Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights -Hill/Irwin
Perfect Competition
Chapter 11
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights -Hill/Irwin
11 - 2
Laugher Curve
Q. How many economists does it take to
screw in a light bulb?
A. Eight.
One to screw it in and seven to hold
everything else constant.
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights -Hill/Irwin
11 - 3
Perfect Competition
uThe concept of competition is used in
two ways in economics.
l Competition as a process is a rivalry
among firms.
l Competition as the perfectly competitive
market structure.
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights -Hill/Irwin
11 - 4
Competition as a Process
uCompetition involves one firm trying to
take away market share from another
firm.
uAs a process, competition pervades the
economy.
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights -Hill/Irwin
11 - 5
Competition as a Market
Structure
u It is possible to imagine something that
does not exist – a perfectly competitive
market in which the invisible hand works
unimpeded.
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights -Hill/Irwin
11 - 6
Competition as a Market
Structure
uCompetition is the end result of the
competitive process under highly
restrictive assumptions.
uA perfectly competitive market is one in
which economic forces operate
unimpeded.
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights -Hill/Irwin
11 - 7
A Perfectly Competitive
Market
uA perfectly competitive market is one
in which economic forces operate
unimpeded.
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11 - 8
A Perfectly Competitive
Market
uA perfectly competitive market must
meet the following requirements:
l Both buyers and sellers are price takers.
l The number of firms is large.
l There are no barriers to entry.
l The firms' products are identical.
l There is complete information.
l Firms are profit maximizers.
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights -Hill/Irwin
11 - 9
The Necessary Conditions for
Perfect Competition
uBoth buyers and sellers are price
takers.
l A price taker is a firm or individual who
takes the market price as given.
l In most markets, households are price
takers – they accept the price offered in
stores.
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11 - 10
The Necessary Conditions for
Perfect Competition
uBoth buyers and sellers are price
takers.
l The retailer is not perfectly competitive.
l A store is not a price taker but a price
maker.
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights -Hill/Irwin
11 - 11
The Necessary Conditions for
Perfect Competition
uThe number of firms is large.
l Large means that what one firm does has
no bearing on what other firms do.
l Any one firm's output is minuscule when
compared with the total market.
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11 - 12
The Necessary Conditions for
Perfect Competition
uThere are no barriers to entry.
l Barriers to entry are social, political, or
economic impediments that prevent other
firms from entering the market.
l Barriers sometimes take the form of patents
granted to produce a certain good.
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11 - 13
The Necessary Conditions for
Perfect Competition
uThere are no barriers to entry.
l Technology may prevent some firms from
entering the market.
l Social forces such as bankers only lending
to certain people may create barriers.
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11 - 14
The Necessary Conditions for
Perfect Competition
uThe firms' products are identical.
l This requirement means that each firm's
output is indistinguishable from any
competitor's product.
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights -Hill/Irwin
11 - 15
The Necessary Conditions for
Perfect Competition
uThere is complete information.
l Firms and consumers know all there is to
know about the market – prices, products,
and available technology.
l Any technological advancement would be
instantly known to all in the market.
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights -Hill/Irwin
11 - 16
The Necessary Conditions for
Perfect Competition
uFirms are profit maximizers.
l The goal of all firms in a perfectly
competitive market is profit and only
profit.
l Firm owners receive only profit as
compensation, not salaries.
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11 - 17
The Definition of Supply
and Perfect Competition
u If all the necessary conditions for
perfect competition exist, we can talk
formally about the supply of a produced
good.
uThis follows from the definition of
supply.
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11 - 18
The Definition of Supply
and Perfect Competition
uSupply is a schedule of quantities of
goods that will be offered to the market
at various prices.
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights -Hill/Irwin
11 - 19
The Definition of Supply
and Perfect Competition
uThis definition requires the supplier to
be a price taker (the first condition for
perfect competition).
uSince most suppliers are price makers,
any analysis must be modified
accordingly.
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights -Hill/Irwin
11 - 20
The Definition of Supply
and Perfect Competition
uBecause of the definition of supply, if
any of the conditions are not met, the
formal definition of supply disappears.
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11 - 21
The Definition of Supply
and Perfect Competition
uThat the number of suppliers be large
(the second condition), means that they
do not have the ability to collude.
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights -Hill/Irwin
11 - 22
The Definition of Supply
and Perfect Competition
uConditions 3 through 5 make it
impossible for any firm to forget about
the hundreds of other firms just itching
to replace their supply.
uCondition 6 specifies a firm's goal –
profit.
