Perfect Competition: Maximizing Profit in a Competitive Market

1. 11 CHAPTER Perfect Competition

2. After studying this chapter you will be able to • Define perfect competition • Explain how firms make their supply decisions and why they sometimes shut down temporarily and lay off workers • Explain how price and output in an industry are determined and why firms enter and leave the industry • Predict the effects of a change in demand and of a technological advance • Explain why perfect competition is efficient

3. The Busy Bee • The busy bee pollinates plants and beekeepers rent their hives to farmers. • Across the United States from Vermont to California, a parasite is killing off bees and the rent farmers pay for hives has more than doubled. • How does competition in beekeeping and other industries affect prices and profits? • We study a fiercely competitive market in this chapter. • We explain the changes in price and output as the firms in perfect competition respond to changes in demand and technological advances.

4. What Is Perfect Competition? • Perfect competitionis an industry in which • Many firms sell identical products to many buyers. • There are no restrictions to entry into the industry. • Established firms have no advantages over new ones. • Sellers and buyers are well informed about prices.

5. What Is Perfect Competition? • How Perfect Competition Arises • Perfect competition arises: • When firm’s minimum efficient scale is small relative to market demand so there is room for many firms in the industry. • And when each firm is perceived to produce a good or service that has no unique characteristics, so consumers don’t care which firm they buy from.

6. What Is Perfect Competition? • Price Takers • In perfect competition, each firm is a price taker. • A price taker is a firm that cannot influence the price of a good or service. • No single firm can influence the price—it must “take” the equilibrium market price. • Each firm’s output is a perfect substitute for the output of the other firms, so the demand for each firm’s output is perfectly elastic.

7. What Is Perfect Competition? • Economic Profit and Revenue • The goal of each firm is to maximize economic profit, which equals total revenue minus total cost. • Total cost is the opportunity cost of production, which includes normal profit. • A firm’s total revenue equals price, P, multiplied by quantity sold, Q, or PQ. • A firm’s marginal revenue is the change in total revenue that results from a one-unit increase in the quantity sold.

8. What Is Perfect Competition? • Figure 11.1 illustrates a firm’s revenue concepts. • Part (a) shows that market demand and market supply determine the market price that the firm must take.

9. What Is Perfect Competition? • Figure 11.1(b) shows the firm’s total revenue curve (TR)—the relationship between total revenue and quantity sold.

10. What Is Perfect Competition? • Figure 11.1(c) shows the marginal revenue curve (MR). • The firm can sell any quantity it chooses at the market price, so marginal revenue equals price and the demand curve for the firm’s product is horizontal at the market price.

11. What Is Perfect Competition? • The demand for the firm’s product is perfectly elastic because one of Cindy’s sweaters is a perfect substitute for the sweater of another firm. • The market demand is not perfectly elastic because a sweater is a substitute for some other good.

12. The Firm’s Decisions in Perfect Competition • A perfectly competitive firm faces two constraints: • 1. A market constraint summarized by the market price and the firm’s revenue curves. • 2. A technology constraint summarized by firm’s product curves and cost curves (like those in Chapter 10). • The goal of the firm is to make maximum economic profit, given the constraints it faces. • So the firm must make four decisions: Two in the short run and two in the long run.

13. The Firm’s Decisions in Perfect Competition • Short-Run Decisions • In the short run, the firm must decide: • 1. Whether to produce or to shut down temporarily. • 2. If the decision is to produce, what quantity to produce. • Long-Run Decisions • In the long run, the firm must decide: • 1. Whether to increase or decrease its plant size. • 2. Whether to stay in the industry or leave it.

14. The Firm’s Decisions in Perfect Competition • Profit-Maximizing Output • A perfectly competitive firm chooses the output that maximizes its economic profit. • One way to find the profit-maximizing output is to look at the firm’s the total revenue and total cost curves. • Figure 11.2 on the next slide looks at these curves along with the firm’s total profit curve.

15. The Firm’s Decisions in Perfect Competition • Part (a) shows the total revenue, TR, curve. • Part (a) also shows the total cost curve, TC, which is like the one in Chapter 10. • Total revenue minus total cost is economic profit (or loss), shown by the curve EP in part (b).

