Perfect Competition

Ref. Pindyck & Rubinfeld

Henderson & Quandt
 PERFECTLY COMPETITIVE MARKETS

Assumptions:

(1) Small but large number of sellers (and buyers);

(2) product homogeneity;

(3) free entry and exit;

(4) Perfect information on part of all economic agents;

(5) All agents are identical

 PERFECTLY COMPETITIVE MARKETS

● price taker Firm that has no influence over

market price and thus takes the price as given.

Product Homogeneity
When the products of all of the firms in a market are perfectly substitutable
with one another—that is, when they are homogeneous—no firm can raise the
price of its product above the price of other firms without losing most or all of
its business.

● free entry (or exit) Condition under which

there are no special costs that make it difficult for
a firm to enter (or exit) an industry.
Restrictions on size and number of plants

• DRS must set in.

• But the optimum scale must be very small, that is, all IRS must be exhausted for a very small level of
output

• Each firm must operate only on one plant.

 MARGINAL REVENUE, MARGINAL COST,
AND PROFIT MAXIMIZATION

Demand and Marginal Revenue for a Competitive Firm

Demand Curve Faced by a Competitive Firm

A competitive firm supplies only a small portion of the total output of all the firms in an
industry. Therefore, the firm takes the market price of the product as given, choosing its
output on the assumption that the price will be unaffected by the output choice.
In (a) the demand curve facing the firm is perfectly elastic, even though the market demand
curve in (b) is downward sloping.
 MARGINAL REVENUE, MARGINAL COST,
AND PROFIT MAXIMIZATION

Demand and Marginal Revenue for a Competitive Firm

The demand d curve facing an individual firm in a competitive market

is both its average revenue curve and its marginal revenue curve.
Along this demand curve, marginal revenue, average revenue, and
price are all equal.

Profit Maximization by a Competitive Firm

MC(q) = MR = P
 Characterization of SR eqm:

1. P = MR = MC at the profit-maximizing output;

𝜋=𝑇𝑅 −𝑇𝐶=𝑝𝑞− 𝐶(𝑄, 𝑤 , 𝑦 )

•FOC 𝜕𝜋
=0 ⇒ 𝑀𝑅=𝑀𝐶
𝜕𝑞

2. MC is increasing.

•SOC
2
𝜕 𝜋
2
𝜕 𝑅 𝜕 𝐶
2
𝜕 (𝑀𝐶)
<0 ⇒ − < 0⇒ >0
𝜕𝑞
2 2
𝜕𝑞 𝜕𝑞
2
𝜕 𝑞
3.

∀ 𝑝>min 𝑆 𝐴𝑇𝐶 , 𝜋>0

∀ 𝑝=min 𝑆 𝐴𝑇𝐶 ,𝜋=0

∀ 𝑝<min 𝑆 𝐴𝑇𝐶 , 𝜋<0

4. Shut down point:

a) If SC = 0, F > 0, firm quits for all p < min SATC

b) If SC > 0, F = 0, firm quits for all p < min SAVC
 MARGINAL REVENUE, MARGINAL COST,
AND PROFIT MAXIMIZATION

● profit Difference between total revenue and total cost.

π(q) = R(q) − C(q)
● marginal revenue Change in revenue resulting from a
one-unit increase in output.

Profit Maximization in the Short Run

A firm chooses output q*, so that

profit, the difference AB between
revenue R and cost C, is
maximized.
At that output, marginal revenue
(the slope of the revenue curve)
is equal to marginal cost (the
slope of the cost curve).
Δπ/Δq = ΔR/Δq − ΔC/Δq = 0
MR(q) = MC(q)
 CHOOSING OUTPUT IN THE SHORT RUN

Short-Run Profit Maximization by a Competitive Firm

Marginal revenue equals marginal cost at a

point at which the marginal cost curve is
rising.

Output Rule: If a firm is producing any

output, it should produce at the level at
which marginal revenue equals marginal
cost.
 SR Competitive Equilibrium
p

MC MC

SMC

p = AR = MR

q' q1 q‘’ q
q0
 CHOOSING OUTPUT IN THE SHORT RUN

The Short-Run Profit of a Competitive Firm

A Competitive Firm Making a

Positive Profit
In the short run, the
competitive firm maximizes
its profit by choosing an
output q* at which its
marginal cost MC is equal to
the price P (or marginal
revenue MR) of its product.

