Perfect Competition

Firm Behavior Under Perfect
Competition
Fill in the Blanks
Firms Maximize Profit at the quantity
where the difference between Total
________ and ________ Cost is
greatest.
At this profit-maximizing level of
output , _________ = _________.
Fill in the Blanks
Firms Maximize Profit at the quantity
where the difference between Total
Revenue and Total Cost is
greatest.
At this profit-maximizing level of

output , MR = MC.
Perfect Competition Defined
• Perfect competition
– Many small firms and customers
– Standardized (homogeneous) product
– Free entry and exit of firms (in long run)
– Well-informed producers and consumers
The Competitive Firm
• Perfect competition
– Firm is a price taker.
– Price is set in the market.
– Firm is too small to affect the market.
• The Firm’s Demand Curve under Perfect
Competition
– Perfectly Elastic (Horizontal)
– Can sell as much as it wants at the market
price.
Demand Curve for a Firm under
Perfect Competition
D Industry S
supply
curve
Price per Bushel
A B C E Industry
$3 $3 demand
in Chicago
curve
Firm’s demand
curve
S
D
0 1 2 3 4 0 100 200 300 400
Truckloads of Corn Total Sales in Chicago
Sold by Farmer Jasmine in Thousands of Truckloads
per Year per Year
(a) (b)
DEMAND AS SEEN BY A
PURELY COMPETITIVE SELLER
Perfectly Elastic Demand
Price Taker Role
Total Revenue = P x Q
Average Revenue = P
Marginal Revenue = P
For example...
DEMAND AS SEEN BY A
Product Price (P) Quantity Total Marginal
(Average Revenue) Demanded (Q) Revenue (TR) Revenue (MR)
$131 0 $ 0
DEMAND AS SEEN BY A
$131 0 $ 0
] $131
131 1 131
DEMAND AS SEEN BY A
$131 0 $ 0
] $131
131 1 131
] 131
131 2 262
DEMAND AS SEEN BY A
$131 0 $ 0
] $131
131 1 131
] 131
131 2 262 ]
131
131 3 393
DEMAND AS SEEN BY A
$131 0 $ 0
] $131
131 1 131
] 131
131 2 262 ]
131
131 3 393 ]
131
131 4 524
DEMAND AS SEEN BY A
$131 0 $ 0
] $131
131 1 131
] 131
131 2 262 ]
131
131 3 393 ]
131
131 4 524 ]
131
131 5 655 ]
131
131 6 786 ]
131
131 7 917 ]
131
131 8 1048 ]
131
131 9 1179 ]
131
131 10 1310
DEMAND AS SEEN BY A
$131 0 $ 0
] $131
131 1 131
] 131
131
131
Graphically
2
3
262 ]
393 ]
131
131
131
131
Presented…
4
5
524 ]
655 ]
131
131
131 6 786 ]
131
131 7 917 ]
131
131 8 1048 ]
131
131 9 1179 ]
131
131 10 1310
DEMAND, MARGINAL REVENUE, AND TOTAL
REVENUE IN PURE COMPETITION
1179
TR
1048
Price and revenue
917
786
655
524
393
262
131
D = MR
0
1 2 3 4 5 6 7 8 9 10
Quantity Demanded (sold)
• Short-Run Equilibrium for the Perfectly
Competitive Firm
 Marginal revenue = Price
 Profit-maximizing level of output: MC = MR
 So, a perfectly competitive firm should

maximize profit by producing the output where
Price = Marginal Cost
• D = MR = AR at all levels of output
• D = MR = AR = MC at the equilibrium level
of output
Short-Run Equilibrium of the
Perfectly Competitive Firm
Revenue and Cost per Bushel
MC AC
B
$3.00
D = MR = AR
2.25
A
1.50
0 50,000
Bushels of Corn per Year

S-R Equilibrium of Competitive
Firm w/ Lower Price
MC AC
Revenue and Cost
per Bushel
A
$2.25
1.50
B D = MR = P
0 30,000
Bushels of Corn per Year