16. The Firm’s Decisions in Perfect Competition • At low output levels, the firm incurs an economic loss—it can’t cover its fixed costs. • At intermediate output levels, the firm makes an economic profit.

17. The Firm’s Decisions in Perfect Competition • At high output levels, the firm again incurs an economic loss—now the firm faces steeply rising costs because of diminishing returns. • The firm maximizes its economic profit when it produces 9 sweaters a day.

18. The Firm’s Decisions in Perfect Competition • Marginal Analysis • The firm can use marginal analysis to determine the profit-maximizing output. • Because marginal revenue is constant and marginal cost eventually increases as output increases, profit is maximized by producing the output at which marginal revenue, MR, equals marginal cost, MC. • Figure 11.3 on the next slide shows the marginal analysis that determines the profit-maximizing output.

19. The Firm’s Decisions in Perfect Competition • If MR > MC, economic profit increases if output increases. • If MR < MC, economic profit decreases if output increases. • If MR = MC, economic profit decreases if output changes in either direction, so economic profit is maximized.

20. The Firm’s Decisions in Perfect Competition • Profits and Losses in the Short Run • Maximum profit is not always a positive economic profit. • To determine whether a firm is making an economic profit or incurring an economic loss, we compare the firm’s average total cost at the profit-maximizing output with the market price. • Figure 11.4 on the next slide shows the three possible profit outcomes.

21. The Firm’s Decisions in Perfect Competition • In part (a) price equals average total costand the firm makes zero economic profit (breaks even).

22. The Firm’s Decisions in Perfect Competition • In part (b), price exceeds average total cost and the firm makes a positive economic profit.

23. The Firm’s Decisions in Perfect Competition • In part (c) price is less than average total cost and the firm incurs an economic loss—economic profit is negative.

24. The Firm’s Decisions in Perfect Competition • The Firm’s Short-Run Supply Curve • A perfectly competitive firm’s short run supply curve shows how the firm’s profit-maximizing output varies as the market price varies, other things remaining the same. • Because the firm produces the output at which marginal cost equals marginal revenue, and because marginal revenue equals price, the firm’s supply curve is linked to its marginal cost curve. • But there is a price below which the firm produces nothing and shuts down temporarily.

25. The Firm’s Decisions in Perfect Competition • Temporary Plant Shutdown • If price is less than the minimum average variable cost, the firm shuts down temporarily and incurs an economic loss equal to total fixed cost. • This economic loss is the largest that the firm must bear. • If the firm were to produce just 1 unit of output at a price below minimum average variable cost, it would incur an additional (and avoidable) loss.

26. The Firm’s Decisions in Perfect Competition • The shutdown point is the output and price at which the firm just covers its total variable cost. • This point is where average variable cost is at its minimum. • It is also the point at which the marginal cost curve crosses the average variable cost curve. • At the shutdown point, the firm is indifferent between producing and shutting down temporarily. • It incurs a loss equal to total fixed cost from either action.

27. The Firm’s Decisions in Perfect Competition • If the price exceeds minimum average variable cost, the firm produces the quantity at which marginal cost equals price. • Price exceeds average variable cost, and the firm covers all its variable cost and at least part of its fixed cost.

28. The Firm’s Decisions in Perfect Competition • Short-Run Supply Curve • Figure 11.5 shows how the firm’s short-run supply curve is constructed. • If price equals minimum average variable cost, $17 in this example, the firm is indifferent between producing nothing and producing at the shutdown point, T.

29. The Firm’s Decisions in Perfect Competition • If the price is $25, the firm produces 9 sweaters a day, the quantity at which P = MC. • If the price is $31, the firm produces 10 sweaters a day, the quantity at which P = MC. • The blue curve in part (b) traces the firm’s short-run supply curve.

30. The Firm’s Decisions in Perfect Competition • Short-Run Industry Supply Curve • The short-run industry supply curve shows the quantity supplied by the industry at each price when the plant size of each firm and the number of firms remain constant.

