Chapter 7

Perfect competition
Chapter summary
There are three characteristics of perfect competition:
• large number of sellers
• firms sell a homogenous product
• there are virtually no barriers to entry or exit.
In addition, firms are price takers.
Like all firms, the competitive firm is assumed to attempt to maximise profits. This can
be achieved either through the total revenue–total cost method, or the marginal revenue equals
marginal cost method. When output is produced at which marginal revenue equals marginal
cost, the firm will be maximising its profit, if a profit is being made. If losses are incurred, then
it will be minimising its losses. The shut-down rule is where price (marginal revenue) is less
than average variable cost.
A competitive firm’s short-run supply curve is its MC curve above minimum AVC. The
industry’s short-run supply curve is the horizontal summation of all firms’ short-run MC curves
above the minimum AVC.
In the short run, a competitive firm may earn either make economic profits, zero
economic profits (only a normal profit), or incur losses. However, in the long run (over time),
only normal profits can be made because of the lack of barriers to entry and exit. Long-run
competitive equilibrium occurs when the firm earns a normal profit by producing where price
equals minimum long-run average cost equals minimum short-run average cost equals short-run
marginal cost.
The three possible perfectly competitive industry long-run supply curves depend on
whether a constant-cost, decreasing-cost, or increasing-cost industry is experienced.

New concepts introduced

• perfectly competitive firm’s short-run supply curve
• market structure
• perfectly competitive industry’s short-run supply curve
• perfect competition
• perfectly competitive industry’s long-run supply curve
• marginal revenue
• constant-cost industry
• price taker
• decreasing-cost industry
• increasing-cost industry
• competition policy

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 Chapter 7: Perfect competition 51

Instructional objectives
After completing this chapter, students should be able to:
• describe the characteristics of perfect competition
• graphically express the competitive firm’s demand curve and understand that this curve
reflects the fact that the competitive firm is a price taker
• graphically find the profit maximising quantity to produce and explain why this output is the
profit maximising quantity
• graphically determine the area representing any economic profits or losses
• find on a graph the competitive firm’s short-run supply curve and explain why this is the
case
• derive the industry’s short-run supply curve
• explain what is expected to happen over time, given short-run economic profits or losses
and express this graphically
• graphically illustrate long-run equilibrium for a competitive industry and explain why this is
the case
• explain what can cause the three possible perfectly competitive industry’s long-run supply
curves to be observed.

Chapter 7 outline
Introduction
Market structures
Perfect competition
Large number of small firms
Exhibit 7.1 Comparison of market structures
Homogeneous product
Very easy entry and exit
The perfectly competitive firm as a price taker
Exhibit 7.2 The market price and demand for the perfectly competitive firm
Short-run profit maximisation for a perfectly competitive firm
The total revenue–total cost method
Exhibit 7.3 Short-run profit maximisation schedule for Atmach as a perfectly
competitive firm
The marginal revenue equals marginal cost method
Exhibit 7.4 Short-run profit maximisation using the total revenue-total cost
method
Exhibit 7.5 Short-run profit maximisation using the marginal revenue equals
marginal cost method
Short-run loss minimisation for a perfectly competitive firm
A perfectly competitive firm facing a short-run loss
Exhibit 7.6 Short-run loss minimisation
A perfectly competitive firm shutting down
Exhibit 7.7 The short-run shutdown point
Short-run supply curves under perfect competition
You make the call: Should motels offer rooms at the beach for only $40 a night?
The perfectly competitive firm’s short-run supply curve

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52 Economics for Today Instructor’s Manual

