Part 6

Perfect Competition
• Many markets are characterized
by competitive conditions
• Theory of competitive markets
is based on a model of “perfect
competition” – an idealized
competitive market
- Many buyers and sellers
- Identical outputs
- Free entry and exit
- Complete information
The Firm Under Perfect
Competition
• Firm must be small relative to
the size of the market (minimum
efficient scale must be small
relative to the market)
• Individual firms cannot affect
the market price (price taker)
• Price is set in the market as a
whole, the individual firm
adjusts output so as to maximize
profit given the market price
 The Firm’s Total
Revenue and Marginal
Revenue Curves
• As the market price is given, the
firm’s total revenue is its output
times the market price (P x Q)
• The TR function will be a
straight line from the origin
• The firm’s marginal revenue is
MR = ΔTR/ΔQ
As all units of output sell for the
same price
MR = P
 The Firm’s TR and MR
Curves
TR

TR
P = $1.25

125

Q
100
MR

1.25 MR = P

Q
 Profit Maximization

• The firm has to decide whether

to produce at all, and if so what
output to produce
• The firm will produce in the
short run so long as its variable
costs can be covered
• Assuming the firm produces at
all, the profit maximizing
output is where there is the
maximum excess of TR over
TC or where MR = MC
 Profit Maximum: TR
and TC
TC
$
TR

Economic Profit

Q
Q’ Q”
Profit Profit Max

0 Q
Q’ Q* Q”
Loss Profit/Loss
 Profit Maximum: MR
and MC
$ MC

P MR

Q* Q

Why does MC = MR imply profit max?

What would happen to TR and TC if output
went up or down by a unit?
 Profit in the Short Run
$ MC

MR
P
ATC

Economic
profit
Q
Q*
$ MC
Normal profit
or break even ATC

P
MR

Q
Q*
 Economic Loss in the
Short Run
$ MC

ATC

P MR

Q* Q
Economic loss

Firm will produce Q* as long as P>AVC

 Firm’s Short Run
Supply Curve
• The firm’s short run supply
curve will be its MC curve
above its AVC curve
• If P is equal to or grater than
Min AVC the firm will produce
where P = MR = MC
• If P < Min AVC the firm’s loss
minimizing strategy is to shut
down. Loss will equal TFC
 Firm’s Short Run
Supply Curve
$ Break even or
normal profit ATC
point MC

P” MR”

P’ MR’
P MR

Shut down point AVC

Q Q’ Q” Q
At prices below P the firm will shut down
At prices between P and P’ the firm will
produce where MC=MR at an economic loss
At prices above P’ the firm will produce where
MC=MR at an economic profit
 Market Supply Curve

• We can now derive the market

supply curve
• The supply curve of each firm is
its MC curve above its min
AVC point
• The market supply curve is the
horizontal sum of the supply
curves of all the firms in the
industry
 Short Run Equilibrium
of the Market and Firm
• Market demand curve is the
horizontal sum of all the demand
curves of individuals
• Short run market supply curve is the
horizontal sum of all the short run
supply curves of all the firms
currently in the industry
• Market price and quantity is
determined by D = S
• Each individual firm will produce at
its profit max point of MR = MC
 SR Equilibrium of
Market and Firm
Market equilibrium
P S = ΣhMC

P*
D = ΣhDi

Q* Q
Equilibrium of the firm
P MC
P* MR
ATC

q
q*
 Shifts in Demand in the
Short Run
• Shifts in demand will create a
movement along the market
short run supply curve,
changing market price
• Each individual firm will adjust
output to its new profit max
level as price changes, moving
along its own short run supply
curve
 Long Run Adjustments
• In the long run capital is not fixed
• Firms can change the size of their
plants and move along their LAC
curves
• Firms can enter or leave the industry.
They will enter if there is economic
profit and leave if they are suffering
economic losses
• If firms change size or the number of
firms in the industry changes the short
run industry supply curve will shift
• What conditions must hold for a
perfectly competitive industry to be in
long run equilibrium?
 Long Run Equilibrium
• Market price must adjust (via shifts in
the short run supply curve) until all
firms are just making normal profit
• With normal profit there is no
economic profit to attract new
entrants and no economic losses to
create exit
• Also, for their to be no prospect of
economic profit, price must equal
minimum LAC
• Otherwise firms could make
economic profit by changing their
plant size which would shift the SR
supply curve of the industry
 Long Run Equilibrium
for Market and Firm
P S = ΣhSMC

P*
D = ΣhDi

Q
Q*

ATC SMC LAC

P* MR

q*
Long Run Supply Curve
P
S S’
P’
P LRS
D D’
Q
Q Q’
D shifts to D’, raising market price to P’.
This will create excess profit for firms
attracting new entrants and shifting S to S’
where all economic profit is again eliminated
and new entry stops .

This diagram shows a constant cost industry.

Long run supply curve is horizontal
 Possible Long Run
Supply Curves
• Constant cost industry -- horizontal
LRS. Changes in the size of the
industry do not affect firms’ costs of
production
• Increasing cost industry – upward
sloping LRS. As an industry grows a
factor price rises as a result, increasing
costs for all firms
• Decreasing cost industry – downward
sloping LRS. As an industry grows a
factor price falls as a result, decreasing
costs for all firms—network effects
• Technological change shifts the LRS
 Are Competitive Markets
Efficient?
• In long run competitive equilibrium
price is such that D=S and
production is at min LAC
• Productive efficiency—min LAC
• The market D curve is can be
interpreted as willingness to pay or
marginal benefit curve
• The market supply curve can be seen
as the marginal opportunity cost of
production curve
• Competitive equilibrium is
allocatively efficient (maximizes
social surplus) provided all costs and
benefits are reflected in the market D
and S curves
Economic Inefficiencies
• The efficient allocation may not be
achieved even in competitive markets
• Not all resources may be privately
owned (open access resources)
• It may not be possible for firms to
capture peoples’ willingness to pay
(public goods, external benefits)
• Not all social costs may be reflected
in the prices firms pay for factors of
production (external costs)
• Economic inefficiencies may also
arise from lack of competition
--Monopoly