Econ101 Notes 2

ECON101: Introductory
Microeconomics
Topic 6
Perfect Competition
Essential reading:
Hubbard et al. (2017), Microeconomics, 4th edition,
Pearson Education Australia,
Chapter 8
ECON101: Introductory
Microeconomics
These powerpoint slides are a modified version
of the slides that form part of the teaching
resources provided by Pearson Australia with
the text book
Copyright ©2018 Pearson Australia (a division

of Pearson Australia Group Pty Ltd) –
9781488612497/Hubbard/Microeconomics/4th
edition
Chapter 8
Firms in perfectly
competitive markets
Learning objectives
1. Explain what a perfectly competitive market is and why a perfect

competitor faces a horizontal demand curve.
2. Explain how a firm maximises profits in a perfectly competitive

market.
3. Use graphs to show a firm’s profit or loss.
4. Explain why firms may shut down temporarily.
5. Explain how entry and exit ensure that perfectly competitive firms
earn zero economic profit in the long run.
6. Explain how perfect competition leads to economic efficiency.
4 Copyright ©2018 Pearson Australia (a division of Pearson Australia Group Pty Ltd)–9781488612497/Hubbard/Microeconomics/4e
How uber brought competition to the taxi industry
 Since the arrival of app-based ride sharing,
the passenger car transport industry is an
example of an industry that is close to being
perfectly competitive.
 Firms in perfectly competitive industries are

unable to control the prices of the products
they sell and are unable to earn an
economic profit in the long run.
 There are two main reasons for this result:
• firms in these industries sell identical

products, and
• it is easy for new firms to enter these

industries.
Market structures
Economists group industries into four market structures:
 Perfect competition Assumed in

this topic
 Monopolistic competition
 Oligopoly
 Monopoly
The four market structures: Table 8.1
Characteristic Perfect
Competition
Number of Many
firms
Type of product Identical
Ease of entry High
Examples of Apples
industries Wheat
7
Characteristic Perfect Monopolistic

Competition Competition
Number of Many Many

firms
Type of Identical Differentiated

product
Ease of entry High High
Examples of Apples Clothing Stores

industries Wheat Restaurants
8
Characteristic Perfect Monopolistic Oligopoly

Competition Competition
Number of Many Many Few

firms
Type of product Identical Differentiated Identical or

differentiated
Ease of entry High High Low
Examples of Apples Clothing Stores Banking

industries Wheat Restaurants Supermarkets
9
Characteristic Perfect Monopolistic Oligopoly Monopoly

competition competition
Number of Many Many Few One

firms
Type of product Identical Differentiated Identical or Unique

differentiated
Ease of entry High High Low Entry blocked
Examples of Apples Clothing Stores Banking Letter delivery

industries Wheat Restaurants Supermarkets Tap water
10
Market structures
The decision about which industry belongs to which market

structure depends on three key characteristics:
 The number of firms in the industry.
 The similarity of the good or service produced by the firms in the

industry.
 The ease with which new firms can enter the industry.
Perfectly competitive markets
The conditions that make a market perfectly competitive are:
 There are many buyers and sellers, all of whom are small relative to
the market.
 All firms sell identical products.
 There are no barriers to new firms entering the market or to existing

firms leaving the market.
Perfectly competitive
markets (Cont’d)
A perfectly competitive firm cannot affect the market price
 It is termed a price taker: A buyer or seller that is unable to affect

the market price.
 The demand curve for a price taker is horizontal, or perfectly elastic.
A perfectly competitive firm faces a perfectly
elastic demand curve: Figure 8.1
Price of oats
(dollars per
bushel)
$4 Demand
0 3000 Quantity of oats

7500
(bushels per year)
Market demand and individual firm demand:
Figure 8.2
Price of oats 1. The intersection of market Price of oats (dollars per
(dollars per supply and market demand bushel)
bushel) determines the equilibrium price 2. …which must be accepted
of oats... by Farmer Jones and every
other seller of oats.
Supply of oats
Demand for
Farmer Jones’
oats
$4 $4
Demand for oats

