12

C h a p t e r
PERFECT
COMPETITION

The Big Picture

Where we have been:
Chapter 12 relies heavily on the productivity and cost analysis material of Chapter 11,
the marginal analysis and efficiency issues introduced in Chapter 2 and Chapter 5, and
the concept of economic profit introduced in Chapter 10.

Where we are going:

Chapter 12 is the first of four chapters that explore the price and output decisions of
firms under various market characteristics. Chapter 12 studies perfect competition,
Chapter 13 studies monopoly, Chapter 14 studies monopolistic competition, and Chapter
15 studies oligopoly. All four chapters use cost curves, marginal analysis, and the
concept of efficiency.

New in the Thirteenth Edition

The introduction still focuses on the app market, but has been lightly edited. The Economics
in the News that used to focus on the exit of record stores now focuses on the entry of record
stores given the comeback of vinyl among some consumers. The final Economics in the
News still focuses on the app market but now considers Apple’s decision to off free app
development curriculum to high school and colleges.

© 2019 Pearson Education Ltd.

Lecture Notes
Perfect Competition
 Firms in perfect competition face the maximum amount of competition because there are many
competing firms, each of which produces an identical product.
 Firms in perfect competition maximize their profit by producing where MR = MC.
 Perfect competition leads to an efficient allocation of resources.
I. What is Perfect Competition?
Perfect competition is an industry in which
 Many firms sell identical products to many buyers
 There are no restrictions on entry into the industry
 Established firms have no advantage over existing ones
 Sellers and buyers are well informed about prices
How Perfect Competition Arises
 These characteristics of perfect competition arise when the minimum efficient scale for a firm is
small relative to the size of the entire market. The minimum efficient scale is the smallest output at
which long-run average costs are minimized.
What markets satisfy the characteristics of perfect competition? Have the students consider the markets for
goods with which they are familiar to see if any meet the strict criteria for perfect competition. The markets
that come closest are agricultural markets, though others such as lawn service, plumbing, gas stations, and so
on, also come close. Students sometimes “worry” that these markets are not exact examples of perfect
competition. Reassure them that the model of perfect competition gives us a great deal of understanding into
the workings of extremely competitive real world markets and the real world firms in the markets.

If there aren’t really any perfectly competitive markets, what use is studying perfect competition? The
perfect competition model serves as a benchmark and its predictions work in a wide range of real markets.
Set the scene for appreciating the power of the perfect competition model with a physical analogy. Explain
that physicists often use the model of a “perfect vacuum” to understand our physical world. For example, to
predict how long it will take a 50 pound steel ball to hit the ground if it is dropped from the top of the
Empire State Building, you will be very close to the actual time if you assume a perfect vacuum and use the
formula that applies in that case. Friction from the atmosphere is obviously not zero, but assuming it to be
zero is not very misleading. In contrast, if you want to predict how long it will take a feather to make the
same trip, you need a much fancier model! Economists use the model of perfect competition in a similar way
to understand our economic world. Emphasize to students that, although no real world industry meets the full
definition of perfect competition, the behavior of firms in many real world industries and the resulting
dynamics of their market prices and quantities can be predicted to a high degree of accuracy by using the
model of perfect competition.

Price Takers
 Firms in perfect competition are price takers, meaning that a firm that cannot influence the market
price and so it sets its own price equal to the market price.

What is a price taker? Spend a few minutes providing intuition to ensure that your students understand why
firms in perfect competition are “price takers.” On the one hand, they could offer to sell for a lower price,
but they’d be giving profits away because they can sell all they want at the going market price. On the other
hand, they can ask for a higher price but not even one consumer will pay because consumers know where to
buy an exact substitute at a lower price.
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Economic Profit and Revenue

 Firms operating in perfect competition seek to maximize economic profit, which is the difference
between total revenue (the price of the firm’s output multiplied by the quantity sold) and its total
opportunity cost of production
 Because the firm is a price taker, its marginal revenue—which is the change in total revenue that
results in a one-unit increase in the quantity sold—is equal to the market price and remains constant
as output sold increases.
 The firm’s demand is perfectly elastic and the firm’s demand curve is a horizontal line at the market
price.

