Weekly Lecture: Week 05
Chaps 11 –Perfect Competition
CHAPTER ROADMAP

What
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nt
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sEdition?
Chapter 11 has slight revisions from the fifth edition.

Where We Are
In this chapter, we examine the profit-maximizing decisions made by a perfectly
competitive firm in the short run and the long run. To do so, we use the groundwork on
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production and costs. The cost material covered in Chapter 10 remains important
also in Chapters 12 and 13.
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and marginal revenue curves for monopolies, oligopolies and monopolistically
competitive firms. We will see operating decisions faced by these firms and we can
compare them with those made by perfectly competitive firms.
CHAPTER LECTURE
 11.1 AFi
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sPr
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-Maximizing Choices
Perfect competition exists when




Many firms sell identical products to many buyers
There are no restrictions on entry into the industry
Established firms have no advantage over existing ones
Sellers and buyers are well informed about prices
Other market types are:
 Monopoly, a market for a good or service that has no close substitutes and in
which there is one supplier that is protected from competition by a barrier
preventing the entry of new firms.
 Monopolistic competition, a market in which a large number of firms
compete by making similar but slightly different products.
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 Oligopoly, a market in which a small number of firms compete.
 Af
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sobj
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t
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omaximize economic profit, which is the difference
between total revenue (
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sold) and its total cost of production. Part of the total cost is the normal profit.
Price Taker
 Perfectly competitive firms are price takers, a firm that cannot influence the
market price and so it sets its own price equal to the market price.
Revenue Concepts
 Because the firm is a price taker, its marginal revenue—which is the change
in total revenue that results in a one-unit increase in the quantity sold—is
equal to the market price and remains constant as output sold increases. The
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sperfectly elastic a
ndt
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sdemand curve is a horizontal
line at the market price.
Profit-Maximizing Output
 The firm produces the quantity of output for which the difference between
total revenue and total cost is at its maximum because this difference is its
economic profit.
 Marginal analysis can be used to determine the profit maximizing quantity.
The firm compares the marginal revenue (which remains constant with output)
to the marginal cost (which changes with output) of producing different levels
of output.
 When MR > MC, then the extra
revenue from selling one more
unit exceeds the extra cost of
producing one more unit, so the
firm increases its output to
increase its profit.
 When MR < MC, then the extra
cost of producing one more unit
exceeds the extra revenue from
selling one more unit, so the firm
decreases its output to increase
its profits.
 When MR = MC, then the extra
cost of producing one more unit equals the extra revenue from selling one
mor
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figure, the firm maximizes its profit by producing q.
2
Marginal Analysis and the Supply Decision
 As output rises, MR is constant, but MC eventually increases. If MR exceeds
MC, increasing output leads to increasing economic profit. But when MC is
greater than MR, a decrease in economic profit will result from selling
additional output.
Temporary Shutdown Decision:
In the event that market prices fall so low that a firm cannot cover its costs, the firm
must consider its options. These depend upon expectations of the duration of low
prices.
 Loss When Shut Down: If the firm stops production temporarily, it earns no
revenue but there are no variable costs. Fixed costs constitute the only losses
so the total economic loss equals the fixed cost.
 Loss When Producing: If the firm carries on producing, it incurs both fixed
and variable costs while gaining some revenue. The economic loss is revenue
minus the sum of total fixed cost plus total variable cost. If total revenue is
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stotal economic loss is less than its
fixed costs, so the firm stays open. But where total revenue is less than total
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closes.
 The Shutdown Point:
 If total revenue is less than variable costs, then P > AVC. In this case, the
firm shuts down temporarily, thus limiting its losses to total fixed costs.
 If total revenue equals variable costs, then P = AVC. In this case, the firm
is indifferent between shutting down temporarily or carrying on, because
in either case the economic loss will equal fixed costs.
TheFi
r
m’
sShor
t
-Run Supply Curve
 The firm will temporarily shut down in the short run when price falls below
the price that just allows it to cover its total variable cost. The minimum AVC
is the lowest price at which the firm will operate because if it operated with a
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owe