0 7500
0
80 000 000 Quantity of oats (bushels per year)
Quantity of oats (bushels per year)
(b) Demand for an individual
(a) Market for oats farmer’s oats
How a firm maximises profit in a
perfectly competitive market
Profit: Total revenue (TR) minus total cost (TC).
Profit = TR - TC
perfectly competitive market (Cont’d)
Revenue for a firm in a perfectly competitive market
Average revenue (AR): Total revenue divided by the number of units

sold.
TR P Q
AR  so, AR  P
Q Q
Marginal revenue (MR): Change in total revenue from selling one
more unit.
Change in total revenue ΔTR

Marginal Revenue  or, MR 
Change in quantity ΔQ
Farmer Jones’ revenue from oats farming: Table
8.2
Number of Market price per Total revenue Average Marginal

bushels (Q) bushel (P) (TR) revenue (AR) revenue (MR)
0 $4 $0 - -
1 4 4 $4 $4
2 4 8 4 4
3 4 12 4 4
4 4 16 4 4
5 4 20 4 4
6 4 24 4 4
7 4 28 4 4
8 4 32 4 4
9 4 36 4 4
10 4 40 4 4
Determining the profit-maximising level of output
Since producers in a perfectly competitive market can sell as much

produce as they wish to at the same constant price:
 Average revenue (AR) = Marginal revenue (MR)
 Price = AR = MR
 The profit-maximising level of output is where the difference
between total revenue and total cost is the greatest.
 The profit-maximising level of output is also where marginal

revenue equals marginal cost, or MR=MC.
Farmer Jones’ profits from oats farming: Table 8.3
Quantity Total revenue Total cost Profit Marginal Marginal

(bushels)(Q) (TR) (TC) (TR – TC) revenue (MR) cost (MC)
0 $0 $1.00 - $1.00 - -
1 4.00 4.00 0.00 $4.00 $3.00
2 8.00 6.00 2.00 4.00 2.00
3 12.00 7.50 4.50 4.00 1.50
4 16.00 9.50 6.50 4.00. 2.00
5 20.00 12.00 8.00 4.00 2.50
6 24.00 15.00 9.00 4.00 3.00
7 28.00 19.50 8.50 4.00 4.50
8 32.00 25.50 6.50 4.00 6.00
9 36.00 32.50 3.50 4.00 7.00
10 40.00 40.50 - 0.50 4.00 8.00
The profit-maximising level of output: Figure 8.3
Figure 8.3: The profit-maximising level of output.

• In panel (a) Farmer Jones maximises his profit where the vertical
distance between total revenue and total cost is the largest. This
happens at an output of six bushels. Panel (b) shows that Farmer
Jones’ marginal revenue (MR) is equal to a constant $4 per bushel.
Farmer Jones maximises profits by producing oats up to the point
where the marginal revenue of the last bushel produced is equal to
its marginal cost, or MR = MC. In this case, at no level of output
does marginal revenue exactly equal marginal cost. The closest
Farmer Jones can come is to produce six bushels of oats. He will
not want to continue to produce once marginal cost is greater than
marginal revenue because this will reduce his profits. Panels (a)
and (b) show alternative ways of thinking about how Farmer Jones
can determine the profit-maximising quantity of oats to produce.
Illustrating profit or loss on the
cost curve graph
 We have seen that profit is the difference between total revenue
and total cost. Profit can also be expressed in terms of average total
cost (ATC). This allows us to show profit on the cost curve graph.
 As profit is equal to total revenue minus total cost (TC) and total
revenue is price multiplied by quantity, we can write the following:
Profit = (P x Q)  TC
 If we divide both sides of this equation by Q we have:
Profit (P  Q) TC Profit
  OR  P  ATC
Q Q Q Q
cost curve graph (Cont’d)
(cont’d)
 This equation tells us that profit per unit (or average profit) equals
price minus average total cost. Finally, we obtain the equation for
the relationship between total profit and average total cost by
multiplying through again by Q :
Profit = (P – ATC ) × Q
 This equation tells us that a firm’s total profit is equal to the
quantity produced multiplied by the difference between price and
average total cost.
The area of maximum profit: Figure 8.4
Price and
cost
(dollars
per MC
bushel) Total profit = ATC
(P – ATC) x
Q
Market Demand
P
price = MR
Profit per unit

