Week 9:

Perfect Competition
ECO 101: INTRODUCTION TO MICROECONOMICS
This Week’s Class
◦Lecture:
◦ How does firm competition affect market outcomes?
◦ Why do Economists like competition?
◦ How does competition affect consumer welfare?
◦ Why does effective competition (sometimes) fail to emerge?
◦Tutorial:
◦ Practice with how the number of firms affect market supply curves.
◦ Practice with competitive entry and exit.
What is Competitive Behaviour?
◦ We say that a firm has market power when it has significant
influence over the price of a product. They can set this price.
◦ A very competitive market will erode an individual firm’s market
power and prevent them from being able to set the price. Why?
◦ Other firms can undercut you if you set the price too high.
◦ This is what we call competitive behaviour. Firms will compete with
each other using prices and services to try and steal customers and
increase profits.
◦ A market is competitive when there is very little market power.
What is Perfect Competition?
◦ Based upon four assumptions:
1. An identical (homogenous) product. Different firms sell perfect
substitutes.
2. Consumers have perfect information (all products and prices).
3. The LRAC minimum is at a small quantity compared to the total
market size.
4. Free entry-and-exit of firms into the market.
◦ This seems extreme, but is an approximation in many contexts,
and well describes some contexts. Can you think of any
examples?
Price-Taking Behaviour
◦These four assumptions provide the basic story that:
◦ Firms are small and many (A3).
◦ Consumers will purchase whichever product is the cheapest (A1 & A2).
◦Therefore, these firms become price-takers.
◦ They cannot sell above the market price without being undercut by
competitors.
◦ Therefore, they must take the market price as given.
◦ These firms are (relatively) small, so they can sell as much quantity as
they might like at this price.
MC MR
SRATC
SRAVC Recall SR Profit Maximizing Choices
◦ Profits are maximized where
Costs

MR = MC.
◦ (in this case, the second point).
◦ This will determine the Q*.
◦ The profits at this point will
therefore be:
𝜋 = 𝑄 ∗ 𝑀𝑅 − 𝐴𝑇𝐶
◦ What do profits look like in this
figure?
Q
 The Short-Run Shutdown Price
◦ Therefore, in the short-run:
Costs

ATC
MC ◦ A firm will shutdown if p < min(AVC)
◦ A firm will produce, but lose money in the
SR if p ∈ (Min(AVC), Min(ATC))
◦ A firm will produce and make accounting
profits if p > Min(ATC)
Min(ATC)
◦ The price where firms will shut down
ps AVC in the Short-Run (p = Min(AVC)) is
called the shutdown price (ps).
◦ Note: In Text, Rule #2 is the MR = MC
Shutdown Price profit-max rule we have been using.
Q
 SI

A Firm’s Short-Run Supply Curve

p
Costs

ATC
MC

AVC

Q Q
SI
SM

Short-Run Market Supply

◦ In order to derive a supply curve
p
for the whole market, we add up
individual firm supply curves.
◦ Critically, for every p, add up all the Qs.
◦ Suppose that we have 2 non-
identical firms. What does market
supply look like?
ps ◦ Now suppose that we have 3 identical.
◦ Therefore, the market supply curve
becomes flatter in the Short-Run.
Q
SI
SM

Short-Run Market Supply Example

QS = 0.5p
N=2?
p
N=4?

N=1,000,000?

Q
SM SI
DM DI

Individual Firm’s Supply & Demand

p Total Market p Individual Firm

Q (Millions) Q (Hundreds)
SM MC
SRATC
DM DI
SRAVC
Short-Run Perfectly Competitive Equilibrium
p Total Market p Individual Firm

Q (Millions) Q (Hundreds)
 What will induce exit?
What happens to N?

Short Run Firm Exit & The Market

What happens to the price?
What happens to 𝜋?

p Total Market p Individual Firm

Q (Millions) Q (Hundreds)
 What will induce entry?
What happens to N?