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when the firm shuts down is equal to its fixed cost.
 As long as the firm remains open, it produces where MR = MC.Sot
hef
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s
supply curve is its MC curve above the minimum AVC. At prices below the
minimum AVC, the firm shuts down and supplies zero.
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 11.2 Output, Price, and Profit in the Short Run
Market Supply in the Short Run
 The market supply curve in the short run shows the quantity supplied by the
industry at each possible price when the number of firms is fixed. The quantity
supplied in the industry at any price is the summation of all quantities supplied
by each firm at that price.
Short-Run Equilibrium in Normal Times
 In normal times, firms make zero economic profit. The figure to the right
shows such a firm. The price is $3 per unit and the firm produces 3 units.
P = ATC, so the firm has zero
economic profit.
Short-Run Equilibrium in Good Times
 There are three possible profit outcomes—an economic profit, zero economic
profit, and an economic loss.
 If the price exceeds the ATC, the
firm makes an economic profit.
 The figure illustrates a perfectly
competitive firm that is making an
economic profit. The firm produces 4
units, has a price of $3 per unit, and
makes an economic profit equal to
the area of the darkened rectangle.
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Short-Run Equilibrium in Bad Times
 If the price is less than the ATC, the
firm incurs an economic loss.
 The figure illustrates a perfectly
competitive firm that is suffering an
economic loss. The firm produces 3
units, has a price of $3 per unit, and
incurs an economic loss is equal to
the area of the darkened rectangle.
 11.3 Output, Price, and Profit in the Long Run
 If the price equals the ATC, the firm makes zero economic profit. In this case,
t
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.
Entry and Exit
 Changes in market demand influence the output and the entry or exit decisions
made by firms.
 An increase in market demand shifts the demand curve rightward and raises
the market price. Each firm in the industry responds by increasing its quantity
supplied.
 Thehi
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enowe
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c
hf
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mumATC and the firms in the
industry make an economic profit. The economic profit motivates firms to
enter the industry, thereby increasing the market supply. The market supply
curve shifts rightward and the market price falls. Eventually the price falls to
equal the minimum ATC for each firm in the industry. At this price, firms in
the industry no longer make an economic profit.
 The effects of a decrease in market demand are the opposite of those outlined
above: The price falls, firms incur an economic loss, some firms exit thereby
decreasing the supply and so the price rises until the surviving firms make
zero economic profit.
Change in Demand
When demand for a good increases, in the short run the existing firms in an
industry make an economic profit.
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The economic profit for the firms is a incentive for other firms to enter the
industry in order to make an economic profit. As they do, the supply increases
which drives down the price. Entry continues until in the long run the firms
make zero economic profit.
Technological Change
 New, cost-saving technologies typically require new plant and equipment. So
it takes time for new technology to spread throughout an industry.
 Firms that adopt the new technology lower their costs and their supply curves
shift rightward. The price of the good falls, so that firms using the old
technology incur economic losses.
 Old-technology firms either adopt the new technology or else exit the industry.
In the long run, all the firms use the new technology and make zero economic
profit.
Is Perfect Competition Efficient?
 Resource allocation in a market is efficient when society values no other use
of the resources more highly. Resource use is efficient when production is
such that the marginal benefit of the good equals the marginal cost of the
good.
 Af
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ss
uppl
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orag
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hes
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’
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lc
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ve
.
 The demand curve is the marginal benefit curve.
 In a competitive equilibrium, the
quantity demanded equals the
quantity supplied. The demand
curve is the same as the marginal
benefit curve and the supply curve
is the same as the marginal cost
curve, so at the competitive
equilibrium, the marginal benefit
equals the marginal cost. Resource
use is efficient. Because resources
are used efficiently, at the
competitive equilibrium there is no
other allocation of resources that
will generate greater net benefits to society. The figure shows this outcome,
where resource use is efficient at the equilibrium quantity of 3,000 units.
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Is Perfect Competition Fair?
 Perfect competition allows anyone to enter the market and the process of
competition brings the maximum benefits for consumers. So fairness of
opportunity and fairness as equality of outcomes are achieved in perfect
competition in the long run.
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