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights -Hill/Irwin
11 - 23
The Definition of Supply
and Perfect Competition
uEven if we cannot technically specify a
supply function, supply forces are still
strong and many of the insights of the
competitive model can be applied to
firm behavior in other market structures.
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights -Hill/Irwin
11 - 24
Demand Curves for the Firm
and the Industry
uThe demand curves facing the firm is
different from the industry demand
curve.
uA perfectly competitive firm’s demand
schedule is perfectly elastic even
though the demand curve for the market
is downward sloping.
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights -Hill/Irwin
11 - 25
Demand Curves for the Firm
and the Industry
uThis means that firms will increase their
output in response to an increase in
demand even though that will cause the
price to fall thus making all firms
collectively worse off.
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights -Hill/Irwin
11 - 26
Market supply
Market
demand
1,000 3,000
Price
$10
8
6
4
2
0
Quantity
Market Firm
Individual firm
demand
Market Demand Versus
Individual Firm Demand Curve
10 20 30
Price
$10
8
6
4
2
0
Quantity
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights -Hill/Irwin
11 - 27
Profit-Maximizing Level of
Output
uThe goal of the firm is to maximize
profits.
uWhen it decides what quantity to
produce it continually asks how
changes in quantity affect profit.
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights -Hill/Irwin
11 - 28
Profit-Maximizing Level of
Output
uSince profit is the difference between
total revenue and total cost, what
happens to profit in response to a
change in output is determined by
marginal revenue (MR) and marginal
cost (MC).
uA firm maximizes profit when MC = MR.
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11 - 29
Profit-Maximizing Level of
Output
uMarginal revenue (MR) – the change
in total revenue associated with a
change in quantity.
uMarginal cost (MC) -- the change in
total cost associated with a change in
quantity.
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11 - 30
Marginal Revenue
uSince a perfect competitor accepts the
market price as given, for a competitive
firm, marginal revenue is price (MR =
P).
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights -Hill/Irwin
11 - 31
Marginal Cost
u Initially, marginal cost falls and then
begins to rise.
uMarginal concepts are best defined
between the numbers.
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights -Hill/Irwin
11 - 32
How to Maximize Profit
uTo maximize profits, a firm should
produce where marginal cost equals
marginal revenue.
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights -Hill/Irwin
11 - 33
How to Maximize Profit
u If marginal revenue does not equal
marginal cost, a firm can increase profit
by changing output.
uThe supplier will continue to produce as
long as marginal cost is less than
marginal revenue.
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights -Hill/Irwin
11 - 34
How to Maximize Profit
uThe supplier will cut back on production
if marginal cost is greater than marginal
revenue.
uThus, the profit-maximizing condition of
a competitive firm is MC = MR = P.
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights -Hill/Irwin
11 - 35
C
A
P = D = MR
Costs
1 2 3 4 5 6 7 8 9 10 Quantity
60
50
40
30
20
10
0
A
B
MC
Marginal Cost, Marginal
Revenue, and Price
0
1
2
3
4
5
6
7
8
9
10
$
Price = MR Quantity
Produced
Marginal
Cost
$
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights -Hill/Irwin
11 - 36
The Marginal Cost Curve Is
the Supply Curve
uThe marginal cost curve is the firm's
supply curve above the point where
price exceeds average variable cost.
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights -Hill/Irwin
11 - 37
The Marginal Cost Curve Is
the Supply Curve
uThe MC curve tells the competitive firm
how much it should produce at a given
price.
uThe firm can do no better than
producing the quantity at which
marginal cost equals price which in turn
equals marginal revenue.
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights -Hill/Irwin
11 - 38
The Marginal Cost Curve Is
the Firm’s Supply Curve
A
B
C
Marginal cost
C
os
t,
P
ric
e
$70
60
50
40
30
20
10
0 1 Quantity2 3 4 5 6 7 8 9 10
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights -Hill/Irwin
11 - 39
Firms Maximize Total Profit
uWhen we speak of maximizing profit,
we refer to maximizing total profit, not
profit per unit.
uFirms do not care about profit per unit;
as long as an increase in output will
increase total profits, a profit-
maximizing firm should increase output.
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights -Hill/Irwin
11 - 40
Profit Maximization Using
Total Revenue and Total Cost
uProfit is maximized where the vertical
distance between total revenue and
total cost is greatest.
uAt that output, MR (the slope of the total
revenue curve) and MC (the slope of
the total cost curve) are equal.
