7 PERFECT COMPETITION
Outline
v Definition of perfect competition
v A firm's short run decision and supply curve
v A firm's long run decision and supply curve
What Is Perfect Competition?
Perfect competition is a market in which
v Many firms sell identical products to many buyers.
v Sellers and buyers are price takers.
v Free entry/exit into the industry.
Price takers
In perfect competition, each firm’s output is a perfect
substitute for the output of the other firms, so
v the demand for each firm’s output is perfectly elastic
v each firm is a price taker.
If a firm is a price taker, then it cannot influence the price
of a good or service. Instead, it must “take” the equilibrium
market price.
.
Firm’s Revenue in A Perfect Competitive Market
Example 1
Part (a) shows that market demand and market supply determine
the market price that the firm must take.
Example 1
With the market price of $25 a sweater, the firm sells 9 sweater and
makes total revenue of $225.
Figure 12.1(b) shows the firm’s total revenue curve (TR).
Example 1
The firm can sell any quantity it chooses at the market price,
so marginal revenue equals the market price of $25.
Marginal Revenue vs. Demand curve
Figure 12.1(c) shows the marginal revenue curve (MR), which
coincides with the demand curve for the firm’s product.
Demand for a firm's product vs. Market demand
v The demand for a firm’s product is perfectly elastic
because one firm’s sweater is a perfect substitute for
the sweater of another firm.
v But the market demand is not perfectly elastic because
a sweater is a substitute for some other good.
Firm's decisions
A perfectly competitive firm’s goal is to make maximum economic
profit, given the constraints it faces.
So the firm must decide:
1. Whether to enter or exit a market
2. If enters, what production scale should be chosen
3. After choosing production scale, what quantity to produce
We start by looking at the firm’s output decision.
Firm’s Output
Decision
The Firm’s Output Decision
v A perfectly competitive firm chooses the output that
maximizes its economic profit.
v One way to find the profit-maximizing output is to look at the
firm’s total revenue and total cost curves.
Figures on the next slide look at these curves along with the
firm’s total profit curve.
TR & TC
Part (a) shows the total
revenue, TR, curve and the
total cost curve, TC.
Total revenue minus total
cost is economic profit (or
loss), shown by the curve EP
in part (b).
Firm's choice of output level
v At low output levels, the
firm incurs an economic
loss—it can’t cover its costs.
v At intermediate output
levels, the firm makes an
economic profit.
v At high output levels, the
firm again incurs an
economic loss—now the
firm faces steeply rising
costs because of diminishing
returns.
Firm's choice of output level
The firm maximizes its
economic profit when it
produces 9 sweaters a
day.
Marginal analysis and supply decision
The firm can use marginal analysis to determine the
profit-maximizing output.
Ø MC=MR
Figure on the next slide shows the marginal analysis that
determines the profit-maximizing output.
Marginal analysis and supply decision
v If MR > MC, economic
profit increases if output
increases.
v If MR < MC, economic
profit decreases if output
increases.
v If MR = MC, economic
profit decreases if output
changes in either
direction, so economic
profit is maximized.
Production decision
In the Short-run:
Shutdown or Not?
Short-run decision: Shutdown or not?
Temporary Shutdown VS. Permanent Exit
Ø A shutdown refers to a short-run decision not to produce
anything during a specific period of time because of current
market conditions.
Ø Exit refers to a long-run decision to leave the market.
Shutdown Decision
Shutdown point
v A firm’s shutdown point is at minimum AVC.
v This point is the same point at which the MC curve crosses
the AVC curve.
v At the shutdown point, the firm is indifferent between
producing and shutting down temporarily.
v At the shutdown point, the firm incurs a loss equal to total
fixed cost (TFC).
Example
The figure shows the
shutdown point.
Minimum AVC is $17 a
sweater.
At $17 a sweater, the profit-
maximizing output is 7
sweaters a day.
The firm incurs a loss equal
to the red rectangle.
Example
If the price of a sweater is between $17 and $20.14, …
v the firm produces the quantity at which marginal cost equals
price.
v The firm covers all its variable cost and some
of its fixed cost.
v It incurs a loss that is less than TFC.
Output, Price, and Profit in the Short Run
(a) price equals ATC: zero economic profit (break even).
–
(b) price exceeds ATC: positive economic profit.
–
(c) price is less than ATC: economic loss—economic profit is negative.
–
Profit and Supply in the Short Run
Profits and Losses in the Short Run
v Maximum profit is not always a positive economic profit.
v To see if a firm is making a profit or incurring a loss, compare
the firm’s ATC at the profit-maximizing output with the
market price.
In the Long-run:
Entry or Not?
Firm's decision in the Long Run
Entry and Exit
v New firms enter an industry in which existing firms make an
economic profit: TR > TC or P > ATC
v Firms exit an industry in which they incur an economic loss.
Supply Curves
Supply Curves
v Supply in the short-run:
vA firm’s supply in the short run
vMarket supply in the short run
v Supply in the long-run
vA firm’s supply in the long run
vMarket supply in the long run
A Firm’s supply curve in the short run
v A perfectly competitive firm’s supply curve shows how the
firm’s profit-maximizing output varies as the market price
varies, other things remaining the same.
v 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.
v But at a price below the shutdown point, the firm produces
nothing.
A Firm’s supply curve in the short run
The competitive firm’s short-run supply curve is the portion of
its MC curve that lies above ATC curve
Market Supply in the Short Run
In the short run, the market supply is the sum of each
individual firm’s supply.
Supply curve in the long run
The competitive firm’s long-run supply curve is the portion of its
marginal-cost curve that lies above average total cost.
Firm's decision in the Long Run
When the market price is $25 a sweater, firms in the market
are making economic profit.
Firm's decision in the Long Run
New firms have an incentive to enter the market.
When they do, the market supply increases and the market price falls.
Firms enter as long as firms are making economic profits.
In the long run, the market price falls until firms are making zero
economic profit.
Firm's decision in the Long Run
A Closer Look at Exit
When the market price is $17 a sweater, firms in the market
are incurring economic loss.
Firm's decision in the Long Run
Firms have an incentive to exit the market.
When they do, the market supply decreases and the market price rises.
Firms exit as long as firms are incurring economic losses.
In the long run, the price continues to rise until firms make zero economic
profit.
Firm's supply curve VS. Market supply
curve
In the long run, each firm in the market makes zero profit.
The long run supply curve being horizontal crucially depends on
v same cost structure
v Unlimited production resources
A Shift in Demand in the Short Run and Long
Run
Initial state: in the long run equilibrium
A Shift in Demand in the Short Run and
Long Run
An increase in demand…
A Shift in Demand in the Short Run and
Long Run
Homework (Due on Dec 4)
(1)Questions for review after Chapter 14 of Mankiw’s book (8th edition)
(2)Choose 4 questions from Problems and Applications after Chapter 14
of Mankiw’s book.
