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Chapter 08 - Analysis of Perfectly Competitive Markets

CHAPTER 8
Analysis of
Perfectly Competitive
Markets

CHAPTER OUTLINE

I. Supply Behavior of the Competitive Firm

a. Behavior of a Competitive Firm
i. Profit Maximization
ii. Perfect Competition
iii. Competitive Supply where Marginal Cost Equal Price
iv. Total Costs and the Shutdown Condition
II. Supply Behavior in Competitive Industries
a. Summing all Firm’s Supply Curves to get Market Supply
b. Short-Run and Long-Run Equilibrium
i. The Long-Run for a Competitive Industry
III. Special Cases of Competitive Markets
a. General Rules
i. Constant Cost
ii. Increasing Costs and Diminishing Returns
iii. Fixed Supply and Economic Rent
iv. Backward-Bending Supply Curve
v. Shifts in Supply
IV. Efficiency and Equity of Competitive Markets
a. Evaluating the Market Mechanism
i. The Concept of Efficiency
ii. Efficiency of Competitive Equilibrium
iii. Equilibrium with Many Consumers and Markets
iv. Marginal Cost as a Benchmark for Efficiency
b. Qualifications
i. Market Failures
ii. Two Cheers for the Market, but Not Three
V. Summary

8-1
Chapter 08 - Analysis of Perfectly Competitive Markets

CHAPTER OVERVIEW AND TEACHING TIPS

After finishing your discussion about costs, you are now ready to impart your first presentation of market
structure: Perfect Competition! Although you might anticipate an easy and intuitive transition from costs to perfect
competition, your students might disagree with you. After all, why should we study the perfectly competitive
model? If it is not real then it is not useful, right? Our advice: do not try to come up with frivolous examples of
perfect competition in the real world, like hotdogs in a baseball park! Your students are smarter than you think and
you don’t want to lose credibility at this crucial stage of the game! Instead, reinforce the important role that the
competitive market model plays as a benchmark for the maximization of efficiency, in particular when confronting
distortions due to externalities. This will be an interesting battle but one that you can win.
With cost concepts still fresh, the presentation and development of the competitive model should be
manageable. Many of the ideas built into this model are important to a sound understanding of even elementary
economics. Your goal should be to make students comfortable with the concept of perfect competition, the
relationship between cost curves equilibrium determination within this market structure, and in particular the
behavior of profits in the long-run. Students sometimes tend to associate the short-run decision to shut-down with
the long-run profitability condition of zero-economic profits. Anticipate arguments such as “if they are not making
money” referring to zero-economic profits “then they must shut down.”
Take advantage of the four special cases of competitive markets considered in the chapter (horizontal, upward-
sloping, vertical, and downward sloping supply curves) to transition within the chapter. Finally, reinforce the
efficiency properties of the perfectly competitive model as a transition tool to the other market structure models that
will follow.

LEARNING OBJECTIVES
1 Describe the characteristics of a perfectly competitive industry, and explain how these characteristics limit
the sphere of economic variables over which a single competitive firm has influence.
2 Identify the profit-maximizing goal of the individual perfectly competitive firm, and indicate decision rules
through which each firm can achieve this goal.
3 Review the notions of total cost, fixed cost, variable cost, average cost, and marginal cost.
4 Derive the supply curve of a competitive firm from the marginal cost curve.
5 Explain the break-even and shutdown conditions and their relevance to the competitive marketplace.
6 Explain the long-run and short-run equilibrium conditions for the competitive firm and the competitive
market.
7 Explain why and under what conditions the supply curve might be (a) horizontal, (b) upward sloping, (c)
vertical, and (d) downward sloping.
8 Provide examples of markets in which these special cases of supply may be relevant.
9 Explain the efficiency of perfect competition in terms of (a) marginal cost and marginal utility and (b)
consumer surplus and social welfare.
10 Contrast efficiency with equity as goals of an economic system, and discuss the role of each goal in
developing policy. Discuss qualifications to the efficiency results.

SUGGESTED ANSWERS TO QUESTIONS IN THE TEXT

1 a. A competitive firm will produce output up to the point where price equals marginal cost if it is to
maximize profits.
b. A firm’s shutdown point comes where price is less than the minimum of average variable cost.
c. A competitive firm’s supply curve depends only on its MC above the shutdown price where MC = AVC.
d. The rule does not hold for downward-sloping MC. Given diminishing returns, MC eventually begins to rise; P =
MC on downward slope is not a profit maximum. To see why, consider increasing output to 1 unit from the
downward intersection; profits climb!
e. A competitive firm chooses output to set marginal cost equal to price. It has no discretion over price.
2 a. You should shut down.
b. Produce 1000 units and profits is – $5000.
c. Produce 1000 units and profits are $5000. Because you are covering you variable cost you only lose $5000 instead
of $10,000 if you shut down.
There is a mistake in the question. Fixed cost should NOT go to $ 0 if you shut down.
3 The profit maximizing level of output is 4000 units for each fixed cost listed. Note that maximum profits
are positive for FC = $0, $55,000, and $30,000 and negative for FC = $100,000 and $l,000,000. Any firm should
continue to produce in the short run if it can cover its variable costs and at least a portion of its fixed costs.
8-2
Chapter 08 - Analysis of Perfectly Competitive Markets

