Ch. 12: Perfect Competition.

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Ch. 12 Perfect Competition.

• Selection of price and output
• Shut down decision in short run.
• Entry and exit behavior.
• Predicting the effects of a change in demand,
  technological advance, or change in cost.
• Efficiency of perfect competition

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Perfect Competition

• Perfect competition is an industry in which
• Many firms sell identical products to many
  buyers.
• No barriers to entry.
• Established firms have no advantages over new
  ones.
• Sellers and buyers are well informed about
  prices.
• Perfect competition arises when
• When firms minimum efficient scale is small
  relative to market demand
• Homogeneous products only price matters to
  buyers.

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Perfect Competition

• In perfect competition, each firm is a price
  taker.
• No single firm can influence the price
• Each firms output is a perfect substitute for
  the output of the other firms,
• Demand for each firms output is perfectly
  elastic.

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Perfect Competition

• Market demand and supply determine the price that
  the firm must take.
• A firms marginal revenue is the change in TR
  resulting from a one-unit increase in the
  quantity sold.
• In perfect competition, MRP.

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Perfect Competition

• Firmss goal maximize economic profit.
• TR TC
• TRPXQ
• TCopportunity costs of production, including
  normal profit for the owner.

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Profit Max. in Perfect Comp.

• A perfectly competitive firm faces two
  constraints
• A market constraint summarized by the market
  price and the firms revenue curves
• A technology constraint summarized by firms
  product curves and cost curves.

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Profit Max. in Perfect Comp.

• 2 decisions in the short run
• Whether to produce or to shut down.
• If the decision is to produce, what quantity to
  produce.
• A firms long-run decisions are
• Whether to stay in the industry or leave it.
• Whether to increase or decrease its plant size.

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Profit Max. in Perfect Comp.

• At low output levels, the firm incurs an
  economic lossit cant cover its fixed costs.
• Profits maximized at 9 units of output.

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Profit Max. in Perfect Comp.

• Marginal Analysis
• Because MR is constant and MC eventually
  increases as output increases, profit is
  maximized by producing the output at which
• (P)MR MC

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Profit Max. in Perfect Comp.
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Profit Max. in Perfect Comp.

• Profit (P-ATC)Q

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Profit Max. in Perfect Comp.

• SR decision to shut down.
• P (P-ATC)Q
• (P-AVC)Q TFC
• If P lt minimum of AVC, the firm shuts down
  temporarily and incurs a loss equal to TFC.
• If Pgt minimum of AVC, the firm produces the
  quantity at which PMC, even if profits are
  negative.

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Profit Max. in Perfect Comp.

• The Firms Short-Run Supply Curve
• shows how the firms profit-maximizing output
  varies as the market price varies, other things
  remaining the same.
• MC curve above minimum of AVC

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Graphic representation of firms profit
maximizing output for various prices
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• SR Industry Supply Curve
• The quantity supplied by the industry at any
  given price is the sum of the quantities supplied
  by all the firms in the industry at that price.
• Entry of new firms shifts industry supply curve
  to the right
• Exit of old firms shifts industry supply curve to
  the left.

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LR adjustments

• In SR, economic profits could be positive,
  negative or zero.
• In the LR,
• Firms enter if economic profits are positive
• Firms exit if economic profits are negative.
• No entry or exit if economic profits are zero.

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LR adjustments

• Effect of increase in demand on economic profits
  in LR
• At LR equilibrium
• PMCATC
• P0
• ATC is at a minimum

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SR vs. LR Adjustments

• Summary of effects of an increase in demand when
  starting from a LR equilibrium.

SR effect LR effect
Price
Firm output
Industry output
Number of firms
Profits
ATC
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LR equilibrium

• Long-run equilibrium occurs in a competitive
  industry when
• P is zero, so firms have no incentive to enter
  or exit the industry.
• LRATC is at its minimum, so firms cant reduce
  costs by changing plant size.

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External Economies and Diseconomies

• Constant cost industry
• Industry output has no effect on a given firms
  ATC
• External economies
• decreasing cost industry
• Firms costs fall as industry output rises
• External diseconomies
• Increasing cost industry
• Firms costs rise as industry output rises

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External Economics and Diseconomies

• LR supply curve reflects how change in industry
  output affects ATC.
• External economies ? LR supply upward
  sloping
• External diseconomies ? LR supply downward
  sloping
• Constant cost industry ? LR supply horizontal.

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LR adjustment to change in demand with decreasing
cost industry
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LR adjustment to change in demand with increasing
cost industry
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Changes in Plant Size or adoption of new
technology

• Firms change their production technology (or
  plant size) whenever doing so is profitable.
• If ATC exceeds the minimum of LRATC, firms change
  their technology to lower costs and increase
  profits.
• Suppose a new technology emerges that reduces
  LRATC at a higher level than previously.

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Changes in Production Technology

• Why cant a firm survive in LR at Q6?
• Why is LR equilibrium at Q where LRATC is
  minimized?

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Technological Advances

• New-technology firms enter and old-technology
  firms either exit or adopt the new technology.
• Optimal sized firm could be either larger or
  smaller
• Industry supply increases and the industry
  supply curve shifts rightward.
• The price falls and the quantity increases.
• Eventually, a new long-run equilibrium emerges in
  which
• all the firms use the new technology
• the price has fallen to the minimum average total
  cost
• each firm earns normal profit (zero economic
  profit)

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Competition and Efficiency

• Competitive equilibrium is efficient only if
  there are no external benefits or costs.
• Positive externalities.
• Negative externalities.