Short-Run Firm Entry & The Market

What happens to the price?
What happens to 𝜋?

p Total Market p Individual Firm

Q (Millions) Q (Hundreds)
The Perfectly Competitive Equilibrium in
the Long-Run
◦If firms are making positive profits in the short-run, this will
induce entry in the long-run, driving down prices and profits.
◦If firms are making negative profits in the short-run, this will
induce exit in the long-run, driving up prices and profits.
◦These forces will always push long-run prices towards the
minimum of the LRAC curve, where profits = 0.
◦The implies that in the Long-Run, and in a perfectly
competitive market, firms must make zero profits.
◦How realistic is this result?
10-minute Break
 The Perfectly Competitive Equilibrium
with entry and exit
Long-Run Costs Total Market
Costs p

MR Q Q (Millions)
LRAC SRATC S&D
MC
p
The Long-Run Supply Curve
◦ Supply in the Long-Run is therefore
also perfectly elastic (horizontal).
◦ If the price is above p*, firms will
enter to drive it down.
LRAC ◦ If the price is below p*, firms will
exit, bringing prices back up.
◦ What does this imply for the Long-
p* S$%
Run Prices?
◦ What moves (and does not move)
Long-Run Prices?
Q∗# Q
Conditions for Long-Run Equilibrium
◦There are four conditions that are necessary for this outcome
in Long-Run Equilibrium:
1. All firms must be profit-maximizing.
2. Existing firms must not be suffering losses.
3. Existing firms must not be making (positive) profits.
4. Existing firms must not be able to earn more profits by changing
their Q. In other words, they must be producing at the minimum of
their ATC curve.
 Suppose positive profits in SR equilibrium.
Suppose negative profits in SR equilibrium.

The Full PC Equilibrium

Long-Run Costs Total Market
Costs p

MR Q Q (Millions) SSR
LRAC SRATC D SLR
MC
S$%
D
AR
Total Surplus in Perfect Competition
Perfect Competition ◦ In the Long-Run, firms produce at
p the lowest possible price.
◦ What is the Economy’s Total
Surplus?
◦ What is the Producer Surplus?
◦ What is the Consumer Surplus?
◦ This outcome is why Economists
ppc are so keen on promoting
competition.
◦ PC is a benchmark.
Qpc Q
 SRATC
MC S$%
LRAC
Declining Industry Example
◦ Suppose that we start in Long-Run equilibrium and then market demand starts
decreasing. What would we expect to happen to the number of firms in the
market? What happens to p* in the Short-Run? What about the Long-Run?

costs
p*

Q* Q Q
 SRATC
MC S$%
LRAC
Productivity Growth Example
◦ Suppose that we start in Long-Run equilibrium and then productivity growth
leads to a decrease in firms’ marginal costs. What would we expect to happen
to the number of firms in the market? What happens to p* in the Short-Run?
What about the Long-Run?
p

costs
p*

Q* Q Q
Why Do We Like Competition?
◦Why might society find the perfectly competitive outcome
desirable?

◦What about the perfectly competitive model delivers these

outcomes?

◦What role does free competition play?

Does Competition Naturally Come About?
◦Recall Lecture 1 and the invisible hand.
◦A very common statement: Leave firms alone alone and the
free market will sort it out.
◦ The idea being remove government intervention and oversight.
◦Begs the question: is competition self-enforcing?
◦ Does competitive pressure and the threat of entry keep the stock of
companies fresh and unable to make profits.
◦Answer: sometimes.
Antitrust and Competition
◦The thing about making firms compete, is sometimes they win.
◦In some markets, we see large amount of consolidation.
◦Individual firms begin to compete and win, and then grow in
size.
◦When firms become very large and dominant, they begin to
wield significant market power.
◦ This week’s podcast covers the history a famous example: Standard Oil.
◦Antitrust was created to prevent the consolidation of this
market power from harming competition.
Merger Reviews
◦ The Canadian Competition Bureau reviews proposed mergers when two
companies try to merge.
◦ Will evaluate merger and choose whether to clear block it.
◦ Example: The Carmeuse-Lafarge transaction (Guelph)
◦ Southern Ontario – Three lime producers.
◦ Product: dolime (input into steel production).
◦ Proximity to major Southern Ontario steel producers.
◦ Usually a tension between two forces:
◦ Mergers can lead to increased market power (market share).
◦ Mergers may also lead to cost reductions. Why is this important?
◦ Mergers are can sometimes cause harm or be beneficial to consumers.
Anti-competitive Practices
◦The Canadian Competition Bureau is also called in to
investigate claims of anticompetitive behaviours.
◦Foreclosure: Working to deny competitors access to
downstream markets or upstream inputs.
◦Predatory pricing: Pricing to make negative profits, but force
your competition out of the market.
◦Cartels: Firms getting together in secret to agree on prices and
choose not to compete at all (more in Weeks 10 & 11).
Conclusion
◦Perfect Competition delivers large amount of
consumer surplus in the long-run.
◦The required assumptions are strong however.
◦This is the basis for a lot of Economists’ support for
promoting competition.
◦Competitive markets are not necessarily naturally
occurring however, and sometimes must be
enforced.