Topic 7: Perfect Competition The following textbook conditions describe perfectly competitive markets.

However, in the real world, markets rarely satisfy these four conditions perfectly. The workable conditions listed define real world markets that have a significant amount of competition. Textbook Conditions (clock-work perfection) 1. Many buyers and sellers 2. Homogeneous product 3. Free entry and exit 4. Perfect information Workable Conditions Price taking behavior Good substitutes Easy entry and exit Information available

Profit equals total revenue minus total cost. Economists use the term economic profit (as opposed to accounting profit) to mean total revenue minus total cost including explicit costs and implicit costs. Implicit costs would include the opportunity cost of ones time. Accounting profit would only subtract explicit costs from revenue to get profits. Profit Maximization Rules 1. Maximize profit by selecting q* where p=MC. (Or, produce all the units for which p MC; stop producing before p < MC). 2. Unless p < AVC. If p < AVC, then shut down (q*=0). The price (pi) comes out of the market. Therefore, well typically analyze perfectly competitive markets with a graph for the market and one for a representative perfectly competitive firm.

MC ATC AVC

p*

D Quantity Quantity

A Representative Firm

The Market

Let the following figure represent the cost structure for a firm in a perfectly competitive market in the short run. Shown are the firms marginal cost curve (MC), average total cost curve (ATC), and average variable cost curve (AVC). Perfectly competitive firms must decide how much to produce. They will maximize profit by selecting q* where p=MC. Price is determined in the industry (where S=D).
MC Price p4 ATC AVC p3 p2 p1 Quantity

10

12 13

15

17

20

For each price, state how much output the profit-maximizing firm should produce in the short run. Also, explain economic profits at each price. p4: p3: p2: p1: Notice that the MC curve is really the firms supply curve because it shows how much the firm would be willing to produce at various prices.

Now, do Microsoft excel example to prove that these profit maximization rules work. See topic 7 perfect competition (the excel file). Assume the market price is initially $500. Calculate total revenue (TR), marginal revenue (MR), and profits in order to determine how much to produce. A Representative Firm Q TC TFC TVC 1 2500 2000 500 2 2800 2000 800 3 3000 2000 1000 4 3160 2000 1160 5 3340 2000 1340 6 3540 2000 1540 7 3780 2000 1780 8 4080 2000 2080 9 4410 2000 2410 10 4770 2000 2770 11 5190 2000 3190 12 5760 2000 3760 13 6630 2000 4630 14 7800 2000 5800 15 9800 2000 7800 ATC 2500 1400 1000 790 668 590 540 510 490 477 471.8 480 510 557.1 653.3 AFC 2000 1000 667 500 400 333 286 250 222 200 182 167 154 143 133 AVC 500 400 333.3 290 268 256.7 254.3 260 267.8 277 290 313.3 356.2 414.3 520 MC 500 300 200 160 180 200 240 300 330 360 420 570 870 1170 2000 TR MR Profits

Assume the market is comprised of 100 firms with cost structures that are identical to that given above. Determine the quantity supplied by the representative firm as well as the market. The Market Price 150 200 250 300 350 400 450 500 550 Quantity Supplied Firm Market Quantity Demanded Market 2000 1800 1600 1400 1200 1000 800 600 400

Now suppose that you are the manager of a company that vaccinates human beings for biological diseases. Your company uses two inputs to produce vaccinations: physicians and laboratories. However, this is a short-run analysis where physicians are variable but laboratories are fixed. Suppose that each physician costs $500 per day (for an annual salary of about $175,000) and the daily cost for the laboratory is $1,500 (for rental cost of about $547,500 per year). In the short run, your company has 1 laboratory. The following table presents potential daily production levels with requisite input combinations. Suppose the industry for vaccinating humans is perfectly competitive, and that all companies have production functions and cost functions that are identical to yours. Also, assume that the market price for a vaccination against biological diseases is $6,500. Question: how much output should your company produce per day in the short run to maximize profits? To answer this question, first fill out the following chart. Vaccination Production Function (time unit = 1 day) with Cost Structure Physicians Laboratories Vaccinations (Q) TC TFC TVC MC ATC 0 1 0 3 1 1 5 1 2 6 1 3 9 1 4 15 1 5 24 1 6 36 1 7 51 1 8 AFC AVC

Find the profit-maximizing output level for your company. At this output level, how many physicians do you hire? Calculate economic profits. Are these economic profits positive or negative?

Now consider perfectly competitive markets in the long run.