4 Price = $21; Q* = 3000; profits = $63,000 - $130,000 = -$67,000; firms should exit. Price = $40; Q* =
4000; profits = $160,000 - $160,000 = $0; stable long-run equilibrium. Price = $60; Q* = 5000; profits = $300,000 -
$210,000 = $90,000; firms should enter.
5 ES = [(4001 - 4000)/4000]/[(40.02 - 40.00)/40.00] = O.5. For the industry supply, multiply the single-firm
quantity by 2000 for each price. The supply elasticity does not change. Both the numerator and the denominator of
the “percentage change in quantity” part of the elasticity ratio are multiplied by 2000; the 2000s therefore cancel and
do not change the elasticity estimate.
6 At competitive equilibrium, the price that people are willing to pay for output is less than the smallest MC
for firm C. If C produced 1 unit more and B 1 unit less, total industry cost would increase by [MCC(l) - MCB (last)].
Economies of scale drive “Mom and Pop” stores out of business, except for those having locational advantages (e.g.,
convenience), service advantages, etc. The legislation would increase food prices because equal shares would not
achieve total cost minimization, which only occurs when MCs are equal across firms.
7 Short-run demand is more inelastic than long-run demand. Consult Figure 8-1. At some initial price and
quantity P0 and Q0, short-run demand DD is drawn steeper than long-run demand dd to reflect relatively less elastic
demand at (Q0, P0). A decline in supply from s0s0 to s1s1 produces a dramatic price spike in the short run with little
contraction in quantity (movement from E to ED). Over time, however, conservation and substitution possibilities
are exploited; greater quantity reduction relieves some price pressure, and equilibrium moves toward Ed along s1s1.

Figure 8-1

A decreased supply will increase price most when demand is inelastic. A decreased supply will decrease quantity
least when demand is inelastic. Since demand is more inelastic in the short-run than in the long-run, the effects of a
decrease in supply on price and quantity will decline over time.
8 The definition of pure economic profit includes the opportunity cost of owners’ labor and capital
investment. When a firm is earning economic profit, it is more than covering opportunity costs. Economic profits
are driven to zero in perfect competition, so resources are earning exactly as much as they would earn at their next
best alternative use.
9 a. This curve describes how much it will cost to reduce the amount of pollution by one additional unit.
b. Firm A should produce six units of pollution reduction, Firm B should produce four units of pollution reduction,
and Firm C should not participate in the market.
c. If Firms A and B each produce five units of pollution reduction, Firm B will produce its fifth unit at a higher cost
than Firm A would have had to pay for its sixth unit of pollution reduction. Thus costs are higher by the difference
between the cost of Firm B’s fifth unit and Firm A’s sixth unit.
d. P* would be the optimal charge for the pollution authority to establish. Firm A will “produce” six units of
pollution reduction, Firm B will “produce” four units of pollution reduction, and the marginal cost in the market will
equal the marginal benefit of pollution reduction. Further reduction of pollution would cost more than the value that
it would generate for society.
10 Allocative efficiency means that no reallocation of resources can make one party better off without hurting
another. At the equilibrium point E in Figure 8-11, MC=P; this means that the cost of the last unit produced was just
equal to the value of it to the consumer. If fewer goods were produced, then some consumers would be made worse
off. If more goods were produced, then some producers would be made worse off.

