Definition

Perfect competition is a market structure characterized by many buyers and sellers, where no single
participant has the power to influence the market price. Firms in this structure are price takers.

Key Features of Perfect Competition

1. Large Number of Buyers and Sellers:

o No single buyer or seller can influence the market price.

2. Homogeneous Products:

o All firms sell identical products, so consumers have no preference for one seller over
another.

3. Free Entry and Exit:

o Firms can freely enter or leave the market without significant barriers, ensuring no
long-term economic profits.

4. Perfect Information:

o Buyers and sellers have full knowledge of prices and products.

5. Price Takers:

o Firms accept the market-determined price and cannot influence it.

6. No Externalities:

o Production and consumption do not affect third parties.

Output and Pricing Decisions

1. In the Short Run:

o Profit Maximization Rule: A firm maximizes profit by producing where:

Marginal Cost (MC)=Market Price (P)=Marginal Revenue (MR)\text{Marginal Cost
(MC)} = \text{Market Price (P)} = \text{Marginal Revenue
(MR)}Marginal Cost (MC)=Market Price (P)=Marginal Revenue (MR)

o Possible outcomes:

 Economic Profit: If P>ATCP > ATCP>ATC.

 Break-even Point: If P=ATCP = ATCP=ATC.

 Loss Minimization: If AVC≤P<ATCAVC \leq P < ATCAVC≤P<ATC (operate to

minimize loss).

 Shutdown Point: If P<AVCP < AVCP<AVC, the firm stops production.

 2. In the Long Run:

o Zero Economic Profit: Free entry and exit ensure firms earn normal profit (breaking
even), where: P=LRAC=MCP = LRAC = MCP=LRAC=MC

o Firms operate at the minimum point of the LRAC curve, achieving productive
efficiency.

Efficiency in Perfect Competition

1. Allocative Efficiency:

o Achieved because P=MCP = MCP=MC. Resources are allocated optimally, matching

consumer preferences.

2. Productive Efficiency:

o Achieved in the long run when firms produce at the minimum ATC.

Market Supply and Demand

1. Individual Firm:

o The supply curve is the portion of the MC curve above the AVC curve.

2. Market:

o The industry supply curve is the horizontal sum of all individual firms' supply curves.

Graphical Representation

1. Short-Run Profit/Loss:

o If P>ATCP > ATCP>ATC: Firm earns profit.

o If P<ATCP < ATCP<ATC: Firm incurs a loss.

o Graph shows MCMCMC, ATCATCATC, and AVCAVCAVC with PPP determining the
firm's output.

2. Long-Run Equilibrium:

o Firms enter or exit the market until P=ATCP = ATCP=ATC, and all firms operate at the
minimum ATC.

Examples in Real Life

While perfect competition is rare in practice, some markets approximate it:

 Agricultural markets (e.g., wheat, corn, and rice).

 Financial markets (e.g., foreign exchange markets).

Summary of Key Equations

1. Profit Maximization Rule: MR=MCMR = MCMR=MC.

2. Profit/Loss:

o Profit per unit: P−ATCP - ATCP−ATC.

o Total profit: (P−ATC)×Q(P - ATC) \times Q(P−ATC)×Q.

3. Shutdown Rule: Shut down if P<AVCP < AVCP<AVC.

Definition

A monopoly is a market structure where a single seller controls the entire supply of a good or service
with no close substitutes. This firm is the sole producer, and it has significant market power to
influence price.

Key Features of a Monopoly

1. Single Seller:

o Only one firm supplies the entire market demand.

2. No Close Substitutes:

o Consumers have no alternatives to the product or service.

3. High Barriers to Entry:

o New firms cannot easily enter the market due to:

 Legal barriers (patents, licenses, copyrights).

 Economies of scale (cost advantages of large-scale production).

 Control of essential resources.

4. Price Maker:

o The monopolist can set prices but is constrained by the market demand curve.

5. Downward-Sloping Demand Curve:

o The monopolist faces the entire market demand curve, meaning that to sell more, it
must lower the price.

Output and Pricing Decisions

1. Profit Maximization Rule:

o The monopolist maximizes profit where:

Marginal Revenue (MR)=Marginal Cost (MC)\text{Marginal Revenue (MR)} = \
text{Marginal Cost (MC)}Marginal Revenue (MR)=Marginal Cost (MC)

o Price (PPP) is determined by the demand curve at this output level.

2. Key Equations:

o Profit: Profit=(Price (P)−Average Total Cost (ATC))×Quantity (Q)\text{Profit} = (\

text{Price (P)} - \text{Average Total Cost (ATC)}) \times \text{Quantity
(Q)}Profit=(Price (P)−Average Total Cost (ATC))×Quantity (Q)

3. Inefficiency:

o Monopolies produce less output at a higher price compared to perfect competition,

leading to allocative inefficiency and deadweight loss.
Barriers to Entry

1. Legal Barriers:

o Patents, copyrights, and government licenses protect monopolists.

2. Economies of Scale:

o Large firms benefit from lower average costs, making it difficult for smaller firms to
compete.

3. Control of Key Resources:

o Exclusive ownership of essential resources (e.g., diamonds, oil).

4. Network Effects:

o The value of a product increases as more people use it (e.g., social media platforms).

Efficiency in a Monopoly

1. Allocative Inefficiency:

o Occurs because P>MCP > MCP>MC; the price consumers pay exceeds the cost of
producing the last unit.

2. Productive Inefficiency:

o Monopolies may not produce at the lowest ATC due to lack of competition.

3. Deadweight Loss:

o The reduction in total surplus (consumer + producer) caused by producing less than
the socially optimal quantity.

