Chapter 7

Perfect Competition

Slides by John F. Hall

INTRODUCTION TO ECONOMICS 2e / LIEBERMAN & HALL
CHAPTER 7 / PERFECT COMPETITION
©2005, South-Western/Thomson Learning Animations by Anthony Zambelli
 Perfect Competition
 To determine structure of any particular market, we begin by
asking
 How many buyers and sellers are there in the market?
 Is each seller offering a standardized product, more or less
indistinguishable from that offered by other sellers
• Or are there significant differences between the products of different
firms?
 Are there any barriers to entry or exit, or can outsiders easily enter
and leave this market?
 Answers to these questions help us to classify a market into
one of four basic types
 Perfect competition
 Monopoly
 Monopolistic
 Oligopoly

Lieberman & Hall; Introduction to Economics, 2005 2

 The Three Requirements of Perfect
Competition
 Large numbers of buyers and sellers,
and
 Each buys or sells only a tiny fraction of
the total quantity in the market
 Sellers offer a standardized product
 Sellers can easily enter into or exit from
market

Lieberman & Hall; Introduction to Economics, 2005 3

A Large Number of Buyers and Sellers
 In perfect competition, there must
be many buyers and sellers
 How many?
• Number must be so large that no
individual decision maker can
significantly affect price of the product by
changing quantity it buys or sells

Lieberman & Hall; Introduction to Economics, 2005 4

 A Standardized Product Offered by
Sellers
 Buyers do not perceive significant
differences between products of one
seller and another
 For instance, buyers of wheat do not prefer
one farmer’s wheat over another

Lieberman & Hall; Introduction to Economics, 2005 5

 Easy Entry into and Exit from the
Market
 Entry into a market is rarely free—a new seller must always
incur some costs to set up shop, begin production, and
establish contacts with customers
 But perfectly competitive market has no significant barriers to
discourage new entrants
• Any firm wishing to enter can do business on the same terms as firms
that are already there
 In many markets there are significant barriers to entry
 Legal barriers
 Existing sellers have an important advantage that new entrants can
not duplicate
• Brand loyalty enjoyed by existing producers would require a new entrant
to wrest customers away from existing firms
 Significant economies of scale may give existing firms a cost
advantage over new entrants

Lieberman & Hall; Introduction to Economics, 2005 6

 Easy Entry into and Exit from the
Market
 Perfect competition is also characterized by
easy exit
 A firm suffering a long-run loss must be able to
sell off its plant and equipment and leave the
industry for good, without obstacles
 Significant barriers to entry and exit can
completely change the environment in which
trading takes place

Lieberman & Hall; Introduction to Economics, 2005 7

 Is Perfect Competition Realistic?
 Assumptions market must satisfy to be perfectly competitive
are rather restrictive
 In vast majority of markets, one or more of assumptions of
perfect competition will, in a strict sense, be violated
 Yet when economists look at real-world markets, they use perfect
competition more often than any other market structure
 Why is this?
 Model of perfect competition is powerful
 Many markets—while not strictly perfectly competitive—come
reasonably close
 We can even—with some caution—use model to analyze
markets that violate all three assumptions
 Perfect competition can approximate conditions and yield
accurate-enough predictions in a wide variety of markets

Lieberman & Hall; Introduction to Economics, 2005 8

Figure 1: The Competitive Industry and
Firm
1. The intersection of the market supply 3. The typical firm can sell all it
and the market demand curve… wants at the market price…

Price per Market Price per Firm

Ounce Ounce
S

$400 $400
Demand
Curve Facing
D the Firm

Ounces of Gold per Day Ounces of Gold per Day

2. determine the equilibrium 4. so it faces a horizontal
market price demand curve

Lieberman & Hall; Introduction to Economics, 2005 9

 The Way of
Horizontal Demand Curve
of Perfect Competition

 What is the demand curve faced by the firm?

Lieberman & Hall; Introduction to Economics, 2005

 Perfect Competition
P

Market Supply

pe

Market Demand
Q

Lieberman & Hall; Introduction to Economics, 2005

 Perfect Competition
P
Market Supply
p’
pe At a price of p’, zero is
demanded from the firm.

Market Demand
Q

Lieberman & Hall; Introduction to Economics, 2005

 Perfect Competition
P

Market Supply
p’
pe At a price of p’, zero is
demanded from the firm.
p”
Market Demand
Q
At a price of p” the firm faces the entire
market demand.
Lieberman & Hall; Introduction to Economics, 2005
 Perfect Competition
 Therefore, the demand curve faced by the
individual firm is ...