8-3
Chapter 08 - Analysis of Perfectly Competitive Markets

DISCUSSION QUESTIONS
1. Why would a firm ever supply goods at a loss along a short-run marginal cost curve?
2. One of the most important rules in economics is “Let bygones be bygones.” This means that fixed costs
already incurred should be ignored in making short run decisions; only incremental or marginal costs
should be computed. Relate this to Table 8-1 in the text by looking for the profit-maximizing level of
output when fixed costs are $0, $55,000, and when someone gives you $50,000 to start the business. How
does this concept apply when you look at the price you originally paid when you sell your house?
3. Given the supply curve of each individual firm, how does one construct the industry supply curve? Are
there any difficulties in finding the long-run industry supply curve? If there are 1000 identical firms in the
industry, what will the industry short-run supply curve look like, compared to those of the individual firms?
4. The directors of a business firm once fired its president for refusing to produce an extra unit that would
have cost only $1 and could have been sold for $3. Were they crazy? Why or why not?
5. “The rule that states that price equals marginal cost equals marginal utility holds even in a total planned
economy as long as the planners are attempting to maximize net social welfare measured by total consumer
surplus.” Discuss the accuracy of this statement.
6. “The existence of decreasing cost industries can undermine the competitive pricing system.” Discuss.
7. Discuss the role of constant returns to scale in a competitive market. Argue, in particular, why CRS would
make it impossible to predict the number of firms in long-run equilibrium.
8. List and explain the importance of the characteristics of a perfectly competitive industry.
9. Carefully explain why the perfectly competitive firm faces a perfectly elastic demand curve. How can the
firm’s demand curve be perfectly elastic when the industry demand curve is downward-sloping?
10. Define the term consumer surplus. Show the area on market diagrams that represents this area of surplus.
Define the term producer surplus. Show the area on market diagrams that represents this area of surplus.
11. For each of the following examples, decide which of the special cases of competitive markets applies. Use
a supply-and-demand diagram to explain each of the observations.
a. When the federal individual income-tax rate fell after 1981, a leading movie star did not change her
supply of labor.
b. As wine became more popular, the price of wine rose sharply.
c. Even though real wages have increased considerably since 1900, hours of work have fallen.
12. What is the effect of a per-unit tax when supply is as described in each of the special cases of competitive
markets? Use diagrams to describe the effect of a tax in each case.
13. You hear that your doctor has increased the prices charged for services. She has also canceled office hours
on Wednesday afternoons and will be playing golf instead. Does this mean that her labor supply curve is
downward sloping? Explain using a diagram.

ESSAY QUESTIONS
1. “Perfect competition can be a useful industrial structure if our goal is to give people the goods they want at
the most efficient modes of production and in the right quantitative amounts, where marginal costs and
utilities balance. If dollar votes are grossly inequitable, however, then this efficiency will not bring
equity.” Use tools of supply and demand to explain the correct and incorrect portions of this statement.
2. You are given the following supply schedules for two firms:
Firm A Firm B
Price Quantity Price Quantity
$0 0 $0 0
1 0 1 2
2 0 2 4
3 2 3 6
4 4 4 8
5 6 5 10

a. Construct the market supply schedule for the combined firms.

b. What increase in supply will a $1 increase in price elicit from firm A? From firm B?
c. What increase in market supply will an increase in price from $1 to $2 elicit? An increase in price from
$3 to $4?

8-4
Chapter 08 - Analysis of Perfectly Competitive Markets

3. “Summing horizontally, the decreasing MC curves of 1000 identical firms give us an industry supply curve
that looks like a hundredfold horizontal blowup of each one.” Discuss this statement in light of the relation
between decreasing internal cost for the firm and the possibility of a downward-sloping supply for the
industry.
4. “My firm, which has a rising short-run MC curve, is now operating at a loss. If P rises a little, I will not
increase Q because MC would go up and I’d just be taking a greater loss on a higher volume.” Is this
reasoning correct? Why or why not? Use a diagram to illustrate your answer.
5. Consider an industry composed of 1000 firms. Describe this industry’s long-run supply curve when (a) free
entry exists, and (b) there is no possibility of new firms entering the industry.
6. List and discuss the conditions that must exist for the long-run supply curve of a competitive industry to be
infinitely elastic. Under what conditions will it be upward sloping?
7. “In a perfectly competitive industry, the efficient firms will come to displace the wasteful firms.” Explain,
using cost diagrams when appropriate.
8. Given a firm’s marginal cost curve, explain how to derive its supply curve. In the short run, at what point
will the firm cease producing anything at all? Discuss.
9. Explain why the existence of decreasing costs for a firm is incompatible with the economist’s model of
perfect competition.
10. “The concept of marginal cost has great importance for welfare economics. The resources of society are
being efficiently allocated and used only if there is an equality in the marginal costs of similar goods
produced everywhere.” Discuss.
11. Will markets always lead to an efficient allocation of resources? What sorts of market failure exist? List
examples of situations in which markets have been seen to fail.
12. Does efficiency always lead to equity in the distribution of resources? Why might these goals of an
economic system sometimes contradict one another?
13. If an industry has a perfectly elastic supply curve, why is it described as a “constant-cost” industry? How
might expansion of industry output result in no changes in output price?
14. Some economists claim that the best way of raising revenues for government is to tax land. Why might this
be? What is the result of a tax on something that is supplied inelastically?
15. “If all workers in a particular labor market have backward bending individual supply curves, the market
supply curve will also be backward bending.” Is this statement true or false?
16. Under what conditions would a firm operate in the short run if they are losing money?
17. What are the operating profits of a competitive firm in the long run?
18. Why would a firm continue to operate in the long run if profits are zero?

8-5
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