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights -Hill/Irwin
11 - 41
TC TR
0
T
ot
al
c
os
t,
re
ve
nu
e $385350
315
280
245
210
175
140
105
70
35
Quantity1 2 3 4 5 6 7 8 9
Profit Determination Using
Total Cost and Revenue Curves
Maximum profit =$81
$130
Loss
Loss
Profit
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights -Hill/Irwin
11 - 42
Total Profit at the Profit-
Maximizing Level of Output
uWhile the P = MR = MC condition tells
us how much output a competitive firm
should produce to maximize profit, it
does not tell us the profit the firm
makes.
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11 - 43
Determining Profit and Loss
From a Table of Costs
uProfit can be calculated from a table of
costs and revenues.
uProfit is determined by total revenue
minus total cost.
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11 - 44
Determining Profit and Loss
From a Table of Costs
uThe profit-maximizing position is not
necessarily a position that minimizes
either average variable cost or average
total cost.
u It is only the position that maximizes
total profit.
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights -Hill/Irwin
11 - 45
Costs Relevant to a Firm
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11 - 46
Costs Relevant to a Firm
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights -Hill/Irwin
11 - 47
Determining Profit and Loss
From a Graph
uFind output where MC = MR.
uThe intersection of MC = MR (P)
determines the quantity the firm will
produce if it wishes to maximize profits.
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights -Hill/Irwin
11 - 48
Determining Profit and Loss
From a Graph
uFind profit per unit where MC = MR.
uTo determine maximum profit, you must
first determine what output the firm will
choose to produce.
uSee where MC equals MR, and then
drop a line down to the ATC curve.
uThis is the profit per unit.
(a) Profit case (b) Zero profit case (c) Loss case
Determining Profits Graphically
Quantity Quantity Quantity
Price
65
60
55
50
45
40
35
30
25
20
15
10
5
0
65
60
55
50
45
40
35
30
25
20
15
10
5
01 2 3 4 5 6 7 8 9 10 12 1 2 3 4 5 6 7 8 9 10 12
D
MC
A P = MR
B ATC
AVC
E
Profit
C
MC
ATC
AVC
MC
ATC
AVC
Loss
65
60
55
50
45
40
35
30
25
20
15
10
5
0 1 2 3 4 5 6 7 8 910 12
P = MR
P = MR
Price Price
© The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-Hill
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights -Hill/Irwin
11 - 50
Zero Profit or Loss Where
MC=MR
uFirms can also earn zero profit or even
a loss where MC = MR.
uEven though economic profit is zero, all
resources, including entrepreneurs, are
being paid their opportunity costs.
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11 - 51
Zero Profit or Loss Where
MC=MR
u In all three cases (profit, loss, zero
profit), determining the profit-maximizing
output level does not depend on fixed
cost or average total cost, by only
where marginal cost equals price.
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11 - 52
The Shutdown Point
uThe firm will shut down if it cannot
cover average variable costs.
l A firm should continue to produce as long
as price is greater than average variable
cost.
l Once price falls below that point it makes
sense to shut down temporarily and save
the variable costs.
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11 - 53
The Shutdown Point
uThe shutdown point is the point at
which the firm will gain more by shutting
down than it will by staying in business.
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11 - 54
The Shutdown Point
uAs long as total revenue is more than
total variable cost, temporarily
producing at a loss is the firm’s best
strategy since it is taking less of a loss
than it would by shutting down.
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights -Hill/Irwin
11 - 55
MC
P = MR
2 4 6 8 Quantity
Price
60
50
40
30
20
10
0
ATC
AVC
Loss
A$
The Shutdown Decision
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11 - 56
Short-Run Market Supply
and Demand
uWhile the firm's demand curve is
perfectly elastic, the industry's is
downward sloping.
uFor the industry's supply curve we use
a market supply curve.
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11 - 57
Short-Run Market Supply
and Demand
u In the short run when the number of
firms in the market is fixed, the market
supply curve is just the horizontal sum
of all the firms' marginal cost curves,
taking account of any changes in input
prices that might occur.
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11 - 58
Short-Run Market Supply
and Demand
uSince all firms have identical marginal
cost curves, a quick way of summing
the quantities is to multiply the
quantities from the marginal cost curve
of a representative firm by the number
of firms in the market.
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights -Hill/Irwin
11 - 59
Long-Run Competitive
Equilibrium
uProfits and losses are inconsistent with
long-run equilibrium.
uProfits create incentives for new firms
to enter, output will increase, and the
price will fall until zero profits are made.
uOnly zero profit will stop entry.