The profit of the firm is

measured by the rectangle
ABCD.

Any change in output,

whether lower at q1 or
higher at q2, will lead to
lower profit.
 CHOOSING OUTPUT IN THE SHORT RUN

The Short-Run Profit of a Competitive Firm

A Competitive Firm Incurring

Losses
A competitive firm should
shut down if price is below
AVC.

The firm may produce in

the short run if price is
greater than average
variable cost.

Shut-Down Rule: The firm should shut down if the price of the
product is less than the average variable cost of production at the
profit-maximizing output.
Firm’s supply curve in SR

∀ 𝑝>~
𝑝 , 𝑃 =𝑆𝑀𝐶

∀ 𝑝<~
𝑝 ,𝑞 𝑠 =0

𝑞 𝑠=0 ∀ 𝑝< ~
𝑝

𝑞 𝑠=𝑐− 1 ′ (𝑝)∀ 𝑝>~

𝑝

In SR each firm may be in equilibrium but the industry is not in equilibrium.

 The Short-Run Supply Curve for a Competitive Firm

The firm’s supply curve is the portion of the marginal cost curve for
which marginal cost is greater than average variable cost.

In the short run, the firm

chooses its output so that
marginal cost MC is equal to
price as long as the firm
covers its average variable
cost.

The short-run supply curve is

given by the crosshatched
portion of the marginal cost
curve.
The Short-Run Profit of a Competitive Firm

The Response of a Firm to a

Change in Input Price
When the marginal cost of
production for a firm
increases (from MC1 to MC2),
the level of output that
maximizes profit falls (from q1
to q2).
The shaded area in the figure
gives the total savings to the
firm (or equivalently, the
reduction in lost profit)
associated with the reduction
in output from q1 to q2.
 THE SHORT-RUN MARKET SUPPLY CURVE

Industry Supply in the Short Run

The short-run industry supply

curve is the summation of the
supply curves of the individual
firms.
Because the third firm has a lower
average variable cost curve than
the first two firms, the market
supply curve S begins at price P1
and follows the marginal cost
curve of the third firm MC3 until
price equals P2, when there is a
kink.
For P2 and all prices above it, the
industry quantity supplied is the
sum of the quantities supplied by
each of the three firms.

Elasticity of Market Supply

Es = (ΔQ/Q)/(ΔP/P)
 THE SHORT-RUN MARKET SUPPLY CURVE

Producer Surplus in the Short Run

● producer surplus Sum over all units produced by a firm
of differences between the market price of a good and the
marginal cost of production.

Producer Surplus for a Firm

The producer surplus for a firm

is measured by the yellow area
below the market price and
above the marginal cost curve,
between outputs 0 and q*, the
profit-maximizing output.
Alternatively, it is equal to
rectangle ABCD because the
sum of all marginal costs up to
q* is equal to the variable costs
of producing q*.
 THE SHORT-RUN MARKET SUPPLY CURVE

Producer Surplus in the Short Run

Producer Surplus versus Profit

Producer surplus = PS = R − VC

Profit = π = R − VC − FC

Producer Surplus for a Market

The producer surplus for a

market is the area below
the market price and above
the market supply curve,
between 0 and output Q*.
 CHOOSING OUTPUT IN THE LONG RUN

Long-Run Profit Maximization

Output Choice in the Long Run

The firm maximizes its profit by

choosing the output at which price
equals long-run marginal cost
LMC.
In the diagram, the firm increases
its profit from ABCD to EFGD by
increasing its output in the long
run.

