Perfect Competition

Chapter: 22
 Agenda

22-1 The Theory of Perfect Competition

22-2 Perfect Competition in the Short Run

22-3 Perfect Competition in the Long Run

22-4 Topics for Analysis in the Theory of Perfect

Competition
 22-1 The Theory of Perfect Competition

• Market Structure: The environment whose

characteristics influence a firm’s pricing and output
decisions
• Perfect Competition: A theory of market structure
based on four assumptions: (1) There are many sellers
and buyers; (2) the sellers sell a homogenous good; (3)
buyers and sellers have all relevant information; (4)
entry into, and exit from, the market is easy
• 22-1a A Perfectly Competitive Firm is a Price Taker
• Price Taker: A seller that does not have the ability to
control the price of the product it sells; the seller
“takes” the price determined in the market
 22-1 The Theory of Perfect Competition

• 22-1b The Demand Curve for a Perfectly

Competitive Firm is Horizontal
• Why Does a Perfectly Competitive Firm Sell at
the Equilibrium Price?
– If it tries to charge a price higher than the market-
established equilibrium, it won’t sell any of its
products
– If the firm wants to maximize profits, it does not
offer to sell at a lower price
– See Exhibit 1
Exhibit 1 The Market Demand Curve in Perfect
Competition
 22-1 The Theory of Perfect Competition

• 22-1c Common Misconceptions about Demand Curves

– Many think that all demand curves must be downward
sloping, but this is not so
– A single perfectly competitive firm’s supply is so small,
compared with the total market supply, that the inverse
relationship between price and quantity demanded
cannot be observed on the firm’s level, only on the
market level
• 22-1d The Marginal Revenue Curve of a Perfectly
Competitive Firm is the Same as Its Demand Curve
– Marginal Revenue (MR): The change in total revenue
(TR) that results from selling one additional unit of
output (Q)
 Exhibit 2 The Demand Curve & the Marginal
Revenue Curve for a perfectly competitive Firm
 22-1 The theory of Perfect Competition

• 22-1e Theory and Real-World Markets

• The assumptions underlying the theory of perfect
competition are closely met in some real-world markets,
such as some agricultural markets and a small subset of
retail trade; the stock market also
• The four assumptions are also approximated in some real-
world markets; in them, the number of sellers may not be
large enough for every firm to be a price taker, but the
firm’s control over price may be negligible; the amount of
control in that market may be so negligible that the firm
act as if it were a perfectly competitive firm
• Therefore, the theory of perfect competition can be used
to predict that market’s behavior
 22-2 Perfect Competition

• For the perfectly competitive firm, a price taker, price is

equal to marginal revenue (P=MR), and therefore the
firm’s demand curve is the same as its marginal
revenue curve
• This section discusses the amount of output the firm
will produce in the short run
• 22-2a What Level of Output Does the Profit-Maximizing
Firm Produce?
• Profit Maximization Rule: Profit is maximized by
producing the quantity of output at which MR = MC
• Exhibit 3
Exhibit 3 The Quantity of Output that the perfectly
competitive firm will produce
 22-2 Perfect Competition

• 22-2b The Perfectly Competitive Firm and Resource

Allocative Efficiency
• Resource Allocative Efficiency: The situation in which
firms produce the quantity of output at which price equals
marginal cost: P = MC
• 22-2c To Produce or Not to Produce: That is the Question
• Case 1. Price is Above Average Total Cost (Ex 4a)
• Case 2. Price is Below Average Variable Cost (Ex 4b)
• Case 3. Price is Below Average Total Cost but Above
Average Variable Cost (Ex 4c)
 Exhibit 4 Profit Maximization and Loss
Minimization for the Perfectly Competitive Firm: 3
cases
 22-2 Perfect Competition

• 22-2d Common Misconceptions over the Shutdown

Decision
• Even if price is below average total cost and a
loss is being incurred, a firm should not
necessarily shut down; the decision depends in
the short run on whether the firm loses more by
shutting down than by not shutting down
– Even though price is below average total cost, it
could still be above average variable cost
– If it is, the firm minimizes its losses in the short run
by continuing to produce
 22-2 Perfect Competition

• 22-2d Common Misconceptions over the Shutdown

Decision
Exhibit 5 What Should a Perfectly Competitive Firm
do in the Short Run?
Exhibit 6 Q & A about Perfect Competition
 22-2 Perfect Competition

• 22-2e The Perfectly Competitive Firm’s Short-Run

Supply Curve
• Short-Run (Firm) Supply Curve: The portion
of the firm’s marginal cost curve that lies above
the average variable cost curve
• Short-Run Market (Industry) Supply Curve:
The horizontal sum of all existing firms’ short-run
supply curves
Exhibit 7 The Perfectly Competitive Form’s Short-
Run Supply Curve
Exhibit 7 The Perfectly Competitive Form’s Short-
Run Supply Curve
Exhibit 8 Deriving a Market (Industry) Supply Curve
for a Perfectly Competitive Market
 22-2 Perfect Competition

• 22-2g Why is the Market Supply Curve Upward Sloping?