$ MC(M) p1 MC(S) ATC(S) ATC(M) MC(L) ATC(L) LRAC

p2

Q1

Q2

Q3 Quantity

Suppose farmer A goes into production on the small scale (S), farmer B goes into production on the medium scale (M), and farmer C goes into production on the large scale (L). If the market price were p1, how much would each farmer produce? Would each farmer earn positive or negative economic profits? In the long run, new firms will enter if existing firms are earning positive economic profits and existing firms will exit if negative economic profits are being earned. Assuming firms are making positive economics profits, the market adjusts to a long run equilibrium as the output price gradually falls from p1 to p2 as new firms enter. Each farmer on the small and large scales switch to a different scale of production in the long run. This illustrates why there is entry and/or exit in the long run, why firms must be earning zero economic profits to be at a long run equilibrium, why existing firms are motivated to operate on the most efficient scale of production in the long run, and why existing firms produce their output at lowest possible long run average cost. A long run equilibrium is characterized as when: a) Market Supply = Market Demand b) Each firm maximizes profits (set q* such that P*=MC) c) Each firm earns zero economic profits d) No entry or exit of firms e) Firms produce at the lowest point of their LRAC curve.

Problem Set 7: Perfect Competition 1. Let the Florida Orange industry produce oranges from labor and land inputs where labor is variable and land is fixed in the short run. Suppose Florida orange producers are all identical and all make negative economic profits in the short run in an industry that is perfectly competitive. Draft two diagrams. The first diagram should show the short run cost curves of a representative firm in the Florida orange industry. The second diagram will show the industry supply and demand curves. Make sure diagram 1 comes complete with average total, average variable and marginal cost curves and that diagram 2 produces a market price which allows Florida orange producers to earn negative economic profits. (i) Using the four characteristics used to describe perfectly competitive markets, evaluate the assumption that the orange industry is indeed perfectly competitive. (ii) Shade in the negative economic profits the modeled farmer earns in your diagram should the farmer produce in the short run. (iii) Your modeled farmer advocates production in the short run though negative economic profits are being earned. According to your model, is the farmer making a profit maximizing decision? (iv) Your farmer's mother advises shutting down in the short run due to negative economic profits. According to your diagrams, is she giving good advice? (v) Describe what the individual Florida orange farmer's individual demand curve looks like. Could it be better described as being elastic or inelastic? Explain. 2. Consider the Georgia peach industry, a perfectly competitive market where labor (variable in the short run) and land (fixed in the short run) are used to produce peaches. Assume Georgia peach farmers are identical, that their long run average cost curve is ushaped representing first increasing and then decreasing returns to scale, and that they operate on a scale in the short run which is in the region of the LRAC curve which exhibits increasing returns to scale. (i) Graph the long run average cost curve, with a short run average total cost and marginal cost curve representing the scale on which peach farmers produce for a representative Georgia peach farmer. (ii) Draft an industry supply and demand curve which produce a market price that allows the modeled peach farmer to earn positive economic profits in the short run. (iii) Indicate what output the modeled farmer produces in the short run and shade in the economic profits. (iv) Describe how the peach industry adjusts from the short run position described above to long run equilibrium. Does this adjustment process involve new firms entering the industry? Does this process involve each existing firm producing more or less output? Make graphical additions to your figures illustrating your explanation.

3. The "land of cotton" (the south) in the eighteenth and nineteenth century had seen the scale of cotton production be the plantation. However, the scale of production decreased between 1860 and 1870: the average size of the southern farm was cut in half. Consider the following phenomenon: The "plantation" scale of production didn't occur on the lowest point of the long run average total cost curve. However, the "small" farm (farms half the size of the average plantation) did. Assume (i) the cotton industry is a perfectly competitive industry, (ii) cotton production requires labor (which is variable in the short run) and land (which is fixed in the short run), and (iii) plantations made positive economic profits initially in the short run. Using two figures -- one which depicts the cotton industry's supply and demand curve and one which shows a representative plantation farmers short and long run cost structure in the industry -- explain what effect the phenomenon had on the southern cotton plantation in the long run. Does this adjustment process involve new firms entering the industry? Does this process involve each existing firm producing more or less output? List the three characteristics of long run equilibrium and explain what must happen for them to become satisfied in this model. 4. Consider the family restaurant industry, assuming it to be a perfectly competitive constant cost industry where all its firms are identical. Let Shoney's, a representative firm in this industry, have earned zero economic profits in the long run in 1996 where operation occurred on the most efficient scale of production. However, suppose in 1997 due to an exogenous change in tastes (a decline in demand), Shoney's earned negative economic profits in the short run. Indeed, in 1997 Shoney's lost 35.7 million dollars. Due to this loss, the end of 1997 saw 75 of Shoney's restaurants close, leaving 1387 in operation. Considering the facts, explain whether this is what we could expect to have happen in a perfectly competitive industry in the long run if there was a decline in demand. Use graphs to support your answer. Also, state whether you believe the family restaurant industry to be a good example of perfect competition.