The long-run output of a profit-maximizing competitive firm is the point at

which long-run marginal cost equals the price.
 LR Adjustment

P,C P
SMC1
D
SMC* LAC
SAC1
P0 P0

q0 q Q
q* q’’ q’ n0q0 n0q’’ n*q*
= Q0 = Q’’ = Q*
 CHOOSING OUTPUT IN THE LONG RUN

Long-Run Competitive Equilibrium

Accounting Profit and Economic Profit

π = R − wL − rK

Zero Economic Profit

● zero economic profit A firm is

earning a normal return on its
investment—i.e., it is doing as well
as it could by investing its money
elsewhere.
 CHOOSING OUTPUT IN THE LONG RUN

Long-Run Competitive Equilibrium

Entry and Exit

Long-Run Competitive Equilibrium

Initially the long-run equilibrium
price of a product is $40 per
unit, shown in (b) as the
intersection of demand curve D
and supply curve S1.
In (a) we see that firms earn
positive profits because long-
run average cost reaches a
minimum of $30 (at q2).
Positive profit encourages
entry of new firms and causes
a shift to the right in the supply
curve to S2, as shown in (b).
The long-run equilibrium
occurs at a price of $30, as
shown in (a), where each firm
earns zero profit and there is
no incentive to enter or exit the
industry.
 CHOOSING OUTPUT IN THE LONG RUN

Long-Run Competitive Equilibrium

Entry and Exit

In a market with entry and exit, a firm enters when it can

earn a positive long-run profit and exits when it faces
the prospect of a long-run loss.

● long-run competitive equilibrium All firms in an

industry are maximizing profit, no firm has an
incentive to enter or exit, and price is such that
quantity supplied equals quantity demanded.
A long-run competitive equilibrium occurs when three conditions hold:
1. All firms in the industry are maximizing profit.
2. No firm has an incentive either to enter or exit the industry because
all firms are earning zero economic profit.
3. The price of the product is such that the quantity supplied by the
industry is equal to the quantity demanded by consumers.
Long run equilibrium:

P=LAC=LMC=SAC=SMC

Profit=0 (zero economic proft)

Profit maximization condition:

𝜋=𝑇𝑅−𝑇𝐶=𝑝𝑞−𝑐(𝑞)
𝜋=𝜋 (𝑛)=𝜋 (𝑞 ,𝑛)

𝐷=𝑆 (𝑛)⇒ 𝑛

Set 𝜋 (𝑞, 𝑛)=0

Get n*
 CHOOSING OUTPUT IN THE LONG RUN

Producer Surplus in the Long Run

Firms Earn Zero Profit in Long-Run Equilibrium

In long-run equilibrium, all firms earn zero economic profit.

In (a), a baseball team in a moderate-sized city sells enough tickets so that price ($7) is equal to
marginal and average cost.
In (b), the demand is greater, so a $10 price can be charged. The team increases sales to the point
at which the average cost of production plus the average economic rent is equal to the ticket price.
When the opportunity cost associated with owning the franchise is taken into account, the team
earns zero economic profit.
 THE INDUSTRY’S LONG-RUN SUPPLY CURVE

● constant-cost industry Industry whose long-run

supply curve is horizontal.

In (b), the long-run supply curve in

a constant-cost industry is a
horizontal line SL.
When demand increases, initially
causing a price rise (represented
by a move from point A to point C),
the firm initially increases its output
from q1 to q2, as shown in (a).
But the entry of new firms causes
a shift to the right in industry
supply. The long-run supply curve for a constant-cost
Because input prices are industry is, therefore, a horizontal line at a price
unaffected by the increased output
of the industry, entry occurs until that is equal to the long-run minimum average cost
the original price is obtained (at of production.
point B in (b)).
 ● increasing-cost industry: Industry whose long-
run supply curve is upward sloping.

Long-Run Supply in an
Increasing-Cost Industry
In (b), the long-run supply curve
in an increasing-cost industry is
an upward-sloping curve SL.
When demand increases,
initially causing a price rise,
the firms increase their output
from q1 to q2 in (a).
In that case, the entry of new
firms causes a shift to the right
in supply from S1 to S2.
Because input prices increase
as a result, the new long-run In an increasing-cost industry, the long-run
equilibrium occurs at a higher
price than the initial equilibrium. industry supply curve is upward sloping.
 Remark

• Long run supply curve is not related to Returns to scale. Even

with CRS throughout, the LRS can be upward rising/ downward
sloping.

• Shape of LRS depends on the impact of output change on input

price.

• hence, shape of LRS is external to the firm.

 Special Case: CRS throughout
P,C
For example: If the TC fn is C=ϴQ, determine
the number of firms on the LR.

Here LAC= LMC=ϴ = p.

q*Є [0, D(ϴ)]

Cannot determine the number of firms.

Perfect Indeterminacy of perfect competition

(Samuelson)