of output (P –
ATC)
0 Quantity
Q
Profit-maximising level of
25
output
Illustrating when a firm is operating at a profit, breaking even

or operating at a loss
 If P > ATC; the firm makes a profit.
 If P = ATC; the firm breaks even (its per unit cost equals per unit
revenue; thus, the firm’s total cost equals its total revenue).
 If P < ATC; the firm experiences losses.
A firm breaking even: Figure 8.5(a)
Price and cost
MC
ATC
Break-even
point
P Demand =
marginal
revenue
0 Q Quantity
Profit-maximising level
of output
A firm experiencing losses: Figure 8.5(b)
Price and cost

MC
ATC
Losses
ATC
Demand =
P
marginal
revenue
0 Q Quantity
Loss minimising level
of output
Solved Problem 1
Determining profit-maximising price
and quantity
Suppose that Diane sells candles in the perfectly competitive candle

market. Her output per day and her costs are as follows:
Solved Problem 1
and quantity
1. If the current equilibrium price in the candle market is $12.50, to

maximise profit how many candles will Diane produce, what price
will she charge, and how much profit (or loss) will she make? Draw
a graph to illustrate your answer. Your graph should be labelled
clearly and should include Diane’s demand, ATC, AVC, MC and MR
curves, the price she is charging, the quantity she is producing,
and the area representing her profit (or loss).
2. Suppose the equilibrium price of candles falls to $5. Now how

many candles will Diane produce, what price will she charge and
how much profit (or loss) will she will make? Draw a graph to
illustrate the situation, using the instructions in Question 1.
Solved Problem 1
and quantity
STEP 1: Review the chapter material. The problem is about using

cost curve graphs to analyse perfectly competitive firms, so
you may want to review the section in the textbook,
‘Illustrating profit or loss on the cost curve graph’.
STEP 2: Calculate Diane’s marginal cost, average total cost and

average variable cost.
To maximise profit, Diane will produce the level of output
where MR is equal to MC. We can calculate MC from the
information given in the table. We can also calculate ATC and
AVC to draw the required graph.
ATC=TC/Q, AVC=VC/Q, VC=TC-FC.
Solved Problem 1
and quantity
When output is equal to zero, TC=FC. In this case fixed cost is

equals $10.00.
Solved Problem 1
and quantity
STEP 3: Use the information from the table in Step 2 to calculate how
many candles Diane will produce, what price she will charge
and how much profit she will earn if the market price of
candles is $12.50.
Diane’s MR=P=$12.50. MR=MC when Diane produces 6
candles per day. So Diane will produce 6 candles per day and
charge a price of $12.50 per candle. Diane’s profit is equal to
TR-TC. TR equals to the 6 candles she sells multiplied by
$12.50 price or $75.00. So her Profit equals to $75.00 -
$52.50 = $22.50.
STEP 4: Use the information from the table in Step 2 to illustrate your
answer to question 1 with a graph.
Solved Problem 1
and quantity
Solved Problem 1
and quantity
STEP 5: Calculate how many candles Diane will produce, what price
she will charge and how much profit she will earn when the
market price of candles is $5.00.
Referring to the table in Step 2, we can see that MR=MC

when Diane produces three candles per day. She charges the
market price of $5.00 per candle. Her TR=$5.00x 3 =
$15.00, while her TC= $22.50, so she will have a loss of
$7.50.
Solved Problem 1
and quantity
STEP 6: Illustrate your answer to question 2 with a graph.
Deciding whether to produce or to
shut down in the short run
 In the short run, a firm suffering losses has two choices:

1. continue to produce
2. stop production by shutting down temporarily.
Note that fixed costs are assumed to be sunk costs, costs that have
already been paid and cannot be recovered, and are not relevant
to this decision
shut down in the short run (Cont’d)
The supply curve of a firm in the short run
 For any given price, the marginal cost curve shows the quantity of
output that a firm will supply.
 Therefore, the perfectly competitive firm’s marginal cost curve is

also its supply curve—but only for prices at or above average
variable cost.
The supply curve of a firm in the short run (cont’d)
 Even if a firm suffers losses, it should continue to operate as long

as P > AVC.
 Shutdown point: The minimum point on a firm’s average variable

cost curve; if the price falls below this point, the firm shuts down
production in the short run.
– Shutdown point: P < AVC
The firm’s short-run supply curve: Figure 8.6
Price and The supply curve for the

cost firm in the short run
MC
ATC
AVC
The minimum
price at which
the firm will
continue to
produce
PMIN
Shutdown point
0 Quantity
QSD
The market supply curve in a perfectly competitive industry
 The market supply curve is derived from individual firms’ marginal

cost curves.
 This horizontal summation of MC curves is shown on the next slide
Firm supply and market supply: Figure 8.7
Price (dollars
Price (dollars One oats farmer Oats market
per bushel)
per bushel)
MC Supply
$4 $4
0 0 80 000 000
8000 Quantity (bushels)
Quantity (bushels)
(a) Individual firm supply (b) Market supply
Losing money in the solar panel industry
Making the Connection 8.1
 By the mid 2000s, high oil prices and concern over the pollution
caused by burning fossil fuels led more people to become interested
in solar energy.
 Technological advances reduced the cost of solar photovoltaic (PV)
cells used in solar panels. In addition, Australian households
installing a solar energy system for many years received various
subsidies from federal and state governments towards the cost of
the system. This occurred in many countries throughout the world,
including the United States and countries in the European Union.
Losing money in the solar panel industry (Cont’d)
Making the Connection 8.1 (cont’d)
 For several years, falling production costs and increased demand

led entrepreneurs in a number of countries to start manufacturing
solar panels. Tindo Solar is a major PV manufacturer in Australia,
with demand for panels also being met by imports from
manufacturers in the United States and Germany.
 However, between 2009 and 2011, Chinese firms quadrupled
production, and now have the largest share of the market in
Australia and in Europe, driving prices of PV panels down by an
estimated 45 percent.
 In the following figure: Panel (a) shows the fall in the industry price
of solar panels.
 Panel (b) shows the situation some firms producing solar panels
faced, with the international price below their average total cost of
producing solar panels, leading to these firms suffering losses.
 In the US, Europe, India and Japan, firms argued that Chinese firms
were able to sell at low prices because they were receiving
subsidies from the Chinese government, which is not allowed under
international trade agreements (selling below cost is referred to as
‘dumping’).
 In response, United States imposed large tariffs (taxes) on imports

of Chinese solar panels and then, after initially using tariffs, moved
to set a minimum price (price floor).
 In Australia, in 2015, the use of tariffs was rejected by the

Australian Anti-Dumping Commission, who argued that even after
accounting for the dumping price margin, that the local firm would
still not be able to reduce its selling price to match cheaper Chinese
PV panels.
 Some international firms also oppose the use of tariffs because they
use solar panels in the products they export, which means tariffs
would raise their production costs.
‘If everyone can do it, you can’t
make money at it’—The entry and
exit of firms in the long run
Economic profit and the entry or exit decision
 Economic profit: A firm’s revenues minus all its costs—implicit and

explicit.
 Economic profit in a perfectly competitive industry is only a short-

run occurrence.
 Economic profit leads to the entry of new firms into the industry.
Anne Moreno’s costs per year : Table 8.4
The effect of entry on economic profits: Figure 8.8
The entry and exit of firms in
the long run
Economic profit and the entry or exit decision (cont’d)
 Economic loss: The situation in which a firm’s total revenue is less

than its total cost, including all implicit costs.
 Economic loss in a perfectly competitive industry is only a short-run

