Microeconomics Set 6 - Perfectly Competitive Markets

Competitive Firm Competitive Industries General Rules Efficiency and Equity Summary
Economics 1
Set 6: Perfectly Competitive Markets
Nordhaus and Samuelson, Economics 19e, Chapter 8
Dr. Christoph Bierbrauer

Professorship for Economics
Cologne Business School
Summer Term 2016
Dr. Christoph Bierbrauer Professorship for Economics Cologne Business School

Economics 1
Review of Central Concepts
Characterize the following concepts

Production function
Total product
Marginal product
Average product
Law of diminishing returns
Returns to scale
Increasung returns to scale
Constant returns to scale
Decreasing returns to scale

Economics 1
In general, we distinguish between the short-run and the

long-run. What are the implication of these concepts of
production
Characterize the concept of technological change
Explain the concept of productivity
Summarize the role of business firms in the organization and
execution of production

Economics 1
Characterize the following concepts

Total Costs
Marginal Costs
Unit Costs
Productivity
Opportunity Costs

Economics 1
Supply Behavior
Perfectly Competitive Markets
A perfectly competitive market is an idealized example that helps

us to understand the interplay between supply and demand
Key assumptions: All agents on the demand or supply side of a

market are too small to influence prices, a competitive firm
maximizes profits
is a price-taker
A perfectly competitive market is efficient. However, in the real

world, there are other forms of market behavior, e.g. imperfect
competition and monopolies

Economics 1
Supply Behavior
Example: Cost Structure of a firm

Economics 1
Supply Behavior
Perfectly Competitive Firm
Assumptions: A competitive firm

maximizes profits in order to maximize the economic
benefits of its owners
is a price-taker as it is small and one of many firms on the
supply-side
Profit maximization requires that the firm has sound knowledge

of its cost structure as well as of the demand it is facing, profit
maximization involves costs and revenues

Economics 1
Supply Behavior
Demand Faced by a perfectly Competitive Firm
A perfectly competitive firm sells a homogenous product and takes

prices as given, it faces a horizontal demand curve
Economics 1
Supply Behavior
Perfect Competition: Summary
Perfect competition implies that

i. that there are many small firms, each selling a homogeneous
product and acting as price taker
ii. each individual firm faces a horizontal demand curve
iii. the revenue any firm gains from any extra unit sold
corresponds to the market price

Economics 1
Profit Maximization in Competitive Markets
Profit Maximization
The decision of whether or not to start or increase production
implies strategic thinking about marginal increases
Maximum profit is realized, if

marginal costs = price (1)
Economics 1
Profit Maximization in Competitive Markets
Marginal Costs and Pricing
An individual firm’s profit is maximized when there is no longer

any extra profit by selling one additional unit
An individual competitive firm maximizes its profits, if

marginal costs = price (2)
Thus, the firm’s marginal cost curve corresponds to its supply curve

Economics 1
Shutdown Condition in the Short-run
Shutdown Condition
To maximize profits/minimize losses in the short-run, a firm will
shutdown its production, if
price < variable costs (3)

Economics 1
Shutdown Condition in the Short-run
Shutdown Rule
Maintaining production is beneficial if P ≥ MC , which implies that

the revenue from selling goods covers variable costs
At the shutdown point, losses exactly equal fixed costs
Shutdown rule: If a firm’s revenues just cover its variable costs,

losses equal fixed costs. Thus, if the market price is below average
costs, the firm will maximize profits (minimize losses) by
shutting down

Economics 1
Aggregate Supply of a Competitive Industry
Once again, aggregate supply in a competitive market is obtained

by adding up the supply schedules of all producers in that market

Economics 1
Equilibrium
Short-run vs. Long-run
In response to price changes, we observe smaller changes in supply

in the short run, compared to the long run:
i. Short-run equilibrium; Output changes must be
implemented utilizing a fixed amount of capital input
ii. Long-run equilibrium; All factors in production are variable
and there is free entry or exit of producers into or from the
market

Economics 1
Equilibrium
Example: Market for Sea Fish
Short-run supply curve: Producers adjust variable factors in production,

supply is increasing along the existing supply curve
Long-run supply curve: Shifts in the supply schedule, all factors in
production can be adjusted, constant costs imply a horizontal long-run
supply curve
Economics 1
Equilibrium
Long-run Supply of a Competitive Industry

