competition The perfect competitor’s demand curve The short run and and the long run Economic and accounting profits Decreasing, constant, and increasing cost industries

3. 22-3 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Perfect Competition Is the first of four competitive modes It is a theoretical model that does not exist in the real world This will serve as the standard by which we will measure the next three competitive models –Monopoly –Monopolistic Competition –Oligopoly

4. Definition of Perfect Competition There are so many firms that no one firm is large enough to influence price –Either by withholding output from the market or by increasing its output The firms are selling an identical product –A product is identical, in the minds of the buyers, if they have no reason to prefer one seller over another 22-4 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

5. Definition of Perfect Competition The market has perfect mobility –No barriers to entry such as licenses, long- term contracts, government franchises, patents, control over vital resources, etc. –One possible exception is money Perfect knowledge about the market exist –Everyone knows about every possible economic opportunity 22-5 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

6. 22-6 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Perfect Competitor’s Demand Curve The intersection of the industry supply and demand curve set the price that is taken by the individual firm, in this case $6

7. 22-7 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Perfect Competitor’s Demand Curve The perfect competitor faces a horizontal, or perfectly elastic, demand curve A firm with a perfectly elastic demand curve has an identical MR curve (MR=P)

8. 22-8 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Perfect Competitor’s Demand Curve The perfect competitor has to take the market price (it is a price taker!)

9. 22-9 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Perfect Competitor’s Demand Curve Why is the individual firm’s demand curve flat instead of sloping down to the right? The individual firm’s output is between 0 & 30 units. The industry’s output in the millions. It is impossible for the individual firm to increase output enough to change the price even one cent. Theoretically, the individual firm’s demand curve slopes down and to the right ever so slightly. But we can’t see the slope, so we draw it horizontally and consider it perfectly elastic 30/4,000,000 =.0000075 75 10,000,000

10. 22-10 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Perfect Competitor in the Short Run In the short run the perfect competitor may make a profit or lose money

11. 22-11 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Perfect Competitor in the Short Run Is this firm making a profit or losing money? Answer: Losing money because the D,MR curve is below the ATC curve

12. 22-12 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Perfect Competitor in the Short Run How much money is this firm losing? Price = $6 ATC = $8.50 Output = $8 TP = ( P – ATC) X Output TP = ($6 - $8.50) X 8 TP = -$2.50 X 8 TP = - $20

13. 22-13 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Perfect Competitor in the Short Run Is this firm making a profit or losing money? Answer: Making a profit because the D,MR curve is above the ATC curve

14. 22-14 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Perfect Competitor in the Short Run Output = $11 ATC = $8.10 Price = $10 TP = ( P – ATC) X Output TP = ($10 - $8.10) X 11 TP = $1.90 X 11 TP = $20.90

15. 22-15 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Perfect Competitor in the Long Run In the long run the perfect competitor breaks even Since the ATC curve lives above the demand curve, the firm is losing money at a price of $6. How do we then get to the long run where the firm is breaking even?

16. 22-16 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Going from Taking a Loss in the Short Run to Breaking Even in the Long Run At a price of $6 the firm is losing money and so, too, are all the other firms in the industry

17. 22-17 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Going from Taking a Loss in the Short Run to Breaking Even in the Long Run Some firms leave the industry in the long run pushing the supply down from S 1 to S 2

18. 22-18 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Going from Taking a Loss in the Short Run to Breaking Even in the Long Run This pushes the industry price up to $8. At this price the firm breaks even.

19. 22-19 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Going from Making a Profit in the Short Run to Breaking Even in the Long Run At a price of $10 all firms in the industry are making a profit

20. 22-20 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Going from Making a Profit in the Short Run to Breaking Even in the Long Run New firms are attracted into the industry. This increases supply moving the supply curve from S 1 to S 2

21. 22-21 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Going from Making a Profit in the Short Run to Breaking Even in the Long Run This reduces the industry price to $8, at which the firms break even

22. 22-22 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Perfect Competitor in the Long Run In the long run the firm breaks even The ATC curve is tangent to the demand curve at the point where MC = MR. ATC will equal price at the break-even point (the minimum point on the ATC curve) Price = ATC The most profitable level of output is 11.1