Exhibit 7.8 The firm’s short-run supply curve

The perfectly competitive industry’s short-run market supply curve
Exhibit 7.9 Deriving the industry short-run market supply curve
Short-run equilibrium for a perfectly competitive firm
Exhibit 7.10 Short-run perfectly competitive equilibrium
Long-run supply curves under perfect competition
You make the call: Are you in business for the long-run?
Long-run equilibrium for a perfectly competitive firm
Exhibit 7.11 Long-run perfectly competitive equilibrium
Analyse the issue: Efficiency gains from holding prices at competitive levels
Three types of long-run supply curves
Constant-cost industry
Exhibit 7.12 Long-run supply in a constant-cost industry
Decreasing-cost industry
Exhibit 7.13 Long-run supply in a decreasing-cost industry
Increasing-cost industry
International focus: Internet increases competition in global marketplace
Exhibit 7.14 Long-run supply in an increasing-cost industry
Key concepts
Summary
Study questions and problems
Online exercises
Answers to ‘You make the call’
Multiple-choice solutions

Hints for effective teaching

1 Point out that although there are only four market models that are discussed, in reality there
are as many differing forms of competition, as there are real-world markets. The four-
market-model approach is a theoretical illustration that tries to make things more
manageable. However, almost all the real-world markets one may be interested in vary in
some way. Use examples to identify which firms fall under or closely resemble each of
these four market models.
2 Point out that it is the strength of the barriers to entry that really determines the degree of
competition in markets. That is, the strength of the barriers to entry is a distinguishing
characteristic of the four market structures.
3 From the characteristics of the perfectly competitive market, other characteristics such as,
no non-price competition and that firms are price takers, should be examined.
4 It may be helpful to analyse each of the four market environments using the following steps:
a What does demand look like facing the representative firm?
b What is the profit-maximising quantity of output to produce?
c Graphically determine the short-run profit or loss.
d Given profits or losses, what is expected to happen in this market or industry over
time? (compare the short run with the long run).
e What are the pros and cons associated with this type of market structure from
society’s perspective?

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 Chapter 7: Perfect competition 53

Doing all of this for each market structure will allow students to compare and contrast the
four market structures.
5 Emphasise to students that the profit-maximising criteria is where MR=MC.
6 Other ways to explain the shut-down rule (in addition to that stated in the text: if P (MR) <
AVC):
a if losses are greater than total fixed cost
b if total revenue is less than total variable cost.
It is intuitive, if one keeps in mind that when a firm shuts down its losses will equal TFC. If
one remains in operation and loses more than their TFC, then one should naturally shut
down and lose less.
7 Have students note that because there are no barriers to entry or exit, then any profits or
losses experienced in the short run will disappear in the long run (over time). Entrepreneurs
will continue to enter or leave an industry until only normal profits can only be made.
8 You may find it helpful to take a few minutes to stress the pros and cons associated with the
competitive market from society’s perspective:
a P = minimum ATC implies no contribution toward a more inequitable distribution of
income as well as consumers getting the product at the cheapest possible price
b P = MC implies an efficient allocation of resources, etc
c Homogenous product indicates lack of variety.

Solutions to text problems

Analyse the issue
Efficiency gains from holding prices at competitive levels (p 193)
1 No. An efficient long-run outcome requires that P=MC. If the firms earn economic profits in
the long run, there must be barriers to entry resulting in a situation where P>MC.
2 If the price of a good was below its marginal cost, society will not benefit, as there will be
allocative inefficiency. There may be some consumers who value the good/service at less
than the MC of producing it, but at more than the price at which it is being sold.
3 The difference is that market power (i.e. monopoly power) applies in the Telstra case,
whereas the markets discussed in Chapter 4 were assumed to be competitive.

Internet increases competition in global marketplace (p 198)

1 On-line commerce has the potential to force industries to conform more closely with the
perfectly competitive market structure by increasing competition among suppliers and by
decreasing the opportunity and transaction costs faced by buyers in gathering and processing
information.
Electronic commerce can also lead to increased competition due to ‘lower barriers to entry
and increased numbers of suppliers competing in product markets’.
2 The author welcomes this possibility, as this will lead to significant gains to consumers in
terms of price, quality and service. That is, greater economic efficiency will prevail.