occurrence.
 Economic loss leads to the exit of some firms from the industry.
‘If everyone can do it, you can’t
make money at it’—The entry and
exit of firms in the long run
 In panel (a) Farmer Jones maximises his profit where the vertical
distance between total revenue and total cost is the largest. This
happens at an output of six bushels. Panel (b) shows that Farmer
Jones’ marginal revenue (MR) is equal to a constant $4 per bushel.
Farmer Jones maximises profits by producing oats up to the point
where the marginal revenue of the last bushel produced is equal to
its marginal cost, or MR = MC. In this case, at no level of output
does marginal revenue exactly equal marginal cost. The closest
Farmer Jones can come is to produce six bushels of oats. He will not
want to continue to produce once marginal cost is greater than
marginal revenue because this will reduce his profits. Panels (a) and
(b) show alternative ways of thinking about how Farmer Jones can
determine the profit-maximising quantity of oats to produce.
The effect of exit on economic losses: Figure 8.9,
panels (a) and (b)
The effect of exit on economic losses: Figure 8.9,
panels (c) and (d)
the long run
Long-run equilibrium in a perfectly competitive market
 Long-run competitive equilibrium: The situation in which the

entry and exit of firms has resulted in the typical firm breaking even.
The long-run equilibrium market price is at the minimum point on
the typical firm’s average cost curve.
 Long-run supply curve: A curve showing the relationship in the

long run between market price and the quantity supplied.
The long-run supply curve will be horizontal at the market price.
 In the long run, a perfectly competitive market will supply whatever

amount of a good consumers demand at a price determined by the
minimum point on the typical firm’s average cost curve.
The long-run supply curve in a perfectly
competitive industry: Figure 8.10
the long run (Cont’d)
We can distinguish between constant-cost, increasing-cost and

decreasing-cost industries
 Constant-cost industry: An industry in which a firm’s average costs

do not change as the industry expands (horizontal long-run supply
curve).
 Increasing-cost industry: An industry in which a firm’s average costs

rise as the industry expands (upward-sloping long-run supply
curve).
 Decreasing-cost industry: An industry in which a firm’s average

costs fall as the industry expands (downward-sloping long-run
supply curve).
In the App Store, easy entry makes the long run
pretty short
Making the Connection 8.2
 One reason for the popularity of Apple’s iPhones and iPads is the
section of Apple’s iTunes music and video store devoted to
applications (or ‘apps’). Independent software programmers write
apps that Apple makes available in the store in exchange for
receiving 30 per cent of the revenue the app generates.
 At first, app developers were able to earn significant amounts by

charging for downloads. For example, Hogrocket, developed the
game Tiny Invaders and began selling it in the App Store in 2011.
Initially, the company was successful in selling the app for $2.99.
By 2015, about 750 new games were being added to the App Store
per day by other firms. This flood of games forced Hogrocket to
lower the price of its game to $0.99. At that price, though, the
company was unable to sell enough downloads to break even, and
the firm had to shut down.
pretty short (Cont’d)

 The competition in the App Store was so intense that by 2015 many
people were unwilling to download games unless they were free.
Some app designers have tried the strategy of allowing apps to be
downloaded for free while attempting to earn revenue by forcing
users to see advertisements before the app opens or while it runs.
 Many people find these advertisements annoying, though, so

developers have begun offering free apps that lack advertisements
but where the developers earn revenue from users making in-app
purchases.
 Still, only about 3 per cent of people who play these games make
any in-app purchases. That leaves developers dependent on ‘whales’
who make $50 to $100 per month in in-app game purchases. Only
the best games can attract whale players and survive the intense
60
competition.
Copyright ©2018 Pearson Australia (a division of Pearson Australia Group Pty Ltd)–9781488612497/Hubbard/Microeconomics/4e
pretty short (Cont’d)
 The competition in the App Store got so intense that by 2015 many
people were unwilling to download games unless they were free.
Even these games have to constantly add new features if they hope
to keep users from switching to playing newly released games.
 Yet the incentive to develop new games remains substantial, with

players of app games spending nearly US$35 billion worldwide in
2015. In fact, games account for 85% of total app expenditure.
 In a competitive market, earning an economic profit in the long run

is extremely difficult. And the ease of entering the market for
smartphone and tablet apps has made the long run pretty short.
Perfect competition and
efficiency
 Productive efficiency: When a good or service is produced using