The long-run supply schedule depends on the long-run availability of
inputs
If at least one factor in production is in relatively short supply as

compared to the other factors in production (increasing costs), the
long-run supply schedule will be upward-sloping
Economics 1
Long-run Shutdown Condition
In the short-run, firms shut down if they can’t cover their variable
costs. All costs are variable in the long-run
In the long-run firms shut down if

p < mc (4)
i.e. below the zero-profit condition
In the long-run, the price must be equal or above total average cost

Economics 1
Zero-economic-profit Condition
Zero-profit long-run equilibrium: In a competitive industry

populated by identical firms with free entry and exit, the long-run
equilibrium condition is that price equals marginal cost equals the
minimum long-run average cost for each individual firm
P = MC = minimum long-run AC = zero-profit price (5)
which is the long-run zero-economic-profit condition
The long-run equilibrium in a perfectly competitive industry is

therefore one with no economic profits

Economics 1
Qualitative Effects of Shifts in Supply/Demand
General Rules
We are interested in the general qualitative effects of shifts in

demand and supply schedules
Demand rule: In general, an increase in demand (the supply curve

being unchanged) will lead to an increase in the price of a good.
Moreover, an increase in demand will increase the quantity
demanded while a decrease in demand will have the opposite effect
Supply rule: An increase in supply (the demand schedule being

constant) will lower the price and increase the quantity bought and
sold. A decrease in supply has the opposite effect
Economics 1
Example: Constant Cost, a Shift in the Demand Curve
Constant costs: Any input comes at constant costs
A horizontal supply curve: A response in Q at constant P

Economics 1
Example: Increasing Costs, a Shift in the Demand Curve
Increasing costs: At least one input is in limited supply, which

implies diminishing returns
An upward-sloping supply curve: A response in Q and P

Economics 1
Concept of Efficiency
An economy is efficient when it provides consumers with the

most desired goods and services, given the resources and
technology of the economy
Pareto efficiency; Efficiency occurs, when no possible

reorganization of production or distribution can make anyone
better off without making someone else worse off
producing on the production possibility frontier
right mix of goods is produced
goods are allocated among consumers in a way that
maximizes consumer satisfaction
Economics 1
Efficiency of the Competitive Equilibrium
A key result in economics is that in perfectly competitive markets

the allocation of resources is efficient (invisible hand doctrine)
A simple example, we assume:

An economy made up of identical yeoman farmers
A given endowment of land, i.e. diminishing returns in the
production of food
Decreasing marginal utility from the consumption of food

Economics 1
Basic Concept: Consumer surplus
Consumer surplus measures the amount a consumer gains from a

purchase by computing the difference between the market price and the
price he would have been willing to pay
Economics 1
Basic Concept: Producer surplus
Producer surplus measures the amount a producer gains from selling his
products by computing the difference between the market price and the
price at which he would have been willing to sell

Economics 1
Efficiency of the Competitive Equilibrium
Aggregating MC = SS and MU = DD yields:
MC = P = MU (6)
Economics 1
Economic Surplus
Economic surplus is the welfare or net utility gain from

production and consumption, it is defined as the sum of both the
consumer and producer surplus
The competitive equilibrium (under the assumption of perfect

competition) maximizes the economic surplus in a particular
market or industry
The result carries over to a market of heterogeneous consumers,

many factors and a wide variety of goods. If we guarantee
perfect competition, the invisible hand doctrine holds

Economics 1
Marginal Costs as the Benchmark for Efficiency
Suppose there are several approaches to achieve an objective (e.g.

produce cars, feed the hungry) that involves scarce resources, all
approaches will be costly. Only if the mc of all inputs are equalized
you can squeeze the maximum out of scarce resources
The marginal cost-concept is fundamental for efficiency and

applicable to all problems involving the aim of obtaining the
maximum result from scarce resources. Efficiency requires equal mc
should be equal in every activity in amarket. Production takes place
at minimum total costs when each producers individual mc = p