SHORT RUN PROFIT MAXIMIZATION
Two Approaches...
First:
Total Revenue - Total Cost Approach
The Decision Process:
•Should the firm produce?
•What quantity should be produced?
•What profit or loss will be realized?
The Decision Rule:
Produce in the short-run if the firm
can realize
1) a profit (or)
2) a loss less than its fixed costs
Two Approaches...
First:
The Decision Process:
Applied
•Should the firm produce?
•What quantity should be produced?
Graphically…
•What profit or loss will be realized?
The Decision Rule:
Produce in the short-run if the firm
can realize
1) a profit (or)
2) a loss less than its fixed costs
TOTAL REVENUE-TOTAL COST APPROACH
h e ?
t
e Total n Total
s e t i o Price: $131
a
uTotal iz Fixed Variable Total Total
yo im Cost Cost Cost
n a Product
x Revenue Profit
C tma
f i 0 $ 100 $ 0 $ 100 $ 0 - $100
r o
p 1 100 90 190 131 - 59
2 100 170 270 262 -8
3 100 240 340 393 + 53
4 100 300 400 524 + 124
5 100 370 470 655 + 185
6 100 450 550 786 + 236
7 100 540 640 917 + 277
8 100 650 750 1048 + 298
9 100 780 880 1179 + 299
10 100 930 1030 1310 + 280
Total Total Price: $131

Total Fixedl Variable Total Total
a
ProductTotCoste Cost Cost Revenue Profit
g n u
h i n
0 v$e100 $ 0 $ 100 $ 0 - $100
p 1R 100 e
r a & 90 190 131 - 59
G st 2 100 170 270 262 -8
C o
3 100 240 340 393 + 53
4 100 300 400 524 + 124
5 100 370 470 655 + 185
6 100 450 550 786 + 236
7 100 540 640 917 + 277
8 100 650 750 1048 + 298
9 100 780 880 1179 + 299
10 100 930 1030 1310 + 280
$1,800 Break-Even Point

1,700 (Normal Profit)
1,600
1,500
Total revenue and total cost
1,400
1,300 Total
1,200 Maximum
1,100 Revenue Economic
1,000
900
Profits
800 $299
700
600
Total
500 Cost
400
300
200
Break-Even Point
100
(Normal Profit)
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14
Two Approaches...
First:
Second:
Marginal Revenue - Marginal Cost
Approach
MR = MC Rule
Three Characteristics of MR=MC Rule:
• The rule applies only if producing
is preferred to shutting down
• Rule applies to all markets
• Rule can be restated P=MC
MARGINAL REVENUE-MARGINAL COST APPROACH
AverageAverage Average Price = Total

Total Fixed Variable Total Marginal
MarginalEconomic
Product Cost Cost Cost Cost Revenue Profit/Loss
0 The - $100
1 $100.00 $90.00 $190.00 90 $ 131 - 59
2 same profit
50.00 85.00 135.00 80 131 -8
3 33.33 80.00 113.33 70 131 + 53
4 maximizing
25.00 75.00 100.00 60 131 + 124
5
6
result!
20.00 74.00
16.67 75.00
94.00
91.67
70
80
131
131
+ 185
+ 236
7 14.29 77.14 91.43 90 131 + 277
8 12.50 81.25 93.75 110 131 + 298
9 11.11 86.67 97.78 130 131 + 299
10 10.00 93.00 103.00 150 131 + 280
AverageAverage Average Price = Total

Total Fixed Variable Total Marginal
MarginalEconomic
Product Cost Cost Cost Cost Revenue Profit/Loss
0 - $100
1 $100.00 $90.00 $190.00 90 $ 131 - 59
2
3 Graphically
50.00 85.00 135.00 80
33.33 80.00 113.33 70
131
131
-8
+ 53
4 25.00 75.00 100.00 60 131 + 124
5 20.00 74.00 94.00 70 131 + 185
6 16.67 75.00 91.67 80 131 + 236
7 14.29 77.14 91.43 90 131 + 277
8 12.50 81.25 93.75 110 131 + 298
9 11.11 86.67 97.78 130 131 + 299
10 10.00 93.00 103.00 150 131 + 280
Profit Maximization Position

$200
Cost and Revenue
Economic Profit MC
150
$131.00 MR
ATC
100 AVC
$97.78
50
0
1 2 3 4 5 6 7 8 9 10
Profit Maximization Position

$200
Cost and Revenue
Economic Profit MC
150
$131.00 MR
MR = MC ATC
100 AVC
Optimum
$97.78
Solution
50
0
1 2 3 4 5 6 7 8 9 10
Loss Minimization Position

If the price is lowered
from $131 to $81…
the MR=MC rule still applies
…but the MR = MC point

changes.
Loss Minimization Position

$200
Cost and Revenue
Economic Loss MC
150
ATC
100 AVC
$91.67
$81.00 MR
50
0
1 2 3 4 5 6 7 8 9 10
Short-Run Shut Down Point