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11 - 60
Long-Run Competitive
Equilibrium
uThe existence of losses will cause firms
to leave the industry.
uZero profit condition is the requirement
that in the long run zero profits exist.
uThe zero profit condition defines the
long-run equilibrium of a competitive
industry.
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights -Hill/Irwin
11 - 61
Long-Run Competitive
Equilibrium
uZero profit does not mean that the
entrepreneur does not get anything for
his efforts.
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11 - 62
Long-Run Competitive
Equilibrium
u In order to stay in business the
entrepreneur must receive his
opportunity cost or normal profits the
owners of business would have
received in the nest-best alternative.
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights -Hill/Irwin
11 - 63
Long-Run Competitive
Equilibrium
uNormal profits are included as a cost
and are not included in economic profit.
Economic profits are profits above
normal profits.
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11 - 64
Long-Run Competitive
Equilibrium
uEven if some firm has superefficient
workers or machines that produce rent,
it will not take long for competitors to
match these efficiencies and drive down
the price.
uRent is an income received by a
specialized factor of production.
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights -Hill/Irwin
11 - 65
Long-Run Competitive
Equilibrium
uThe zero profit condition is enormously
powerful.
l It makes the analysis of competitive
markets far more applicable to the real
world than can a strict application of the
assumption of perfect competition.
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11 - 66
Long-Run Competitive
Equilibrium
MC
P = MR
0
60
50
40
30
20
10
Price
2 4 6 8 Quantity
SRATC LRATC
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11 - 67
Adjustment from the Long
Run to the Short Run
u Industry supply and demand curves
come together to lead to long-run
equilibrium.
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11 - 68
An Increase in Demand
uAn increase in demand leads to higher
prices and higher profits.
uExisting firms increase output and new
firms will enter the market, increasing
output still more, price will fall until all
profit is competed away.
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11 - 69
An Increase in Demand
u If the the market is a constant-cost
industry, the new equilibrium will be at
the original price but with a higher
output.
uA market is a constant-cost industry if
the long-run industry supply curve is
perfectly elastic.
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11 - 70
An Increase in Demand
uThe original firms return to their original
output but since there are more firms in
the market, the total market output
increases.
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11 - 71
An Increase in Demand
u In the short run, the price does more of
the adjusting.
u In the long run, more of the adjustment
is done by quantity.
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11 - 72
Profit
$9
10120
FirmPrice
Quantity
B
A
Market Response to an
Increase in Demand
Market
Quantity
Price
0
B
A
C
MC
AC
SLR
S0SR
D0
7
700
$9
8401,200
D1
S1SR
7
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11 - 73
Long-Run Market Supply
uTwo other possibilities exist:
l Increasing-cost industry – factor prices
rise as new firms enter the market and
existing firms expand capacity.
l Decreasing-cost industry – factor prices
fall as industry output expands.
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11 - 74
An Increasing-Cost Industry
u If inputs are specialized, factor prices
are likely to rise when the increase in
the industry-wide demand for inputs to
production increases.
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11 - 75
An Increasing-Cost Industry
uThis rise in factor costs would force
costs up for each firm in the industry
and increases the price at which firms
earn zero profit.
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11 - 76
An Increasing-Cost Industry
uTherefore, in increasing-cost industries,
the long-run supply curve is upward
sloping.
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11 - 77
A Decreasing-Cost Industry
u If input prices decline when industry
output expands, individual firms'
marginal cost curves shift down and the
long-run supply curve is downward
sloping.
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11 - 78
A Decreasing-Cost Industry
u Input prices may decline to the zero-
profit condition when output rises and
when new entrants make it more cost-
effective for other firms to provide
services to all firms in the market.
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11 - 79
A Real World Example
uOwners of the Ames chain of
department stores decide to close over
100 stores after experiencing two years
of losses (a shutdown decision).
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11 - 80
A Real World Example
u Initially, Ames thought the losses were
temporary.
uSince price exceeded average variable
cost, it continued to produce even
though it was losing money.
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11 - 81
A Real World Example
uAfter two years of losses, its
prospective changed.
uThe company moved from the short run
to the long run.
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11 - 82
A Real World Example
uThey began to think that demand was
not temporarily low, but permanently
low.
uAt that point they shut down those
stores for which P < AVC.
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11 - 83
Price
Quantity
MC
ATC
AVC
P = MR
Loss
A Real World Example:
A Shutdown Decision
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Perfect Competition
End of Chapter 11