23. 22-23 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Perfect Competitor in the Long Run Price = ATC The most profitable level of output is 11.1 A firm operates at peak efficiency when it produces at the minimum point of its ATC. For the perfect competitor in the long run, the most profitable output is at the minimum point of its ATC because this is also where MC=MR

24. Efficiency A firm operates at peak efficiency when it produces at the lowest possible cost –That would be the minimum point of its ATC curve ( the break-even point) For the perfect competitor in the long run, the most profitable output is at the minimum point of is ATC curve because this will be where MC=MR Because of the degree of competition, the perfect competitor is forced to operate at peak efficiency –Other forms of competition do not force firms to operate at peak efficiency 22-24 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

25. Economic and Accounting Profits 22-25 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Accounting profits are what is left over from sales (revenue) after a firm has paid all of its explicit cost –Explicit cost is the cost of doing business rent, wages, cost of goods sold, fuel, taxes, etc. Sales $200,000 - Explicit cost 115,000 Accounting Profit 85,000

26. Economic and Accounting Profits 22-26 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Accounting profit $ 85,000 - Explicit cost 85,000 Economic Profit 0 Economic profits are what is left over from accounting profits after a firm has subtracted its implicit cost –Implicit cost are a firm’s opportunity cost the opportunity cost of any choice is the forgone value of the next best alternative Suppose you have invested $100,000 of your own money in your business. You could have earned $15,000 interest on this money. Instead of you and your spouse working 12 hours a day, seven days a week, you both could have earned $70,000 working for some one else. ($15,000 + $70,000 = $85,000 implicit cost)

27. Why stay in business if your economic profits are zero? –You are still making accounting profits –You wouldn’t do any better if you invested your money elsewhere and worked for someone else –You are your own boss by having your own business 22-27 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Economic and Accounting Profits

28. 22-28 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Economic and Accounting Profits When economic profits become negative, particularly if those losses are substantial and appear they may be permanent, more and more people will close their business –They will go to work for some one else –They will go into a different business Market supply decreases and forces prices up –This process continues until people stop getting out

29. 22-29 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Economic and Accounting Profits When economic profits become negative, particularly if those losses are substantial and appear they may be permanent, more and more people will close their business –They will go to work for some one else –They will go into a different business Market supply decreases and forces prices up –This process continues until people stop getting out S1S1 S2S2 P2P2 P1P1

30. 22-30 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Economic and Accounting Profits When there are economic profits (short run) more people are attracted into this type of business Market supply increases and forces prices down –This process continues until people stop getting in –Economic profits are zero at this point (long run) –No one else wants to enter or leave

31. 22-31 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Economic and Accounting Profits When there are economic profits (short run) more people are attracted into this type of business Market supply increases and forces prices down –This process continues until people stop getting in –Economic profits are zero at this point (long run) –No one else wants to enter or leave S2S2 S1S1 P2P2 P1P1

32. 22-32 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Decreasing, Constant, and Increasing Cost Industries Decreasing cost industries are characterized by firms operating on the declining segments of their ATC curves They can take advantage of economies of scale (discounts for buying larger quantities, declining AFC as output expands, lower cost from specialization, etc.)

33. 22-33 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Decreasing, Constant, and Increasing Cost Industries Constant cost industries are where ATC does not change as output expands Economies of scale & diseconomies of scale are in balance (improvements in technology can help keep cost declining as output expands; improvements in production processes can increase quality and lower cost at the same time)

34. 22-34 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Decreasing, Constant, and Increasing Cost Industries Increasing cost industries are where diseconomies of scale overwhelm economies of scale. Examples of diseconomies of scale are managerial inefficiencies (the cost of maintaining a huge bureaucracy, increased difficulties of communication, duplication and waste, etc.)

35. 22-35 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Decreasing, Constant, and Increasing Cost Industries Factor cost - wages, rent, and interest - are by far the most important determinants of whether cost are falling, constant, or increasing Usually, factor cost will eventually rise, which ultimately makes every industry an increasing cost industry (but the range of output within which they often operate is one of decreasing or constant cost)