Natural Monopoly

1. Definition:

o Occurs when a single firm can supply the entire market at a lower cost than multiple
firms due to large economies of scale.

2. Examples:

o Utilities like water, electricity, and public transportation.

Price Discrimination

1. Definition:

o Charging different prices to different customers for the same product, not based on
cost differences.
 2. Types:

o First Degree: Charging each consumer their maximum willingness to pay.

o Second Degree: Prices vary based on quantity consumed (e.g., bulk discounts).

o Third Degree: Different prices for different groups (e.g., student discounts, senior
citizen rates).

Examples of Monopolies

1. Legal Monopolies:

o Microsoft’s Windows (early dominance).

o Pharmaceutical companies with patent-protected drugs.

2. Natural Monopolies:

o Utility providers like electricity and water supply.

3. Local Monopolies:

o A single gas station in a remote area.

Graphical Representation

 Demand Curve: Downward-sloping (price decreases as quantity increases).

 Marginal Revenue (MR): Lies below the demand curve.

 Profit Maximization: Intersection of MRMRMR and MCMCMC; price is set from the demand
curve.
Barriers to entry: A barrier to entry is anything that makes it difficult for entrepreneurs to
enter the market and compete. Barriers to entry can be high start up costs, customer
loyalty, government regulation, etc. In perfectly competitive markets, barriers to entry are
low. That means, when firms are earning economic profits, competing firms seek that profit
and enter the market in the long run. When firms enter the market, prices fall and economic
profit goes to zero. When firms are earning economic losses, firms exit the market (as
resources will be more profitable elsewhere) in the long run, causing prices to rise until
economic losses are zero. In the end, low barriers to entry (and exit) mean competitive
markets earn zero economic profit in the long run.

On the graph, when firms enter the market it shifts the market supply curve to the right,
decreasing the market price and MR=D=AR=P until firms break even. When there are
economic losses in the short run, firms exit the market in the long run which shifts the
market supply curve to the left, increasing price and MR=D=AR=P until the firm breaks even.

Note: Firms cannot enter or exit the market in the short run. The number of firms can only
change in the long run.

Long-run Profit: No, due to the low barriers to entry.

Allocatively Efficient: Yes, because price equals marginal cost in both the short-run and
long-run.
Productively Efficient: Productive efficiency occurs when the firm is producing at the
minimum of the average total cost (ATC) curve (where it intersects the MC). In the short
run, perfectly competitive firms are not productively efficient, but in the long run they are.
Firm’s supply curve: Below the ATC there is an average variable cost curve (AVC) that isn’t
always drawn in . The minimum point on the AVC correlates to the lowest price a firm would
be willing to accept. If the market price is above the AVC, the firm will produce the quantity
where MR=MC. As the price falls, profit will fall but the firm will continue to produce where
MR=MC. If the price continues to fall, the firm will produce lower quantities as long as the
price stays above the AVC.

If the price falls below the AVC, the firm shuts down (temporarily) as the firm will only lose
it’s fixed costs if it shuts down. Producing at a price below the AVC would cause the firm to
lose more than their fixed costs. If the price equals the minimum of the AVC, the firm will
produce that quantity; it is the lowest quantity the firm would produce. As a result, the
firm’s supply curve is the MC curve above the AVC.

Note: This is true for all firms. The supply curve for all firms is the MC above the AVC.
Perfect competition total revenue and total cost: Profit maximizing firms produce where
MR=MC. An alternative way to find the profit maximizing quantity is to look at a firm’s total
cost and total revenue. A perfectly competitive firm’s total revenue curve rises at a constant
rate (it is an upward sloping straight line). That is because the marginal revenue is equal to
the price and does not change. When you graph total cost and total revenue on the same
graph, you can also find the profit maximizing quantity by finding the quantity where the
total revenue is farthest above the total cost. In the graph above, Qf would be the profit
maximizing quantity. Q1 and Q2 both result in an economic loss.
Increasing Cost Industry: Generally questions regarding perfectly competitive firms will be
about constant cost industries. Those are industries where the firm’s cost curves do not shift
based on the equilibrium output in the market.
You could see a question or two (on the AP Micro Exam) about an increasing cost industry.
That would be a product where an increase in the market equilibrium quantity would cause
an increase in costs for the individual firm. So an increase in Qe would cause the ATC and
MC to shift upward for the firm.

Perfect Competition
- Increasing Cost Industry
Increasing cost industries occur because the long run average total cost curve for the
industry as a whole is upward sloping. Precious metals are an example increasing cost
industry because as more gold and silver is produced (through mining) the cost of producing
more constantly increases; as gold and silver become more and more difficult and costly to
mine.
A decreasing cost industry is just the opposite. Cost curves will shift downward as industry
output increases. This is as a result of the industry’s long-run average total cost curve
sloping downward. These industries capture economies of scale. Microchips are an example
of a product in a decreasing cost industry. The more that are produced, the cheaper
production typically gets.
Market long-run supply curve: The market supply curve is actually a short-run supply curve.
That is because in the short run, the market can produce more at high prices and less at low
prices. The long-run supply curve is a perfectly elastic (horizontal) curve at the bottom of the
firm’s ATC. That is because the market price will always return to the bottom of the ATC in
the long run. If there is an increase in demand, the price will increase and create short-term
profits. Those profits will cause firms to enter the market increasing the market quantity
even more, but decreasing the price back to the long-run price. If there is a decrease in
demand, the price will fall and create short-term losses. Those losses will cause firms to exit
the market decreasing the quantity more and returning the market price back to the bottom
of the ATC. As a result, in the long-run the market can produce any quantity at the long-run
price.