II. The Firm’s Output Decision

Marginal Analysis and the Supply Decision
 The firm produces the quantity of output for which the difference between total revenue and total
cost is at its maximum because this difference is its economic profit.
 Marginal analysis can be used to determine the profit maximizing quantity. The firm compares the
marginal revenue (which remains constant with output) to the marginal cost (which changes with
output) of producing different levels of output.
 When MR > MC, then the extra revenue from selling one more unit exceeds the extra cost of
producing one more unit, so the firm increases
its output to increase its profit.
 When MR < MC, then the extra cost of
producing one more unit exceeds the extra
revenue from selling one more unit, so the firm
decreases its output to increase its profits
 When MR = MC, then the extra cost of
producing one more unit equals the extra
revenue from selling one more unit, so the firm’s
profit is maximized at this level of output.
 In the figure the firm produces 4 units of output
because that is the quantity that sets the firm’s
marginal cost equal to its marginal revenue, that
is, MR = MC. The firm then charges the going
market price of $30 for its good.

What’s the point? Students find the topic of competitive market dynamics challenging. Part of their problem
is that understanding the dynamics requires a strong understanding of the cost curves of the previous chapter,
yet many of them still have only a shaky grasp of that important material. So emphasize the cumulative
nature of economics and remind the students of the huge payoff from mastering material a bite at a time.
You also can help your students by emphasizing the two primary goals of this chapter: (1) To derive the
market supply curve in a competitive industry and (2) to deepen your students’ understanding of how
competition among self-interested consumers and producers will move society’s resources from less valued
uses to more highly valued uses, achieving an efficient allocation in the eyes of society.

Temporary Shutdown Decision

 The firm will temporarily shut down in the short run when price falls below the shutdown point,
which is the output and price that just allows the firm to cover its total variable cost. The minimum
AVC is the lowest price at which the firm will operate because if it operated with a lower price, the
firm’s loss would be greater than if it shut down. (The loss when the firm shuts down is equal to its
fixed cost.)

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 PERFECT COMPETITION 133

 The firm will continue operating in the short run even if it incurs an economic loss as long as the
price exceeds the minimum AVC.

Why would a restaurant open on days it knows business will be bad? Monday is typically the slowest day
in the restaurant industry. So why do so many restaurants stay open on Monday? The answer is that even if a
restaurant incurs an economic loss on Monday, it still might increase its total profit by remaining open. The
point is that as long as the restaurant can cover all its variable costs—the cost of the food, the cost of the
servers, and so on—it likely will be able to pay some of its fixed costs using the revenue left over after
paying its variable costs. As long as the restaurant can pay some of its fixed costs on Monday, its total profit
by staying open exceeds what its total profit would be if it closed. So losing money on Monday might be
good business!

Students often have a hard time understanding why operating at an economic loss can be the best action for a
firm owner. The key is emphasizing:
 The firm’s short-run decisions are made after some irreversible commitments have generated sunk
costs.
 The firm considers only avoidable future costs when making decisions. Unavoidable costs have no
impact on the decision (other than to learn from them).
 For the firm to continue to produce output, the firm needs only to receive revenues that exceed any
avoidable costs, not necessarily all total costs.
Basically, the goal of profit maximization does not guarantee that the firm will earn a positive economic
profit in the short run. Sometimes the best the firm can do is to minimize its economic loss.

The Firm’s Supply Curve

 As long as the firm remains open, it produces where
MR = MC. So the firm’s supply curve is its MC
curve above the minimum AVC. At prices below the
minimum AVC, the firm shuts down and supplies
zero.
 The figure shows the firm’s supply curve as the
heavy dark line.
 At prices less than the minimum average
variable cost, which equals P in the figure, the
firm shuts down and supplies zero.
 At prices greater than the minimum average
variable cost, the firm supplies along its
marginal cost curve. Hence the firm’s marginal
cost curve is its supply, indicated in the figure by
the S = MC curve.

III. Output, Price, and Profit in the Short Run

The short run is a situation in which the number of firms is fixed. In the short run, market demand and market
supply interact to determine the price and quantity produced in a perfectly competitive market.
Market Supply in the Short Run
 The short-run market supply curve shows the quantity supplied by all the firms in the market at
each price when each firm’s plant and number of firms remain the same. The quantity supplied in the
industry at any price is the summation of all quantities supplied by each firm at that price, so the
short-run industry supply curve is the horizontal summation of all the firms’ supply curves.