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54 Economics for Today Instructor’s Manual

Study questions and problems solutions

(pp 203–4)
1 By definition, a perfectly competitive firm will not advertise as the products sold by such
firms are homogenous in nature. Advertising will only lead to higher costs incurred.
2 A New Zealand sheep farmer conforms closely to the perfectly competitive market
structure. This is because there are a large number of sheep farms, lamb is a fairly
homogeneous product, and entry or exit is not extremely difficult.
3 The ACCC or NZCC could impose price controls to ensure that firms behave as if they were
competitive and so that consumers’ welfare is met.
4 The tomato grower is a price taker, as there are many other tomato suppliers. As such, the
tomato grower cannot influence the price (See Exhibit 7.2).

INDUSTRY FIRM
Price ($)

Supply

2 D = MR
Dd=MR

Demand

Qty of Tomatoes Qty of Tomatoes

5 Figure 8A-2 presents the information graphically. Marginal revenue is the change in total
revenue as a result of a change in quantity (kilos). In this case, $5 is the marginal revenue
that remains constant and equal to price. Note the point at which D = MR = TR.

Figure 8A-2

Qty of tomatoes (kilos)

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 Chapter 7: Perfect competition 55

Output TFC TVC TC TR Profit

($) ($) ($) ($) ($)
1 100 120 220 150 -70
2 100 200 300 300 0
3 100 290 390 450 60
4 100 430 530 600 70
5 100 590 690 750 60
When market price is $150 the firm will produce four units as it will make a profit of $70.
The firm will breakeven at output level two.
7 A profitable firm should increase output only when its marginal revenue exceeds its
marginal cost (MR>MC). If the firm increases output when its marginal cost exceeds its
marginal revenue, profits decline because more is added to total cost than to total revenue.
Question 6 is a good illustration of this point. See what happens when output increases
from four units to five units.
8 Disagree. The profit maximising criteria is MR=MC. At this point in the short run, a firm
may be making economic profits, zero profits or economic losses. Since TR=TC only when
zero economic profits occur, TR will differ from TC when economic profits or losses occur.
9 a The firm earns an economic profit.
b MR2 and MR1.
c MR1.
The firm’s short-run supply curve is its marginal cost curve above the minimum point on its
AVC curve.
10 Disagree. Because the firm’s consumers will buy an unlimited amount at the prevailing
market price but the firm will sell only that level of output for which MR=MC (or zero
output if P<AVC).
11 The firm can be in a loss-minimisation situation. If the marginal revenue intersects the
marginal cost above the average variable cost, the firm can make the best of a bad situation
by following the MR = MC rule and producing the corresponding output, rather than
shutting down. Because the marginal revenue (price) exceeds the average variable cost, the
extra revenue pays for a portion of the fixed costs. Note that it is important to cover
variable costs in the short run. On the other hand, if it is not covering its fixed costs it is
better to close the firm.
12 At the current output level, P<AVC. In this instance, the firm should shut down. This is
because the revenue from each unit produced cannot cover the variable cost per unit, let
alone make a contribution to fixed costs. By shutting down, the firm will only make a loss
equalling to the total fixed cost.
13 Earning economic profits attracts new road transport operators to the industry. This
increases the short-run industry supply curve. As a result, the price of road transport services
falls, the industry quantity of output rises, and economic profit is zero in the long run. No,
one can’t say whether the industry has constant, increasing or decreasing costs. To be able
to do this one would need to know weather the new long run equilibrium price is the same
as, greater than or smaller than the equilibrium price that previously prevailed. For example,
if the payment to independent road transport operators rises to attract more individuals into
this business then the independent road transport industry will be an increasing-cost industry
with a higher equilibrium price than previously.

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56 Economics for Today Instructor’s Manual

Multiple-choice solutions
(pp 204–6)
1b a great variety of different products
2b homogeneous products
3b price and marginal revenue
4b $100
5c marginal revenue
6d shut down
7b average variable cost curve
8d 2000 units per week
9b $10 per unit
10b stay in operation for the time being even though it is earning an economic loss
11c less than $10 000 per week
12d all of the total fixed costs and total variable costs
13b B to D and all points above
14d all of the above
15d firms enter and exit the industry
16a an increasing-cost industry
17d all of the above are true.

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