Lieberman & Hall; Introduction to Economics, 2005

 Perfect Competition

P Market P
Supply

P* P*

Market
Demand
y
Q
Firm’s Demand Curve
Lieberman & Hall; Introduction to Economics, 2005 15
 Goals and Constraints of the
Competitive Firm
 Perfectly competitive firm faces a cost
constraint like any other firm
 Cost of producing any given level of
output depends on
 Firm’s production technology
 Prices it must pay for its inputs

Lieberman & Hall; Introduction to Economics, 2005 16

Figure 2(a): Profit Maximization in
Perfect Competition
Dollars
TR TC
$2,800
Maximum Profit
per Day = $700
2,100

550 Slope = 400

1 2 3 4 5 6 7 8 9 10
Ounces of Gold per Day

Lieberman & Hall; Introduction to Economics, 2005 17

Figure 2(b): Profit Maximization in
Perfect Competition
Dollars

MC

$400 D = MR

1 2 3 4 5 6 7 8 9 10
Ounces of Gold per Day

Lieberman & Hall; Introduction to Economics, 2005 18

 The Total Revenue and Total Cost
Approach
 Most direct way of viewing firm’s search
for the profit-maximizing output level
 At each output level, subtract total cost
from total revenue to get total profit at
that output level
 Total Profit = TR - TC

Lieberman & Hall; Introduction to Economics, 2005 19

 The Marginal Revenue and Marginal
Cost Approach
 Firm should continue to increase output as
long as marginal revenue > marginal cost
 Remember that profit-maximizing output is
found where MC curve crosses MR curve
from below
 Finding the profit-maximizing output level for
a competitive firm requires no new concepts
or techniques

Lieberman & Hall; Introduction to Economics, 2005 20

 Measuring Total Profit
 Start with firm’s profit per unit
 Revenue it gets on each unit minus cost per unit
• Revenue per unit is the price (P) of the firm’s output, and cost per
unit is our familiar ATC, so we can write
 Profit per unit = P – ATC
 Firm earns a profit whenever P > ATC
 Its total profit at the best output level equals area of a
rectangle with height equal to distance between P and
ATC, and width equal to level of output
 A firm suffers a loss whenever P < ATC at the best
level of output
 Its total loss equals area of a rectangle
• Height equals distance between P and ATC
• Width equals level of output

Lieberman & Hall; Introduction to Economics, 2005 21

 Short-Run Equilibrium
 How does a perfectly competitive market
achieve equilibrium?
 In perfect competition, market sums buying and
selling preferences of individual consumers and
producers, and determines market price
• Each buyer and seller then takes market price as given
 Each is able to buy or sell desired quantity
 Competitive firms can earn an economic
profit or suffer an economic loss

Lieberman & Hall; Introduction to Economics, 2005 22

 Figure 6: Perfect Competition

Individual Quantity Quantity Individual

Demand Demanded at Supplied at Supply
Curve Different Prices Different Prices Curve

Added together Added together

Market Quantity Demanded Quantity Supplied by Market

Demand by All Consumers at All Firms at Different Supply
Curve Different Prices Prices Curve

Market Equilibrium
P S
D
Quantity Q Quantity Supplied
Demanded by
by Each Firm
Each Consumer

Lieberman & Hall; Introduction to Economics, 2005 23

 A Change in Demand
 Short-run impact of an increase in demand is
 Rise in market price
 Rise in market quantity
 Economic profits
 What happens in long-run after demand curve
shifts rightward?
 Market equilibrium will move from point A to point C
 Long-run supply curve
 Curve indicating quantity of output that all sellers in a
market will produce at different prices
• After all long-run adjustments have taken place

Lieberman & Hall; Introduction to Economics, 2005 24

 Increasing, Decreasing, and Constant
Cost Industries
 Increase in demand for inputs causes price
of those inputs to rise
 This type of industry (which is the most
common) is called an increasing cost
industry
 Entry causes input prices to rise
• Shifts up typical firm’s ATC curve
 Raises market price at which firms earn zero economic profit
 As a result, long-run supply curve slopes upward

Lieberman & Hall; Introduction to Economics, 2005 25

 Increasing, Decreasing, and Constant
Cost Industries
 Other possibilities
 Industry might use such a small percentage of total inputs that—
even as new firms enter—there is no noticeable effect on input
prices
• Called a constant cost industry
 Entry has no effect on input prices, so typical firm’s ATC curve stays put
 Market price at which firms earn zero economic profit does not change
 Long-run supply curve is horizontal
 Decreasing cost industry, in which entry by new firms actually
decreases input prices
• Entry causes input prices to fall
 Causes typical firm’s ATC curve to shift downward
 Lowers market price at which firms earn zero economic profit
 As a result, long-run supply curve slopes downward

Lieberman & Hall; Introduction to Economics, 2005 26

 Application: Tax Incidence In
Perfect Competition
Market
P
Supply

PC = PP

Market
Demand
Q

No tax: PC = PP

Lieberman & Hall; Introduction to Economics, 2005 27

 Application: Tax Incidence In
Perfect Competition
P
Market
PC Supply
This is
the tax.
PP
Market
Demand
Q
A tax is introduced.

Lieberman & Hall; Introduction to Economics, 2005 28

 Application: Tax Incidence In
Perfect Competition
P
Market
PC Supply
This is
the tax.
PP
Market
Demand
Q
The tax creates a wedge between the price firms
receive and the price consumers pays. The difference
is the tax.
Lieberman & Hall; Introduction to Economics, 2005 29
 Application: Tax Incidence In
Perfect Competition
P
Market
PC Supply
This is
the tax
PP
Market
Demand
Q
In the short run, the burden of the tax is shared (not
necessarily on a 50/50 basis) between consumers and
producers.
Lieberman & Hall; Introduction to Economics, 2005 30
 The End

Lieberman & Hall; Introduction to Economics, 2005 31