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Short-run Equilibrium
 Market demand and short-run market supply determine the market price and market output. Each
firm takes the market price as given, and produces its profit maximizing output.
A Change in Demand
 Changes in market demand influence the output and the entry or exit decisions made by firms.
 An increase in market demand shifts the market demand curve rightward and raises the market price.
Each firm responds by increasing its quantity supplied.
 A decrease in market demand shifts the market demand curve leftward and decreases the market
price. Each firm responds by decreasing its quantity
supplied.
Profits and Losses in the Short Run
 In the short run, even though firms attempt to
maximize profit, they may end up breaking even or
incurring an economic loss. The total economic profit
(or loss) is equal to (P − ATC) × q.
 If the price exceeds the ATC, the firm makes an
economic profit (as illustrated in the figure).
 If the price equals the ATC, the firm “breaks
even” by making zero economic profit. In this
case, the entrepreneur makes a normal profit.
 If the price is less than the ATC, the firm incurs
an economic loss.

An Economics in Action application considers the situation of Harley Davidson after a decrease in the
market demand. Harley Davidson cut production and laid off workers. One plant was temporarily idled and
other jobs were lost permanently.

IV. Output, Price, and Profit in the Long Run

In the short run, a firm might break even, earn an economic profit or incur a loss. Because of entry and exit,
in the long run a firm can only break even.
Entry
 Economic profit motivates firms to enter the
industry, thereby increasing the market supply.
 When the market supply curve shifts rightward, the
market price falls. Eventually the price falls to equal
the minimum ATC for each firm in the industry and
firms have adjusted their plant size so they are
producing at the minimum long-run average cost. At
this price, firms in the industry no longer make an
economic profit and so firms no longer enter the
industry. The figure illustrates this long-run
equilibrium. In the figure, LRAC is the long-run
average cost curve and SRAC is the short-run
average cost curve.
 One difference between the old and new market
equilibriums is that the number of firms in the
industry has risen and total quantity produced in the
industry has increased.

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 PERFECT COMPETITION 135

Exit
 The effects of a decrease in market demand are the opposite of those outlined above.
 In the long run, competitive firms make zero economic profit (price = average total cost) so that their
owners make a normal profit.

Long Run Equilibrium

 Long run equilibrium in a competitive market occurs when there is zero economic profit and entry
and exit have stopped.
 Because markets are constantly experiencing new changes and shocks, it is rare to see one in a state
of long-run equilibrium, but each competitive markets reacts to any new changes by pushing toward
it.
Profit as a “signal”: When demand for a good increases so that the existing firms in an industry make an
economic profit, the economic profit indicates that consumers are willing to pay a higher price for the good
than they were willing to pay before the demand increased. The economic profit for the firms is a signal
from the consumers to the owners of firms in other industries that society now values the availability of the
good more highly than the availability of goods from those other industries. These self-interested firm
owners choose to enter the industry in order to make an economic profit. Their self-interested decisions
promote the social interest by using more resources to produce those goods that are more highly valued by
society. The dynamic behavior of a perfectly competitive market characterizes the “invisible hand” coined
by Adam Smith.

Why would a firm stay in business if profit is zero? It is likely that you will hear this question from at least
one of your students. Remind them that the profit we’re measuring is economic profit. Zero economic profit
doesn’t necessarily mean that the firm isn’t making any money. Rather, zero economic profit means that the
profits the accountant is reporting is exactly the same as the value of the firm’s best alternative. If the firm
were to move to its best alternative, it would make the same amount of profit. If a firm is making zero
economic profit, there isn’t any incentive to go anywhere else as there isn’t any place that would generate a
higher return for the firm. You may need to continue reminding your students of this throughout this chapter.

An Economics in Action feature examines entry and exit using the personal computer market and the farm
equipment market.

