Chapter 10 Perfect Competition

1
Chapter 10 -- Perfect Competition
2
Objectives and Readings

• Market structure
• Price determination under perfect competition
• Shifts in supply and demand curves
• Output decision of a perfectly competitive firm
• Short-run equilibrium
• Long-run equilibrium
• Long-run adjustment process
• A constant-cost industry
• An increasing-cost industry
• Resource allocation in a perfectly competitive
  economy
• Reading material Pages 377-402
• Not responsible for the following sections
• Producer surplus in the short-run (pp 391-394)

3
Market Structure

• Every firm has to decide how much to produce and
  sell and what price to charge.
• This decision depends on market-structure
  considerations.
• The market consists of buyers and sellers who can
  communicate with one another.
• Economists classify market structures into four
  broad categories
• Perfect competition
• Monopoly
• Monopolistic competition
• Oligopoly

4
Perfect competition

• Many sellers, so many that firms are price takers
• Homogeneous product
• Small degree of scale economies
• Easy entry and exit
• Examples of perfectly competitive markers
• The stock market
• Many agricultural products
• How are the price and quantity determined in a
  perfectly competitive market?

5
Monopoly

• There is only one producer.
• The product is unique.
• Barriers of entry very high
• legal barriers of entry
• scale economies
• Examples of monopolies are public utilities,
  cable TV companies, etc.
• Frequently monopolies are regulated by the
  government.

6
Monopolistic competition

• Many producers
• Differentiated products
• Each firm has some monopoly power over its price
• Each firm faces low barriers to entry
• Low degree of scale economies
• Low level of minimum efficient scale
• Non price competition takes the form of
  advertising and product differentiation.
• Examples of monopolistically competitive markets
• most of the retailing markets
• the automobile industry

7
Oligopoly

• Few producers
• Product can be homogeneous or differentiated
• Each firm has considerable power over its
  product
• There are high barriers to entry
• High degree of scale economies
• High level of minimum efficient scale
• Examples of oligopolistic markets
• Manufacturing (Steel, tobacco, computers etc)
• Services (insurance, transportation,
  communication etc)

8
Price determination in perfectly competitive
markets

• P 22 - .5Qd
• P 4 .25Qs

9
Revenue (Sales) and Costs of a Perfectly
Competitive Firm
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Total cost, total revenue, and profits
11
Marginal Revenue and Marginal Costs
12
Marginal Revenue and Marginal Cost Curves
13
Output Rule if Demand Curve is Horizontal MC
MR P
14
The Short-run Supply Curve

• What is the maximum output supplied by a
  perfectly competitive firm for any given price?
• The firm maximizes profits by choosing the output
  at which price equals marginal costs.
• As the price goes down, profits decrease
• When the price is above the average total costs
  profits are positive.
• When the price is below the total costs profits
  are negative.
• Even if profits are negative, the firm operates
  at positive levels of output, AV C lt P lt ATC.
• If the price is below the average variable costs,
  the firm shuts down.
• Therefore the short-run supply curve is the part
  of the marginal cost curve that lies above the
  average variable costs curve.

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Short-run Average and Marginal Cost Curves
Dollars per unit of output
Marginal cost
Average total costs
B
A
PROFITS
Average variable costs
Output
0
D
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Derivation of Short-run Supply Curve
Dollars per unit of output
Marginal cost
Average total costs
C
E
Average variable costs
Loss if Qgt0
A
B
Price
H
G
Output
0
D
17
Derivation of Short-run Supply Curve
Dollars per unit of output
Marginal cost
Average total costs
C
E
Average variable costs
Loss Fixed costs
A
B
Output
0
D
18
Illustration of a Short-run Supply Curve
Dollars per unit of output
Marginal cost
Average total costs
Average variable costs
Shut down point
Output
0
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Long-run equilibrium for a competitive firm

• In the long-run, how much will a competitive firm
  produce?
• Free-entry implies that economic profits are
  driven down to zero in the long run.
• Price has to be equal to average costs if profits
  are zero.
• In fact, since the firm can produce any output it
  wants at the market price, price has to be equal
  to the lowest value of its long-run average cost
  curve.
• In addition, since the firm maximizes profits,
  price has to equal its marginal cost as well.
• The equilibrium is illustrated with the following
  slide.

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Long-run Equilibrium for a Perfectly Competitive
Firm

• P MR MC AC

SR cost functions
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Constant-cost Industry
Industry
Firm
S1
D2
D1
Short run costs
S2
Long run costs
6
5
Long run supply curve
12
10
10000
15,000
12,000
22
Increasing-cost Industry
Industry
Firm
S1
D2
S2
D1
7
5
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Allocation of Resources under Perfect Competition

• Assume that the economy produces two goods, food
  and clothing under perfect competition.
• Suppose consumers demand more clothing and less
  food.
• In the short-run
• Price of clothing increases and output of
  clothing rises along its short-run supply curve.
• Price of food decreases and so does its quantity
• Producers of clothing earn economic profits,
  whereas producers of food incur losses.
• Some variable inputs start moving from food to
  clothing.

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Allocation of resources under perfect competition

• In the long run
• Firms enter clothing and exit from food.
• The short-run supply shifts to the right in
  clothing (because of entry) the corresponding
  short-run supply of food shifts to the left
  (because of exit).
• Profits are driven down to zero.
• The price of clothing drops and its output
  increases as resources move into clothing.
• The price of food increases and its output
  declines as resources move away from food.
• Prices and profits rise temporarily and act as
  signals that direct the movement of resources in
  a competitive economy.

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Summary

• Market structure refers to characteristics of
  markets that condition the behavior of firms in
  terms of price and quantity setting.
• There are four market structures Perfect
  competition, Monopoly, Monopolistic competition
  and Oligopoly.
• A perfectly competitive firm will set its output
  so that the price equals marginal costs. The
  short run supply curve of a competitive firm is
  the portion of the marginal cost curve which is
  above the average variable cost curve.
• In the long-run a competitive firm will produce
  the output that corresponds to the minimum of its
  average cost curve.

26
Summary

• A constant-cost industry has a horizontal supply
  curve in the long-run. An increasing-cost
  industry has an upward-sloping supply curve in
  the long run.