$200
Cost and Revenue MC
150
ATC
100 AVC
$71.00 MR
50 Minimum AVC
is the Shut-Down
Point
0
1 2 3 4 5 6 7 8 9 10
Marginal Cost & Short-Run Supply

Observe the impact upon
profitability as price is changed
Quantity Maximum Profit (+)
Price Supplied Or Minimum Loss (-)
$151 10 $+480
131 9 +299
111 8 +138
91 7 -3
81 6 -64
71 0 -100
61 0 -100

Break-even
Cost and Revenue, (dollars)

(Normal Profit) MC
Point
P5 MR5
ATC
P4 MR4
AVC
P3 MR3
P2 MR2
P1 MR1
Do not
Produce –
Below AVC
Q2 Q3 Q4 Q5
Quantity Supplied

Yields the Supply
Short-Run MC
Supply Curve
P5 MR5
P4 MR4
P3 MR3
P2 MR2
P1 MR1
No
Production
Below AVC
Q2 Q3 Q4 Q5
Quantity Supplied

MC2
S2
MC1
S1
AVC2
AVC1
Higher Costs Move the

Supply Curve to the Left
Quantity Supplied
Cost and Revenue, (dollars) Lower Costs Move MC1

S1
the Supply Curve
to the Right MC2
S2
AVC1
AVC2
Quantity Supplied
SHORT-RUN COMPETITIVE EQUILIBRIUM
The Competitive Firm “Takes” its
Price from the Industry Equilibrium
S= MC’s
P P
Economic
ATC Profit S=MC
$111 D $111
AVC
D
8 Q 8000 Q
Firm Industry
(price taker)
SHORT-RUN COMPETITIVE EQUILIBRIUM
The Competitive Firm “Takes” its
Price from the Industry Equilibrium
S= MC’s
P P
Economic
ATC Profit S=MC
$111
How about
D
the $111
long-run?
AVC
D
8 Q 8000 Q
Firm Industry
(price taker)
PROFIT MAXIMIZATION IN THE LONG RUN
Assumptions...
• Entry and Exit Only
• Identical Costs for Firms
• Constant-Cost Industry =
Entry and exit of firms
does not affect firms’
cost curves
Goal of the Analysis

Price = Minimum ATC
Long-Run Equilibrium - The
Zero Economic Profit Model
PROFIT MAXIMIZATION IN THE LONG-RUN
Temporary profits and the reestablishment
of long-run equilibrium
S1
P P
MC
ATC
$60 $60
50 50
40 MR 40
D1
100 Q 100,000 Q
Firm Industry
(price taker)
An increase in demand increases profits.
Economic S1
P Profits P
MC
ATC
$60 $60
50 50
40 MR 40
D2
D1
100 Q 100,000 Q
Firm Industry
(price taker)
New competitors increase supply and lower
prices decrease economic profits.
P Zero Economic
S1
P S2
Profits
MC
ATC
$60 $60
50 50
40 MR 40
D2
D1
100 Q 100,000 Q
Firm Industry
(price taker)
Decreases in demand, Losses, and the
Reestablishment of Long-Run Equilibrium
S1
P P
MC
ATC
$60
50
MR $60
50
40 40
D1
100 Q 100,000 Q
Firm Industry
(price taker)
A decrease in demand creates losses.
Economic S1
P Losses P
MC
ATC
$60
50
MR $60
50
40 40
D1
D2
100 Q 100,000 Q
Firm Industry
(price taker)
Competitors with losses decrease supply and
prices return to zero economic profits.S 3
Return to Zero S1
P Economic Profits P
MC
ATC
$60
50
MR $60
50
40 40
D1
D2
100 Q 100,000 Q
Firm Industry
(price taker)
LONG-RUN SUPPLY IN A
CONSTANT COST INDUSTRY
Constant Cost Industry

Perfectly Elastic
Long-Run Supply
Graphically...
P
P1
Z3 Z1 Z2
P2 =$50 S
P3
D3 D1 D2
Q3 Q1 Q2 Q
90,000 100,000 110,000
P
P1
How does an increasing
P2 cost
=$50 industry
Z Z
differ?
3 Z 1
S
2
P3
D3 D1 D2
Q3 Q1 Q2 Q
90,000 100,000 110,000
INCREASING COST INDUSTRY
Increasing Cost Industry =