V. Changes in Demand and Supply as Technology Advances

Change in Demand
 Technological change can increase demand if it creates new applications for a product or new
products. Technological change can also decrease demand if new ways of doing things or new
products displace previous ones.
 If demand increases, the price and economic profit rise. The economic profit leads to entry,
which increases market supply and causes the price to fall so that eventually firms again make
zero economic profit. The number of firms is greater than before the increase in demand.
 If demand decreases, the price falls and economic losses are created. Firms exit the market,
which raises the price and decreases the remaining firms’ economic losses. Eventually the price
rises so that the surviving firms make zero economic profit. The number of firms is less than
before the decrease in demand.
An Economics in the News case explores the effects of an increase in demand for vinyl records on the
decisions of record stores.

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Change in Supply
 New, cost-saving technologies typically require new plant and equipment. Consequently it takes time
for new technology to spread throughout an industry. Firms that adopt the new technology lower
their costs and their supply curves shift rightward. The price of the good falls but the firms with the
new technology make an economic profit.
 Firms using the old technology incur economic losses. These firms either adopt the new technology
or else exit the industry. In the long run, all the firms use the new technology and make zero
economic profit.
 Changes in technology brings only temporary economic profit to producers, but the lower prices and
better products that technological advances bring are permanent gains for consumers.

An Economics in the News case explores the implications of technological changes that have created falling
costs to sequence DNA.

Do firms in perfectly competitive markets advertise? Firms in perfectly competitive markets have no
incentive to advertise because their product is indistinguishable from the output of rival firms. Industry
associations will sometimes advertize to increase demand for the product as a whole. Brainstorming all the
ads for agricultural products such as “Pork: the other white meat,” and all the varieties of milk ads can be
fun, but the point is that it isn’t a pork producer or a dairy farmer creating the ad, but all of the pork
producers or dairy farmers paying dues to an industrial organization that then creates the ads. Successful
advertisements might lead to an economic profit in the short run, but in the long run entry will force the
firms back to zero economic profit.

VI. Competition and Efficiency

Efficient Use of Resources
 Resource allocation in a market is efficient when society values no other use of the resources more
highly. Resource use is efficient when production is such that the marginal social benefit of the good
equals the marginal social cost of the good.
Choices, Equilibrium, and Efficiency
 Consumers allocate their budgets to get the most
value out of them. Because consumers get the most
value out of their budget, a consumer’s individual
demand curve for a good is the consumer’s marginal
benefit curve for the good. If no one else benefits
from the good other than the consumers, then, as
shown on the figure, the market demand curve for a
good is the marginal social benefit curve.
 Firms maximize their profits in order to get the most
value out of their resources. Firms make choices
across all possible allocations of their resources. A
firm’s supply curve for a good is its marginal cost
curve. If all the costs of production of the good are
paid by the producers, then, as shown in the figure,
the market supply curve for a good is the marginal
social cost curve.
 In a competitive equilibrium, the quantity demanded equals the quantity supplied. If there are no
externalities, the demand curve is the same as the marginal social benefit curve and the supply curve
is the same as the marginal social cost curve, so at the competitive equilibrium, the marginal social
benefit equals the marginal social cost. Resource use is efficient. Because resources are used
efficiently, at the competitive equilibrium there is no other allocation of resources that will generate

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 PERFECT COMPETITION 137

greater net benefits to society. The figure shows this outcome, where resource use is efficient at the
equilibrium quantity of 3,000 units.

Watching the work of the invisible hand: The power of the market to make firms respond to consumers’
changing demands becomes visible to the student in this chapter. When you teach the dynamics of firm entry
and exit, do the analysis with a specific (and current) example with which the students can identify. Have
them pick an industry that has grown and largely died in their lifetime (for me, VCRs, for them, DVDs at
Blockbuster, or video cameras or film cameras). What has replaced it and how is society served by failure as
well as success?

Economics in the News analyzes Apple’s decision to offer free curriculum to high schools and colleges
interested in teaching app development to their students. It explains how the rapid expansion of smartphones
has increased the demand for apps while the recruitment of new app developers increases supply.

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Additional Problems

1. Bob’s is one of many burger stands along the

beach. Figure 12.1 shows Bob’s cost curves.
a. If the market price of a burger is $4, what is
Bob’s profit-maximizing output?
b. Calculate the economic profit that Bob’s makes.
c. With no change in demand or technology, how
will the price change in the long run?