5. The following two figures represent the firm and the market for a perfectly competitive industry. Figure 5a depicts the cost curves facing the individual firm and figure 5b depicts the market supply and demand curves for the perfectly competitive product. Assume that all the individual firms in this market are identical and that they are initially operating in the short run. S

Figure 5a $
8.00

Figure 5b ATC $

MC AVC

6.50 6.00

3.50

D 5 7 8 Quantity 800 910 1000 Quantity

a) What is the short run market price? b) At the short run market price, how many units of output does each profit maximizing firm produce? c) Having calculated the profit maximizing quantity the individual firm will produce at the market clearing price in the short run, calculate profits for the individual firm. Are economic profits positive or negative? d) If all of the firms in this market are identical, then how many firms are there in this industry? e) Given each firm's economic profits in the short run, would we expect there to be entry or exit in the long run?

6. Consider the market for peaches, which is reputed to be perfectly competitive. The production of peaches requires two inputs labor, which is variable, and land, which is fixed in the short run. The following two figures represent the firm and the market for peaches. The first figure depicts the cost curves facing the individual peach farmer and the second figure depicts the market supply and demand curves for peaches. There are three scales of production depicted: S is the small scale, M is the medium scale and L is the large scale. So, for example, MC(S) is the marginal cost of operating on the small scale of production; ATC(M) is the average total cost curve for the medium scale of production. Also, assume that there are only these three scales.
The M arket for P eaches

50 48 46 44 42 40 38 36 34 32 30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0 0 1 2 3 4 5 6 7 8 9 10 11 12 13 P eaches A TC(S) A TC(M ) A TC(L) M C(S) M C(M ) M C(L)

The Market for Peaches

50 48 46 44 42 40 38 36 34 32 30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0 0 100 200 300 400 500 600 700 800 900 1000 1100 1200 1300 1400 1500 Quantity

Dem and Supply

a) b) c) d) e)

What is the short run market-clearing price of peaches? How much should a firm operating on the small scale produce in the short run? At that level of production, characterize the firm's profits. In the long run, we expect the firms to operate on which scale of production? Will a firm operating on the large scale of production in the short run earn positive, negative or zero economic profits? f) What will the long run market-clearing price be? g) Will a firm operating on the large scale of production in the long run earn positive, negative or zero economic profits? h) How many firms will there be in this perfectly competitive market in the long run?

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7. Let the following chart represent the cost structure faced by a perfectly competitive firm, where TFC stands for total fixed cost, TVC stands for total variable cost, etc. Output 0 1 2 3 4 5 TFC 100 100 100 100 100 100 TVC 0 40 60 70 85 130 TC AFC AVC ATC MC

a) Fill in the rest of the table. b) List the four characteristics of a perfect competition. c) Suppose the market price is P = $11. How much should this perfectly competitive firm produce? d) Suppose the market price is P = $30. How much should this perfectly competitive firm produce?

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Answer Key 7: Perfect Competition Answer to question 1.

Graph 1 $ AVC ******************* MC ATC
ATC P

Graph 2 $ S

D q1 Quantity Quantity

i)

ii) iii)

iv) v)

The four characteristics of perfectly competitive markets are (1) a large numbers of buyers and sellers, (2) free entry and exit, (3) product homogeneity, and (4) perfect information. Oranges all look alike to me, so (3) is satisfied. Ill assume there is at least good information about prices in the orange market and that there are many sellers of oranges. There certainly are a lot of buyers of oranges. Free entry into the orange industry is probably easier said than done. Overall, this market satisfies the conditions reasonably well. The farmer produces where P = MC. Negative economic profits are (ATC P)q1. Ive tried to indicate this with *s. Since P>AVC at q1, the farmer should produce in the short run. By producing in the short run, hell lose (ATC-P)q1 instead of (ATC-AVC)q1 where ATCAVC > ATC P. So, producing at q1 is the best option under the circumstances. His mother is giving bad advice. However, if you drew your market supply and demand curve such that a price was created in the market where P< AVC, then shutting down in the short run would be the best option, and moms advice would be good advice. See (iii). Its equal to the price level (D=P) and its perfectly elastic. If the farmer charges more than P, then D=0. There is no reason to sell your oranges at less than the market price of P.