the least amount of resources.
 Allocative efficiency: When production reflects consumer

preferences; in particular, every good or service is produced up to
the point where the last unit provides a marginal benefit to
consumers equal to the marginal cost of producing it.
efficiency (Cont’d)
Allocative efficiency
Firms will supply all those goods that provide consumers with a
marginal benefit at least as great as the marginal cost of producing
them.
 The price of a good represents the marginal benefit consumers
receive from the last unit of the good consumed.
 Perfectly competitive firms produce up to the point where the price
of the good equals the marginal cost of producing the last unit.
 Therefore, firms produce up to the point where the last unit provides
a marginal benefit to consumers equal to the marginal cost of
producing it.
efficiency (Cont’d)
Dynamic efficiency: Occurs when new technologies and innovation are

adopted over time, and when firms adapt their product to changes in
consumer preferences and tastes.
 When striving for dynamic efficiency, firms will use new technology
and thereby reduce production costs (productive efficiency).
 By adapting their product to changes in consumer preferences, firms

will produce goods and services consumers value the most (allocative
efficiency).
An inside look
Why the sharing economy could have a hard landing in
Australia
Figure 1: The short-run effects of an increase in demand for Uber

ride-sharing trips.
An inside look (Cont’d)
Why the sharing economy could have a hard landing in
Australia
Figure 2: The long-run effect of an increase in demand for Uber

ride-sharing trips.
Key terms
Allocative efficiency Marginal revenue (MR)

Average revenue (AR) Perfectly competitive market
Dynamic efficiency Price taker
Economic loss Productive efficiency
Economic profit Profit
Long-run competitive Shutdown point
equilibrium Sunk cost
Long-run supply curve

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ECON101: Introductory

Copyright ©2018 Pearson Australia (a division

1. Explain what a perfectly competitive market is and why a perfect

2. Explain how a firm maximises profits in a perfectly competitive

3. Use graphs to show a firm’s profit or loss.

4. Explain why firms may shut down temporarily.

6. Explain how perfect competition leads to economic efficiency.

 Firms in perfectly competitive industries are

 There are two main reasons for this result:

• firms in these industries sell identical

• it is easy for new firms to enter these

Economists group industries into four market structures:

 Perfect competition Assumed in

Type of product Identical

Ease of entry High

Characteristic Perfect Monopolistic

Number of Many Many

Type of Identical Differentiated

Ease of entry High High

Examples of Apples Clothing Stores

Characteristic Perfect Monopolistic Oligopoly

Number of Many Many Few

Type of product Identical Differentiated Identical or

Ease of entry High High Low

Examples of Apples Clothing Stores Banking

Characteristic Perfect Monopolistic Oligopoly Monopoly

Number of Many Many Few One

Type of product Identical Differentiated Identical or Unique

Ease of entry High High Low Entry blocked

Examples of Apples Clothing Stores Banking Letter delivery

The decision about which industry belongs to which market

 The number of firms in the industry.

 The similarity of the good or service produced by the firms in the

The conditions that make a market perfectly competitive are:

 All firms sell identical products.

 There are no barriers to new firms entering the market or to existing

A perfectly competitive firm cannot affect the market price

 It is termed a price taker: A buyer or seller that is unable to affect

 The demand curve for a price taker is horizontal, or perfectly elastic.

0 3000 Quantity of oats

Demand for oats

Profit: Total revenue (TR) minus total cost (TC).

Revenue for a firm in a perfectly competitive market

Average revenue (AR): Total revenue divided by the number of units

Change in total revenue ΔTR

Number of Market price per Total revenue Average Marginal

Determining the profit-maximising level of output

Since producers in a perfectly competitive market can sell as much

 The profit-maximising level of output is also where marginal

Quantity Total revenue Total cost Profit Marginal Marginal

Figure 8.3: The profit-maximising level of output.

 If we divide both sides of this equation by Q we have:

Profit per unit

Illustrating when a firm is operating at a profit, breaking even

 If P > ATC; the firm makes a profit.

 If P < ATC; the firm experiences losses.

Price and cost

Price and cost