2. Lucy’s Lasagna is a price taker that has the costs

Output Total cost
shown in the table.
(plates per hour) (dollars per hour)
a. If lasagna sells for $7.50 a plate, what is Lucy’s
0 5
profit-maximizing output?
1 20
b. What is Lucy’s shutdown point? 2 26
c. Over what price range will Lucy leave the 3 35
lasagna industry? 4 46
d. Over what price range will other firms with 5 59
costs identical to Lucy’s enter the industry?
e. What is the price of lasagna in the long run?

Solutions to Additional Problems

1. a. Bob’s profit-maximizing quantity is 300 burgers a day. Bob’s maximizes its profit by producing the
quantity at which marginal revenue equals marginal cost. In perfect competition, marginal revenue
equals price, which is $4 a burger. Marginal cost is $4 when 300 burgers a day are produced.
b. Bob’s economic profit is $300 a day. Profit equals total revenue minus total cost. Total revenue
equals $1,200 a day ($4 a burger multiplied by 300 burgers). The average total cost of producing 300
burgers is $3.00 a burger, so total cost equals $900 a day ($3.00 multiplied by 300 burgers). Profit
equals $1,200 minus $900, which is $300 a day.
c. The price will fall in the long run to $2.80 a burger. At a price of $4 a burger, firms make economic
profit. In the long run, the economic profit will encourage new firms to enter the burger industry. As
they do, the price will fall and economic profit will decrease. Firms will enter until economic profit
is zero, which occurs when the price is $2.80 a burger (price equals minimum average total cost).
2. a. Lucy’s profit-maximizing output is 2 plates an hour. Lucy’s maximizes its profit by producing the
quantity at which marginal revenue equals marginal cost. In perfect competition, marginal revenue
equals price, which is $7.50 a plate. Marginal cost is the change in total cost when output is

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increased by 1 plate an hour. The marginal cost of increasing output from 1 to 2 plates an hour is $6
($26 minus $20). The marginal cost of increasing output from 2 to 3 plates an hour is $9 ($35 minus
$26). So the marginal cost of the second plate is half-way between $6 and $9, which is $7.50.
Marginal cost equals marginal revenue when Lucy produces 2 plates an hour.
b. Lucy’s shutdown point is at a price of $10 a plate. The shutdown point is the price that equals
minimum average variable cost. To calculate total variable cost, subtract total fixed cost ($5, which
is total cost at zero output) from total cost. Average variable cost equals total variable cost divided
by the quantity produced. For example, the average variable cost of producing 3 plates is $10 a plate.
Average variable cost is a minimum when marginal cost equals average variable cost. The marginal
cost of producing 3 plates is $10. So the shutdown point is a price of $10 a plate.
c. Lucy will leave the industry if in the long run the price is less than $11 a plate. Lucy’s Lasagna will
leave the industry if it incurs an economic loss in the long run. To incur an economic loss, the price
will have to be below minimum average total cost. Average total cost equals total cost divided by the
quantity produced. For example, the average total cost of producing 2 plates is $13 a plate. Average
total cost is a minimum when it equals marginal cost. The average total cost of producing 3 plates is
$11.67, and the average total cost of producing 4 plates is $11.50. Marginal cost when Lucy's
produces 3 plates is $10 and marginal cost when Lucy's produces 4 plates is $12. At 3 plates,
marginal cost is less than average total cost; at 4 plates, marginal cost exceeds average total cost. So
minimum average total cost occurs between 3 and 4 plates—$11 at 3.5 plates an hour.
d. Firms with costs identical to Lucy’s will enter at any price above $11 a plate. Firms will enter an
industry when firms currently in the industry are making economic profit. Firms with costs identical
to Lucy's will make economic profit when the price exceeds minimum average total cost, which is
$11 a plate.
e. The price in the long run is $11 a plate. At $11 a plate, firms in the industry make zero economic
profit.