– 1. We draw market supply curves upward sloping because they
are the horizontal sum of firms’ supply curves and firms’
supply curves are upward sloping
– 2. They are upward sloping because the supply curve for each
firm is the portion of its marginal cost (MC) curve that is above
its average variable cost (AVC) curve – and this portion of the
MC curve is upward sloping
– 3. MC curves have an upward-sloping portion because the MPP
(marginal physical product) of a variable input eventually
declines. When that happens, the MC curve begins to rise
• Because of the law of diminishing marginal returns, MC curves
are upward sloping, and because MC curves are upward sloping,
so are market supply curves
 22-3 Perfect Competition in the Long Run

• The number of firms in a perfectly competitive market may

not be the same in the short-run as in the long-run
• 22-3a The Conditions of Long-Run Competitive Equilibrium
• Long-Run Competitive Equilibrium: The condition in
which P = MC = SRATC = LRATC Economic profit is zero,
firms are producing the quantity of output at which price is
equal to marginal cost, and no firm has an incentive to
change its plant size
• In Long Run Equilibrium, note that firms cannot enter or
exit the industry, cannot produce more or less output,
cannot change their plant size
Long-Run Competitive Equilibrium: The 3 conditions
Exhibit 9 Long-Run Competitive Equilibrium
 22-3 Perfect Competition in the Long Run

• 22-3b The Perfectly Competitive Firm and

Productive Efficiency
• Productive Efficiency: The situation in which a
firm produces its output at the lowest possible
per-unit cost (lowest ATC)
• 22-3c Industry Adjustment to an Increase in
Demand
• An increase in market demand for a product can
throw an industry out of long-run competitive
equilibrium (Exhibit 10)
Exhibit 10 The Process of Moving from One Long-
run Competitive Equilibrium Position to Another
Exhibit 10 The Process of Moving from One Long-
run Competitive Equilibrium Position to Another
 22-3 Perfect Competition in the Long Run

• 22-3c Industry Adjustment to an Increase in Demand (cont)

• Long-Run (Industry) Supply (LRS) Curve: A graphical
representation of the quantities of output that an industry
is prepared to supply at different prices after the entry and
exit of firms are completed
• Constant-Cost Industry: An industry in which overage
total costs do not change as (industry) output increases or
decreases when firms enter or exit the industry,
respectively
• Increasing-Cost Industry: An industry in which average
total costs increase as output increases and decrease as
output decreases when firms enter and exit the industry,
respectively
 22-3 Perfect Competition in the Long Run

• 22-3c Industry Adjustment to an Increase in Demand (cont)

• Decreasing-Cost Industry: An industry in which average
total costs decrease as output increases and increase as
output decreases when firms enter and exit the industry,
respectively
• Exhibit 11
• 22-3d Profit from Two Perspectives
• From one perspective, profit serves as an incentive for
individuals to produce
• From another perspective, it serves as a signal, identifying
where resources are most welcome
Exhibit 11 Long-Run Industry Supply Curves
 22-3 Perfect Competition in the Long Run
• 22-3e Industry Adjustment to an Increase in Demand
• Suppose market demand decreases; in the short run the
equilibrium price falls, shifting the firm’s demand curve (marginal
revenue curve) downward
• Some firms in the industry then decrease production; in the long
run, some firms will leave the industry
• 22-3f Differences in Costs, Differences in Profits: Now You See It,
Now You Don’t
• Assume two farmers, Cordero and Hancock, who produce wheat,
Cordero on fertile land, Hancock in poor soil; both sell for the
same price, but Cordero has lower average total costs, thus earns
profits; Hancock does not
• But individuals will bid up the price of Cordero’s land, increasing
costs so that eventually, he will be in the same situation as
Hancock (Exhibit 12)
Exhibit 12 Differences in Costs & Profits: Now
you see it, then it’s gone
 22-3 Perfect Competition in the Long Run
• 22-3g Profit and Discrimination
• A firm’s discriminatory behavior can affect its profits in
the context of the model of perfect competition
• Suppose that under the conditions of long-run
competitive equilibrium (zero profits), the owner of a
firm chooses not to hire an excellent worker because of
that worker’s race, religion or gender; what happens?
– His costs will rise above those of competitors who hire
the best employees without regard to race, religion,
etc.
– Because he is earning zero profit, the act of
discrimination will raise TC and put the firm into
taking economic losses; if he is a manager, he may
 Note: Answers to be discussed solely in
class. Please attend the classes to
optimize your learning experience!

Class Discussion:
Q/A
Class Discussion: Q/A
 Class Discussion: Q/A

According to the accompanying table, what quantity of

output should the firm produce? Explain your answer