Perfect Competition

Terminology • An industry consists of all firms that supply output to a particular market, interchangeable with market • Many of the firm’s decisions depend on the structure of the market in which it operates • Market structure describes the important features of a market

Market Structure • Aspects of market structure • Number of suppliers • Many or few • Product’s degree of uniformity • Do firms in the market supply identical products or are there differences across firms? • The ease of entry into the market • Can new firms enter easily or are they blocked by natural or artificial barriers? • Forms of competition among firms • Do firms compete only through prices or are advertising and product differences common as well?

Perfectly Competitive Market Structure • Characteristics of perfect competition • Many buyers and sellers  so many that each buys and sells only a tiny fraction of the total amount exchanged in the market • Firms sell a standardized or homogeneous product • Buyers and sellers are fully informed about the price and availability of all resources and products • Firms and resources are freely mobile  over time they can easily enter or leave the industry

Perfect Competition • If these conditions are present in a market, individual participants have no control over the price • Price is determined by market supply and demand  the perfectly competitive firm is a price taker  it must “take” or accept, the market price • Once the market establishes the price, each firm is free to produce whatever quantity maximizes profit

Perfect Competition • The model of perfect competition allows us to make a number of predictions that hold up when compared with the real world • It provides us with an important benchmark for evaluating the efficiency of other types of markets

Demand Under Perfect Competition • Suppose the market in question is the world market for wheat and the firm in question is a wheat firm

Demand • Each firm is so small relative to the market that each has no impact on the market price  each farmer is a price taker • Because all farmers produce an identical product, anyone who charges more than the market price will sell no wheat • No farmer would sell at a lower price because they can sell all they want at the higher price

Demand • The demand curve facing an individual farmer is therefore a horizontal line drawn at the market price • Ironically, two neighboring wheat farmers in perfect competition are not really rivals  they both can sell as much wheat as they want to at the market price because the amount one sells has no effect on the market price or the amount the other can sell

Short-Run Profit Maximization • How does the perfectly competitive firm maximize profit? • The perfectly competitive firm has no control over price, however, what the firm does control is the amount produced – the rate of output  the question facing the wheat farmer is How much should I produce to earn the most profit?

Total Revenue Minus Total Cost • The firm maximizes economic profit by finding the rate of output at which total revenue exceeds total cost by the greatest amount • Total revenue is simply output times the price per unit

Marginal Revenue Equals Marginal Cost Approach • Another way to find the profit-maximizing rate of output is to focus on marginal revenue and marginal cost • Marginal revenue, MR, is the change in total revenue from selling another unit of output • Since the firm in perfect competition is a price taker, marginal revenue from selling one more unit is the market price  MR = P

Marginal Revenue Equals Marginal Cost Approach • Marginal cost is the change in total cost resulting from producing another unit of output

Marginal Revenue Equals Marginal Cost Approach • Golden rule of profit maximization: Generally, a firm will expand output as long as marginal revenue exceeds marginal cost and will stop expanding output before marginal cost exceeds marginal revenue

Economic Profit in the Short Run • Because the perfectly competitive firm can sell any quantity for the same price per unit, marginal revenue is also average revenue • Average revenue, AR, equals total revenue divided by quantity  AR = TR / q • Regardless of the rate of output, the following equality holds along the firm’s demand curve • Market price = marginal revenue = average revenue

Minimizing Short-Run Losses • Sometimes the price that the firm is required to “take” will be so low that no rate of output will yield an economic profit • Faced with losses at all rates of output, the firm has two options • It can continue to produce at a loss, or • Temporarily shut down • It cannot shut down in the short run because by definition the short run is a period too short to allow existing firms to leave or new firms to enter

Fixed Cost and Minimizing Losses • The firm has two types of costs in the short run • Fixed cost • Variable cost • A firm that shuts down in the short run must still pay its fixed costs • But, by producing, a firm’s revenue may more than cover variable cost  a firm will produce if the revenue thus generated exceeds the variable cost of production  can cover a least a portion of its fixed cost

Shutting Down in the Short Run • As long as the loss that results from producing is less than the shutdown loss, the firm will remain open for business in the short run • However, if the average variable cost of production exceeds the price of all rates of output, the firm will shut down • A re-examination of Exhibit 4 indicates that if the price of wheat were to fall to $2 per bushel, average variable cost exceeds $2 at all rates of output

Shutting Down in the Short Run • Note that shutting down is not the same as going out of business • In the short run, even a firm that shuts down keeps its productive capacity intact  that when demand increases enough, the firm will resume operation • If market conditions look grim and are not expected to increase, the firm may decide to leave the market  a long run decision

Firm and Industry Short-Run Supply Curves • If the price exceeds average variable cost, the firm will produce the quantity where marginal revenue equals marginal cost • Further, the firm will vary output as the market price changes

Short-Run Firm Supply Curve • As long as the price covers average variable cost, the firm will supply the quantity resulting from the intersection of its upward-sloping marginal cost curve and its marginal revenue, or demand curve • Thus, that portion of the firm’s marginal cost curve that intersects and rises above the lowest point on its average variable cost curve becomes the short-run firm supply curve