Additional Discussion Questions

1. Why do firms do what they do? Students should see how a clear understanding of a perfectly
competitive market justifies firm behavior that otherwise might appear somewhat peculiar:
Late night TV is full of zany TV commercials with firm owners who claim “I must be crazy,
because I’m losing money on every sale!” Why do they advertise to increase sales if they’ll
cause the owner to lose even more money? At first, it appears that these owners must be lying
about “losing money on every sale.” Yet their unlikely claim is potentially true, as the
various firms in their industry may currently face a market price above AVC, but below ATC
in the short run. In this case they would remain in business and continue advertising, despite
“losing money on every sale” because they are earning revenues above their variable costs to
at least help contribute toward paying their fixed cost obligations to their creditors.
Why do the same farmers always complain of losing money but never seem to exit the
industry? Point out that agriculture is a collection of highly competitive markets where
farming operations typically have an extremely high capital-to-labor ratio. This fact makes
the typical farm’s ratio of fixed costs to variable costs very high relative to most industries.
Also, much of a farmer’s capital is in the form farmland, which is difficult to sell during
falling agriculture prices, lengthening the farmer’s short run time frame. In this case, the
dollar difference between market price and minimum AVC will be rather large. As long as
market price exceeds AVC, the farmer will minimize losses by continuing to produce output
over an extended short run time frame.

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2. What is implied about efficiency if the average cost of producing a good exceeds the price
people are willing to pay for it? Remind the students that a firm’s cost curves reflect the
opportunity cost to society of the firm using the resources to make the goods in its market
(the resources could be making goods in some other market that could bring benefits to
society). The demand curve reflects the value society places on each quantity of goods
produced. If the price people are willing to pay is determined by the market supply and
demand and the going market price is less than the opportunity cost of producing the last unit
of the good, using more resources to increase output creates fewer net benefits for society
than could be generated if the resources were used elsewhere in other markets.
What happens to the resources that were used by a firm for production when that firm exits
the industry? Point out that when price falls below ATC, this generates an economic loss for
the firm. This is a signal from a society of consumers to the owner of the resources that he or
she will benefit from reallocating the resources to making different goods and services from
the same resources. Society also stands to benefit from this switch.
How can an increase in net benefits to society be generated from the systematic destruction
of firms leaving the market? A famous economist named Joseph Schumpeter coined the
phrase “creative destruction” to describe the dynamics of a competitive market. While the
productive capacity of a perfectly competitive industry facing declining consumer demand is
ultimately destroyed, the resources themselves are not destroyed. They are simply released to
firms in other markets to create goods and services that are relatively more valuable to
society. This “destruction” of an industry creates goods of greater social value in another
industry. That is Schumpeter’s “creative destruction.”
3. What makes all the self-interested firms adopt the latest available technology for producing
at the lowest opportunity cost possible over time? Emphasize that competitive firms cannot
increase their economic profits by raising their price, so they must search for ways to increase
economic profit through lowering production costs. This means that firms are constantly
seeking out the latest production technologies to find a cost advantage over their competitors.
If the other firms failed to adopt this low-cost production technology, they would suffer an
economic loss when those that do adopt the technology lower their prices to increase market
share. Firms that refuse to adopt the technology must then match a lower market price to
retain their market shares, causing them to bear an economic loss and face an eventual exit
from the market.
4. Discuss whether there are economies of scale or diseconomies of scale in class size at
colleges and universities. Does it matter if the “output” is measured in tuition dollars and
costs or in student success as measured by grades? Does technology impact the answer?
This situation can be fun to explore. Can a great teacher supported by excellent technology
be best used in a huge lecture class? Are there some types of instruction, like experimental
labs, where increasing class size might lead to disaster? Why do colleges advertise their
average class size and do parents and students care? How might the educational “plant” and
equipment differ to support various choices in class size?
5. Using the global corn market, consider the impact of increasing demand for ethanol made
from corn in the short and long run. The increase in demand for ethanol raises the price of
corn and thereby increases corn farmers’ economic profit…at least in the short run. But in the
long run, the economic profit leads existing farmers to plant more corn and more corn
farmers to enter the. These long-run changes increase the supply of corn, thereby lowering
the price of corn and decreasing corn farmers’ economic profit. Entry (and expansion)
continues until, in the long run, corn farmers’ economic profit equals zero. At that point entry
ceases and the corn market is back in long-run equilibrium.

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