Firms’ ATC curves shift
upward as firms enter and
downward as firms exit.
Therefore...
LONG-RUN SUPPLY IN AN
P
S
P1 $55
P2 50 Y2
Y1
P3 45 Y3
D3 D1 D2
Q3 Q1 Q2 Q
90,000 100,000 110,000
LONG-RUN SUPPLY IN AN
P
How does a
P1 $55
S
P2 50 Y2
decreasing cost
P3 45 Y3
Y1
industry differ?
D3 D1 D2
Q3 Q1 Q2 Q
90,000 100,000 110,000
DECREASING COST INDUSTRY
Decreasing Cost Industry =

Firms’ ATC curves shift
downward as firms enter and
upward as firms exit.
What is the long-
run competitive
equilibrium?
LONG-RUN EQUILIBRIUM
FOR A COMPETITIVE FIRM
MC
ATC
Price
P MR
Price = MC = Minimum ATC

(normal profit)
Q
Quantity
PURE COMPETITION AND EFFICIENCY
Productive Efficiency
Price = Minimum ATC
Allocative Efficiency
Price = MC
Underallocation
Price > MC
Overallocation
Price < MC
Price = Minimum ATC
c e s a r e
Allocative u r
Reso Efficiency l l o c a te d
i e n tl y a
effic = MCmpetition.
Price
d e r c o
u n
Underallocation
Price > MC
Overallocation
Price < MC
M
Price = Minimum ATC
axim
AllocativeuEfficiency
mT
S
Price u
= rMC ot al
p l us
Underallocation
Price > MC
Overallocation
Price < MC
Price = Minimum ATC
Allocative Efficiency
Price = MC
Underallocation
Price > MC
Overallocation
Price < MC
Perfect Competition and
Economic Efficiency
• In the long run, competitive firms are
driven to produce at the minimum point of
their average total cost curves.
• In this case, output is produced at the
lowest possible cost to society.
Review:
What do I need to know about
perfect competition for the AP
Exam?
PURE COMPETITION
P = MR
The firm’s DEMAND CURVE is perfectly ELASTIC
MR = MC
The firm maximizes profit
P = ATC
Long Run (NORMAL PROFITS)
PRODUCTIVE EFFICIENCY
P = min ATC
Firm is forced to operate with maximum productive efficiency.
(Least-Cost Method Production)
ALLOCATIVE EFFICIENCY
P = MC
There is an optimal allocation of resources.
Pure Competition
P S P
MR=D=AR=P2
p2
MR=D=AR=P
pe
D2
D
qe q2 Q Q
The Market Individual firm

Firm showing Economic Profit
P MC
MR=MC
MR=D=AR=P
$131
Economic Profit
Per unit ATC
profit
$97.78
AVC
Revenue
A
T
C
Q1 Q
Firm showing Economic Loss
P Per unit
loss MC ATC
MR=MC
Economic Loss MR=D=AR=P
$81
AVC
A
T
C Revenue
Q2 Q
Long-run
Long-run Equilibrium
Equilibrium
For
For A
A Competitive
Competitive Firm
Firm
MC
Price
ATC
Pe MR=D=AR=P
Price = MC = MR = Minimum ATC

(normal profit)
Qe
Quantity
Competitive Firm Supply Curve
MC ATC
P MR5
Breakeven point
(normal profit ) MR4
MR3
AVC
MR2
Shutdown point
MR1

Perfect Competition

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Perfect Competition

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Firm Behavior Under Perfect

At this profit-maximizing level of

 So, a perfectly competitive firm should

Bushels of Corn per Year

Bushels of Corn per Year

Total Total Price: $131

$1,800 Break-Even Point

AverageAverage Average Price = Total

AverageAverage Average Price = Total

Profit Maximization Position

Profit Maximization Position

Loss Minimization Position

…but the MR = MC point

Loss Minimization Position

Short-Run Shut Down Point

Marginal Cost & Short-Run Supply

Marginal Cost & Short-Run Supply

Cost and Revenue, (dollars)

Marginal Cost & Short-Run Supply

Marginal Cost & Short-Run Supply

Higher Costs Move the

Marginal Cost & Short-Run Supply

Cost and Revenue, (dollars) Lower Costs Move MC1

Goal of the Analysis

Constant Cost Industry

Increasing Cost Industry =

Decreasing Cost Industry =

Price = MC = Minimum ATC

The Market Individual firm

Price = MC = MR = Minimum ATC

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