Summary • A perfectly competitive firm selects the short-run output rate that maximizes profit or minimizes loss • When confronting a loss, a firm either produces an output that minimizes that loss or shuts down temporarily • Given the conditions for perfect competition, the market will converge toward the equilibrium price and quantity

Perfect Competition in Long Run • In the short run, the quantity of variable resources can change, but other resources, which generally determine firm size, are fixed • However, in the long run, firms have time to enter and exit and to adjust their size  adjust the scale of their operations  there is no distinction between fixed and variable cost because all resources under the firm’s control are variable

Perfect Competition in Long Run • Short-run economic profit will in the long run encourage new firms to enter the market and may prompt existing firms to expand the scale of their operations • Economic profit will attract resources from industries where firms earn only normal profit or suffer losses

Perfect Competition in Long Run • The expansion in the number and size of firms will shift the industry supply curve rightward in the long run, driving down the price • New firms will continue to enter a profitable industry and existing firms will continue to increase in size as long as economic profit is greater than zero

Perfect Competition in Long Run • Conversely, a short-run loss will, in the long run, force some firms to leave the industry or to reduce the scale of operation • In the long run, departures and reductions in scale shift market supply to the left  market price increases until the remaining firms just earn a normal profit

Long-Run Adjustment to a Change in Demand • To explore the long-run adjustment process, let’s consider how a firm and an industry respond to an change in market demand • Further, suppose that the costs facing each individual firm do not depend on the number of firms in the industry

Long-Run Industry Supply Curve • Connecting these long-run equilibrium points yields the long-run industry supply curve, labeled S* in both of these Exhibits • The long-run industry supply curve shows the relationship between price and quantity supplied once firms fully adjust to any short-term economic profit or loss resulting from a shift in demand

Constant-Cost Industry • The industry we have studied thus far is called a constant cost industry because each firm’s long-run average cost curve does not shift as industry output expands • Resource prices and other production costs remain constant in the long run as industry output increases or decreases

Constant-Cost Industry • In a constant-cost industry, each firm’s per-unit production costs are independent of the number of firms in the industry  the firm’s long-run average cost curve remains constant in the long run as firms enter or leave the industry • The industry uses such a small portion of the resources available that increasing industry output does not bid up resource prices • The long-run supply curve for a constant-cost industry is horizontal

Increasing-Cost Industry • Firms in some industries encounter higher average costs as industry output expands in the long run • Firms in these increasing-cost industries find that expanding output bids up the prices of some resources or otherwise increases per-unit production costs  each firm’s cost curves shift upward

Summary • In constant-cost industries, each firm’s costs depend simply on the scale of its plant and its rate of output • For firms in increasing-cost industries, costs depend also on the number of firms in the market • By bidding up the price of resources, long-run expansion in an increasing-cost industry increases each firm’s marginal and average costs

Perfect Competition and Efficiency • How does perfect competition stack up as an efficient allocator of resources? • There are two concepts of efficiency used to judge market performance • Productive efficiency refers to producing output at the least possible cost • Allocative efficiency refers to producing the output that consumers value the most • Perfect competition guarantees both allocative and productive efficiency in the long run

Productive Efficiency • Productive efficiency occurs when the firm produces at the minimum point on its long-run average-cost curve  the market price equals the minimum average total cost • The entry and exit of firms and any adjustment in the scale of each firm ensure that each firm produces at the minimum point on its long-run average cost curve

Productive Efficiency • Firms that do not reach minimum long-run average cost curve must, to avoid continued losses, either adjust their size or leave the industry • Thus, perfect competition produces output at the least possible cost per unit in the long run

Allocative Efficiency • Just because production occurs at the least possible cost does not mean that the allocation of resources is the most efficient one possible • The goods being produced may not be the ones consumers most prefer  they may be producing the wrong goods efficiently from the perspective of minimum costs

Allocative Efficiency • Allocative efficiency occurs when firms produce the output that is most valued by consumers • How do we know that perfect competition guarantees allocative efficiency? • The answer lies with the market supply and demand curves

Allocative Efficiency • The demand curve reflects the marginal value that consumers attach to each unit  the market price is the amount of money that people are willing and able to pay for the final unit they consume • We also know that, in both the short run and the long run, the equilibrium price in perfect competition equals the marginal cost of supplying the last unit sold

Allocative Efficiency • Marginal cost measures the opportunity cost of all resources employed by the firm to produce the last unit sold  the supply and demand curves intersect at the combination of price and quantity at which the marginal value, or the marginal benefit that consumers attach to the final unit purchased, just equals the opportunity cost of the resources employed to produce that unit  there is no way to reallocate resources to increase the total utility consumers reap from production

What’s So Perfect About Perfect Competition • This should not be taken to mean that market exchange confers no net benefits to participants • Market exchange benefits both consumers and producers • Recall that consumers garner a surplus from market exchange because the maximum amount they would be willing to pay for each unit of the good exceeds the amount they in fact pay

Producer Surplus • Producer surplus is not the same as economic profit • Any price that exceeds average variable cost will result in a short-run producer surplus, even though that price could result in a short-run economic loss • The definition of producer surplus ignores fixed cost, because fixed cost is irrelevant to the firm’s short-run production decision

Perfect Competition