31. The Firm’s Decisions in Perfect Competition • Figure 11.6 shows the supply curve for an industry that has 1,000 firms like Cindy’s. • The quantity supplied by the industry at any given price is the sum of the quantities supplied by all the firms in the industry at that price.

32. The Firm’s Decisions in Perfect Competition • At a price equal to minimum average variable cost—the shutdown price—the industry supply curve is perfectly elastic because some firms will produce the shutdown quantity and others will produces zero.

33. Output, Price, and Profit in Perfect Competition • Short-Run Equilibrium • Short-run industry supply and industry demand determine the market price and output. • Figure 11.7 shows a short-run equilibrium.

34. Output, Price, and Profit in Perfect Competition • A Change in Demand • An increase in demand bring a rightward shift of the industry demand curve: the price rises and the quantity increases. • A decrease in demand bring a leftward shift of the industry demand curve: the price falls and the quantity decreases.

35. Output, Price, and Profit in Perfect Competition • Long-Run Adjustments • In short-run equilibrium, a firm may make an economic profit, break even, or incur an economic loss. • Which of these outcomes occurs determines how the industry adjusts in the long run. • In the long run, the firm may: • Enter or exit an industry • Change its plant size

36. Output, Price, and Profit in Perfect Competition • Entry and Exit • New firms enter an industry in which existing firms make an economic profit. • Firms exit an industry in which they incur an economic loss. • Figure 11.8 on the next slide shows the effects of entry and exit.

37. Output, Price, and Profit in Perfect Competition • Effects of Entry • As new firms enter an industry, industry supply increases. • The industry supply curve shifts rightward. • The price falls, the quantity increases, and the economic profit of each firm decreases.

38. Output, Price, and Profit in Perfect Competition • The Effects of Exit • As firms exit an industry, industry supply decreases. • The industry supply curve shifts leftward. • The price rises, the quantity decreases, and the economic loss of each firm remaining in the industry decreases.

39. Output, Price, and Profit in Perfect Competition • Changes in Plant Size • A firm changes its plant size whenever doing so is profitable. • If average total cost exceeds the minimum long-run average cost, the firm changes its plant size to lower average costs and increase economic profit. • Figure 11.9 on the next slide shows the effects of changes in plant size.

40. Output, Price, and Profit in Perfect Competition • If the price is $25 a sweater, the firm is making zero economic profit with the current plant.

41. Output, Price, and Profit in Perfect Competition • But if the LRAC curve is sloping downward at the current output, the firm can increase profit by expanding the plant.

42. Output, Price, and Profit in Perfect Competition • As the plant size increases, the firm’s short-run supply increases, the average total cost falls, and its economic profit increases.

43. Output, Price, and Profit in Perfect Competition • As all firms in the industry change their plant size, industry supply increases, the market price falls, and economic profit decreases.

44. Output, Price, and Profit in Perfect Competition • Long-run equilibrium occurs when each firm is producing at minimum long-run average cost and is making zero economic profit.

45. Output, Price, and Profit in Perfect Competition • Long-Run Equilibrium • Long-run equilibrium occurs in a competitive industry when: • Economic profit is zero, so firms neither enter nor exit the industry. • Long-run average cost is at its minimum, so firms don’t change their plant size.

46. Changing Tastes and Advancing Technology • A Permanent Change in Demand • A decrease in demand shifts the market demand curve leftward. The price falls and the quantity decreases. • Figure 11.10 illustrates the effects of a permanent decrease in demand when the industry is in long-run equilibrium.

47. Changing Tastes and Advancing Technology • A decrease in demand shifts the industry demand curve leftward. The market price falls, and each firm decreases the quantity it produces.

48. Changing Tastes and Advancing Technology • The market price is now below each firm’s minimum average total cost, so firms incur economic losses.

49. Changing Tastes and Advancing Technology • Economic losses induce some firms to exit, which decreases the industry supply and the price starts to rise.

50. Changing Tastes and Advancing Technology • As the price rises, the quantity produced by the industry continues to decrease as more firms exit, but each firm remaining in the industry starts to increase its quantity.