1. Chapter 9 Perfect Competition McGraw-Hill/IrwinCopyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

2. 2 Learning Objectives What is perfect competition? How is the demand curve for a competitive firm? How does a competitive firm decide quantity of output to produce? How does a competitive firm make profit or loss? When does a competitive firm shut down? What is the difference between accounting and economic profit? How does a competitive firm behave in the long run? What are the social benefits of perfect competition? 9-2

3. 3 Assumptions of Perfect Competition There are many buyers and sellers. Limiting competition is unlikely in a crowded market. Firms can enter and exit the market freely in the long run. Free entry inhibits collusion among the firms. Everyone has perfect information about the product sold. Buyers and sellers lacking information may compete less vigorously. 9-3

4. 4 Assumptions of Perfect Competition All firms make exactly the same product. The better substitutes two products are, the more they compete. All firms face exactly the same costs. Average total costs do not continually decrease. If average total costs are continually decreasing, then one single firm can dominate the market. 9-4

5. 5 Assumptions of Perfect Competition All buyers and sellers are price takers: No buyer or seller can affect the price of the good. A price taker firm receives the same price for its good regardless of how much it produces. The demand curve facing a firm is perfectly horizontal. 9-5

6. 6 Perfect Competition as an Approximation Assumptions of perfect competition are never perfectly satisfied in the real world. The assumptions allow one to better understand the complex real world. These assumptions are a reasonable approximation of many real-life economic situations. 9-6

7. 7 Firm’s Behavior in Perfect Competitive Price > marginal cost: Profits will increase by producing more. Price < marginal cost: Profits will increase by producing less. Profits are maximum when Price = marginal cost. 901 $10 Marginal Cost Market Price Bushels Per Year $ The firm chooses output of 901 because at this output the marginal cost curve crosses the market price line. $8 $11 9-7

8. 8 Short Run Profit Profit = [Average profit per good sold] X [Output]. = [Price – Average Total Cost] X [Output]. Bushels Per Year Profit $10 $8 Average Total Cost Market Price Total profit = ($10-$8)(2,000)=$4,000 per year $ 2,000 Marginal Cost 9-8

9. 9 Break Even The firm breaks even when: Price = average total cost. Profit = 0. Bushels Per Year $10 Average Total Cost Market Price $ 600 Marginal Cost 9-9

10. 10 Short Run Loss If price < average total cost at profit maximizing quantity: The firm makes loss. In the short run, a firm can make less loss by producing goods rather than by shutting down. Bushels Per Year $10 Average Total Cost Market Price $ 500 Marginal Cost Loss $12 Total profit = ($10-$12)(500)= -$1,000 per year 9-10

11. 11 Shut Down In the short run, a firm must pay its fixed costs regardless of whether or not it operates. In the short run, fixed costs are sunk costs. Sunk costs are costs a firm can not get back even if it shuts down. Firms should ignore sunk cost when deciding whether to shut down. 9-11

12. 12 Cost Curves and Shut Down The advantage of shut down is that the firm no longer has to pay any variable costs. The disadvantage of shut down is that the firm no longer receives any revenue. A firm should shut down only if for all levels of output: Variable Costs > Total Revenue. Average Variable Costs > Price. 9-12

13. 13 Shut Down vs. Exit Shutting Down: Occurs only in the short run. Firms produce zero output. Firms receive no revenue. Firms pay no variable costs. Firms must still pay their fixed costs. Exiting the Industry: Occurs only in the long run. Firms produce zero output. Firms receive no revenue. Firms pay no costs. 9-13

14. 14 Economic vs. Accounting Profit Unlike accountants, economists consider opportunity cost when determining profits. Accounting profit = total revenue – expenses. Economic profit = total revenue – expenses – opportunity costs. Total revenue = $200,000 Expenses = $120,000 Lost wages of job given up = $75,000 Accounting profit = $200,000 - $120,000 = $80,000 Economic profit = $200,000 - $120,000 - $75,000 = $5,000 9-14

15. 15 Long Run Behavior In the long run, new firms enter an industry if profits are positive. It increases supply, thereby lowering price and decreasing profits. In the long run, firms exit if profits are negative. It decreases supply, thereby increasing price and increasing profits. In the long run, at zero profits, price is at an equilibrium because firms neither enter nor exit. 9-15

16. 16 Long Run Competitive Equilibrium Long run equilibrium. Increase in market demand increasing price and profit. New firms enter the market increasing supply and decreasing price. Once again long run equilibrium. Average Total Cost Marginal Cost Market Price Bushels Per Year 600 $10 $ Market Demand Market Supply 600 $10 Bushels Per Year $ Profit 640 660 $11 9-16

17. 17 Social Benefits of Perfect Competition In the long run, firms are at the low point on their average total costs curve. Under perfect competition in the long run society gets goods at the lowest possible cost. Firms produce goods where price equals marginal cost. Society's welfare is at maximum when the social costs and benefits of producing goods are equal. Marginal cost is the cost of making another good, and price measures the value of a good to the people and hence benefits from it. 9-17

18. 18 Invisible Hand and Perfect Competition Setting marginal cost equal to price causes selfish people to act as if they were altruistic. Perfect competition automatically sets price equal to marginal cost. Adam Smith’s invisible hand works to ensure that selfish people buy goods if and only if the purchase would increase the wealth of society. 9-18

19. 19 Innovations and Perfect Competition Firms in intensely competitive markets have little incentives to innovate. Firms know that any successful innovation will be quickly copied reducing the benefits of innovation. Perfect competition is the ideal to promote the spread of already discovered innovations. 9-19

20. 20 Internet and Perfect Competition The Internet has reduced the physical distance between the stores forcing them to increase competition. The Internet has vastly increased the availability of information. The Internet has brought the world’s economy closer to perfect competition. 9-20

21. 21 Do You Know? How do firms in perfect competition set output? To maximize profits firms produce output where price equals marginal cost. When will a firm in perfect competition shut down? A firm in perfect competition will shut down if variable costs > total revenue or if average variable costs > price. 9-21

22. 22 Do You Know? Why do firms in perfect competition in the long run make zero profits? Firms in perfect competition can enter and exit the market freely in the long run. Positive profits cause new firms to enter and negative profits cause some existing firms to exit. The market finds itself in equilibrium only when firms are making zero profits. What is the social benefit of firms in the long run being on the low point of their average total costs curve? The benefit is so the society gets goods at the lowest possible costs freeing up resources to produce other goods. 9-22

23. 23 Summary Assumptions of perfect competition: There are many buyers and sellers. Firms can enter and exit the market freely in the long run. Everyone has perfect information about the product sold. All firms make exactly the same product. All firms face exactly the same costs. Average total costs do not continually decrease. All buyers and sellers are price takers. The demand curve facing a firm is perfectly horizontal. 9-23

24. 24 Summary A competitive firm maximizes profits by producing output where Price = Marginal Cost. Profit = [Price – Average Total Cost] X [Output]. A competitive firm breaks even when Price = Average Total Cost. A firm should shut down when Variable Costs > Total Revenue or Average Variable Costs > Price. Unlike accountants, economists consider opportunity cost when determining profits. In the long run perfectly competitive firms make zero economic profit. Perfectly competitive market generates social benefits. 9-24

25. 25 Coming Up What are the challenges to market effectiveness? 9-25