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Answer to question 2.
Figure a $ MCSR2 MCSR ATCSR1 P1 ******** ******* * ******** P2
1

Figure b $ S1

ATCSR 2 LRAC

D S2
q1 q2 Quantity

Quantity

Quantity (in thousands)

iii) iv)

The farmer will produce where P1 = MCSR1. Specifically, at q1. Positive economic profits = (P1 ATCSR1)q1, as indicated by the *s Because this firm is making positive economic profits, now firms are going to be attracted to this industry. New firms will continue to enter the industry until there are no longer any more positive economic profits to entice them. As new firms enter the industry, the market supply curve will begin to shift to the right, lowering the market price of peaches. New entry will stop when the market price equals P2. New firms will produce on the most efficient scale, which occurs at the minimum point on the LRAC curve. In order to stay competitive (and not make negative economic profits), existing firms will also need to move to the most efficient scale of production at the minimum point of the LRAC curve. So, well see new firms enter and old firms increase production on a larger scale (at q2) in the long run. In the long run (when price = P2), anyone not operating on the most efficient scale of production will make negative economic profits. This should exemplify why perfect competition produces efficiency: In the long run, everyone should be operating on a scale where costs are at a long run minimum.

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Answer to question 3.
Figure a $ MCS MCP ATC P1 LRAC P2 D S2 q2 Quantity q1 Q2 Quantity (in thousands)
S

Figure b $ S1

ATC

Initially, plantations are making positive economic profits on the p scale of production in the short run when price = P1. However, positive economic profits attract new cotton producers, which shifts the market supply curve to the right. Entry will occur (and on the most efficient scale of production) until there are no longer any more positive economic profits to be had. This occurs at price = P2. P2 will be the long run equilibrium price. At that price, it should be clear that the plantation scale of production will produce negative economic profits. In order to compete, plantation farmers will have to move to a smaller scale of production (to the s scale or small farm scale) and produce q2 (where q2 < q1) to avoid making negative economic profits. In the long run, the plantation scale should cease to exist. The long run equilibrium characteristics are: (1) each firm produces where price = the bottom of the long run average cost curve (this will be q2 where P2 = minimum LRAC), (2) no incentive for further entry or exit exists (this is true since at P2 zero economic profits are being made), and (3) market supply equals market demand (true at P2 and Q2).

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Answer to question 4. Figure 1 Price MC ATCSR LRAC S3 S Figure 2

P1

P2 D2 D1 q1 Quantity Quantity 1 representative firm The Market a) Shoneys is initially in long run equilibrium producing q1 at P1. The exogenous decrease in demand shifts the demand curve to the left from D1 to D2, where a market price of P2 prevails. Clearly, Shoneys earns negative economic profits at P2. So, in the long run, firms will exit the industry until there are no longer negative economic profits. Negative economic profits will cease to exist when the price level again equals P1. So, firms will leave the market (shifting the market supply curve to the left) until price equals P1. P1 will again be the long run equilibrium price where zero economic profits are being made. The difference between the two long run equilibrium positions is that firms have left the industry. Those still in the industry after the exogenous change in demand are producing q1 at P1; however, there are fewer such firms at point b as compared to point a since there has been exit. The family restaurant industry is not a good example of a perfectly competitive market because output is not homogeneous. Shoneys produces a noticeably different product than other family style restaurants.

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Answer to question 5. a) b) c) d) e) Where S=D, P* = $8.00. Where P = MC, q*=8 units. (P*-ATC)q* = (8-6.50)8 = 1.50 (8) = profits of $12.00, positive economic profits. Q* = 800, and the number of firms = Q*/q* = 800/8 = 100 firms. Entry because these firms are making positive economic profits.

Answer to question 6. a) b) c) d) e) f) g) h) p* = 46 cents, where S = D in the market. Where p* = MC(S), q*(S) = 5 units. The firm earns positive economic profits because at p* = 46, p* > ATC(S) = 34. Thus, profits equal 60 cents from 5 times 12 cents (the profit margin per unit). The medium scale of production because that scale allows production at the lowest average total cost. It is therefore the efficient scale of production. Positive economic profits because p* = 46 cents > ATC(L) = 31 cents. p* = 28. Negative economic profits because the long run equilibrium price is p* = 28 cents. At p* = 28, p* < ATC(L) = about 30 cents. Each firm will operate on the medium scale in the long run. The long run market price will be p* = 28. Each firm will produce where p* = MC(M) = 6 peaches. Thus, q* = 6. Market supply will be Q* = 1200 units, so the number of firms will be Q*/q* = 1200/6 = 200 firms. (200 firms each producing 6 units = 1200 = Q*).

Answer to question 7: a) Fill in the chart. Output 0 1 2 3 4 5 TFC 100 100 100 100 100 100 TVC 0 40 60 70 85 130 TC 100 140 160 170 185 230 AFC 100 50 33.3 25 20 AVC 40 30 23.33 21.25 26 ATC 140 80 56.66 46.25 46 MC 40 20 10 15 45

b) Perfectly competitive markets (i) have many buyers and sellers who (ii) all produce a homogeneous product. Also, in perfectly competitive markets, (iii) there is

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free entry and exit of firms in the long run. (iv) Finally, there is assumed to be perfect information. c) The firm should shut down in the short run. d) The firm should produce 4 units of output.

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