Economics 1
Market Failures
Market failures are an important source of inefficiencies:

externalities
(public health, environmental pollution)
imperfect competition (P > MC )
imperfect information
(financial products, counterfeit products, costly information)
Even in an efficient market/distribution of income may not be

socially desirable. However, inequality is a normative question

Economics 1
Perfect Competition: Individual Firm
Perfect competition implies the following:

i. There are many small firms, each selling a homogeneous
product and acting as price takers
ii. Each individual firm faces a horizontal demand curve
iii. The revenue any firm gains from any extra unit sold
corresponds to the market price
Short-run shutdown point: P < VC
In the long-run, a firm will only produce if P ≥ AC

Economics 1
Perfectly Competitive Industries
Supply in perfectly competitive industries:

MC −curve is the supply curve of each individual firm
Aggregate supply represents the MC −curve of the industry as
a whole
In the long-run, firms may enter/exit the market
Competition eliminates any excess profits, P cannot fall below
the zero-profit point or exceed the long-run average costs
If production can be increased without affecting any factor
price, the long-run supply curve will be horizontal

Economics 1
Efficiency and Equity of Competitive Markets
Perfectly competitive markets are Pareto efficient

Efficiency does not necessarily imply that the market outcome
is socially desirable
Please review: Special cases of competitive markets in Chapter 8

Economics 1

Microeconomics Set 6 - Perfectly Competitive Markets

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Competitive Firm Competitive Industries General Rules Efficiency and Equity Summary

Dr. Christoph Bierbrauer

Cologne Business School

Summer Term 2016

Dr. Christoph Bierbrauer Professorship for Economics Cologne Business School

Review of Central Concepts

Characterize the following concepts

Dr. Christoph Bierbrauer Professorship for Economics Cologne Business School

Review of Central Concepts

In general, we distinguish between the short-run and the

Dr. Christoph Bierbrauer Professorship for Economics Cologne Business School

Review of Central Concepts

Characterize the following concepts

Dr. Christoph Bierbrauer Professorship for Economics Cologne Business School

Perfectly Competitive Markets

A perfectly competitive market is an idealized example that helps

Key assumptions: All agents on the demand or supply side of a

A perfectly competitive market is efficient. However, in the real

Dr. Christoph Bierbrauer Professorship for Economics Cologne Business School

Example: Cost Structure of a firm

Dr. Christoph Bierbrauer Professorship for Economics Cologne Business School

Perfectly Competitive Firm

Assumptions: A competitive firm

Profit maximization requires that the firm has sound knowledge

Dr. Christoph Bierbrauer Professorship for Economics Cologne Business School

Demand Faced by a perfectly Competitive Firm

A perfectly competitive firm sells a homogenous product and takes

Perfect Competition: Summary

Perfect competition implies that

Dr. Christoph Bierbrauer Professorship for Economics Cologne Business School

Profit Maximization in Competitive Markets

Maximum profit is realized, if

Profit Maximization in Competitive Markets

Marginal Costs and Pricing

An individual firm’s profit is maximized when there is no longer

An individual competitive firm maximizes its profits, if

Dr. Christoph Bierbrauer Professorship for Economics Cologne Business School

Shutdown Condition in the Short-run

Dr. Christoph Bierbrauer Professorship for Economics Cologne Business School

Shutdown Condition in the Short-run

Maintaining production is beneficial if P ≥ MC , which implies that

At the shutdown point, losses exactly equal fixed costs

Shutdown rule: If a firm’s revenues just cover its variable costs,

Dr. Christoph Bierbrauer Professorship for Economics Cologne Business School

Aggregate Supply of a Competitive Industry

Once again, aggregate supply in a competitive market is obtained

Dr. Christoph Bierbrauer Professorship for Economics Cologne Business School

Short-run vs. Long-run

In response to price changes, we observe smaller changes in supply

Dr. Christoph Bierbrauer Professorship for Economics Cologne Business School

Example: Market for Sea Fish

Short-run supply curve: Producers adjust variable factors in production,

Long-run Supply of a Competitive Industry

If at least one factor in production is in relatively short supply as

Long-run Shutdown Condition

Long-run Shutdown Condition

In the long-run firms shut down if

i.e. below the zero-profit condition

Dr. Christoph Bierbrauer Professorship for Economics Cologne Business School

Long-run Shutdown Condition

Zero-profit long-run equilibrium: In a competitive industry

which is the long-run zero-economic-profit condition