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Chapter 11

Perfect Competition
Main Assumption
Economists assume that the goal of firms is to
maximize economic profit.
Max P*Q – TC =Π= TR – TC : Issue – measuring Costs
Q
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Chapter Outline
 The Goal Of Profit Maximization
 The Four Conditions For Perfect Competition
 The Short-run Condition For Profit Maximization
 The Short-run Competitive Industry Supply
• Short-run Competitive Equilibrium
 Producer Surplus
 Adjustments In The Long Run
 The Invisible Hand
 Application: The Cost Of Extraordinary Inputs
 The Efficiency Of Short-run Competitive Equilibrium
 The Long-run Competitive Industry Supply Curve
 The Elasticity Of Supply
 Applying The Competitive Model

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Profits
Firms exist to maximize economic profits and not
accounting profits

 Economic profit --the difference between total revenue and


total cost, where total cost includes all costs—both explicit
and implicit—associated with resources used by the firm.
 Accounting profit --is simply total revenue less all explicit
costs incurred.
– does not subtract the implicit costs.
The Short-run Condition For Profit Maximization
 To maximize profit the firm will choose that level of output
for which the difference between total revenue and total
cost is largest.
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The Four Conditions For Perfect
Competition
1. Firms Sell a Standardized Product
The product sold by one firm is assumed to be a perfect
substitute for the product sold by any other.
2. Firms Are Price Takers
This means that the individual firm treats the market price
of the product as given.
3. Free Entry and Exit
With Perfectly Mobile Factors of Production in the Long
Run
4. Firms and Consumers Have Perfect Information
The Short-run Condition For Profit Maximization
 Marginal revenue: the change in total revenue that occurs as a
result of a 1-unit change in sales.
 To maximize profits the firm should produce a level of output for
which marginal revenue is equal to marginal cost on the rising
portion of the MC curve. 11-4
Figure 11.2: Revenue, Cost, and Economic Profit

Price
=$18

Π =TR - TC

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Figure 11.3: The Profit-Maximizing
Output Level in the Short-Run

The firm should produce where MR = MC (the rising portion


of it – Point A
In PC, P = MR and the firm sets MR = MC. Thus, P = MC at
equilibrium 11-6
Figure 11.4: The Short-Run Supply Curve of a
Perfectly Competitive Firm

=S

The Shutdown Condition


Shutdown condition: if price falls below the minimum of
average variable cost, the firm should shut down in the short
run, i.e. P < AVC
The short-run supply curve of the perfectly competitive firm is
the rising portion of the short-run marginal cost curve that lies
above the minimum value of the average variable cost curve 11-7
Figure 11.5: The Short-Run Competitive
Industry Supply Curve

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Figure 11.7: A Short-Run Equilibrium Price
that Results in Economic Losses

Short-run Competitive Equilibrium


Even though the market demand curve is downward sloping,
the demand curve facing the individual firm is perfectly elastic
(εP= ∞)
Breakeven point: the point at which price equal to the
minimum of average total cost.
--The lowest price at which the firm will not suffer negative
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profits in the short run.
Figure 11.8: Short-run Competitive
Equilibrium is Efficient

=S

The Efficiency Of Short-run Competitive Equilibrium

Allocative efficiency: a condition in which all possible gains


from exchange are realized.
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Figure 11.9: Two Equivalent Measures
of Producer Surplus

PS = P*Q* - AVC*Q = TR - VC PS = P*Q* - Area under MC

Producer Surplus
A competitive market is efficient when it maximizes the net
benefits to its participants.
Producer surplus: the dollar amount by which a firm benefits
by producing a profit-maximizing level of output.
Profit = TR – TC and TC =VC+FC so PS = TR –VC = TR -(TC –
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FC) = TR –TC +FC
Figure 11.10: Aggregate Producer
Surplus When Individual Marginal Figure 11.11: The Total Benefit from
Cost Curves are Upward Sloping Exchange in a Market
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Throughout
Figure 11.12: Producer and Consumer Surplus in a Market
Consisting of Careful Fireworks Users

CS= ½ base x height =1/2(50 – 30) x 20,000


=$200,000.00

PS= ½ base x height =1/2(30 – 10) x 20,000 =$200,000.00

Total or Aggregate Surplus = CS + PS = $400,000.00 11-13


Figure 11.13: A Price Level that
Generates Economic Profit

Positive Economic profits


invite ENTRY by new firms.

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Figure 11.14: A Step along the Path Toward Long-
Run Equilibrium

Entry is not complete as profits


are still positive

Adjustments In The Long Run


Positive economic profit creates an incentive for outsiders to enter the
industry.
As additional firms enter the industry the industry supply curve to the right.
This adjustment will continue until these two conditions are met:
(1) Price reaches the minimum point on the LAC curve
(2) All firms have moved to the capital stock size that gives rise to a short-
run average total cost curve that is tangent to the LAC curve at its
minimum point. (=ATC3 is tangent to minimum LAC at Point A) 11-15
Figure 11.15: The Long-Run Equilibrium under
Perfect Competition

As prices adjustment downwards towards P*, firms enter until


P* where
1. P= minimum ATC - Zero Economic Profit
2. P= minimum LAC  Zero Economic Profit
3. P = SMC = LMC
4. Minimum ATC = Minimum LAC --- Least Cost
5. Q* is the optimal output both in the SR and LR
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These are the fundamental benchmark results from PC
The Invisible Hand
 Why are competitive markets attractive from the
perspective of society as a whole?
 Price is equal to Marginal Cost.
• The last unit of output consumed is worth exactly the
same to the buyer as the resources required to
produce it, i.e. no gouging of consumers by firms.
 Price is equal to the minimum point on the long-run
average cost curve, i.e. firms zero economic profits in
the LR.
There is no less costly way of producing the product.
 All producers earn only a normal rate of profit.
• The public pays not a penny more than what it cost
the firms to serve them.

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Figure 11.16: The Long-Run Competitive Industry
Supply Curve

The Long-run Competitive Industry Supply Curve (SLR)


Constant cost Industries: long-run supply curve is a horizontal
line at the minimum value of the LAC curve. 11-18
Figure 11.17: Long-Run Supply Curve for an
Increasing Cost Industry

The Long-run Competitive Industry Supply Curve


Increasing cost industries: long-run supply curve is upward
sloping.
Decreasing cost industries: long-run supply curve is
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downward-sloping.
Figure 11.19: The Elasticity of Supply

εS = (∆Q/∆P)* P/Q =
P/Q *(1/slope) =
P/Q *(dQ/dP)

Price elasticity of supply: the percentage change in quantity


supplied that occurs in response to a 1 percent change in
product price. 11-20
Figure 11.20: Cost Curves for Family
and Corporate Farms: Application 1

Family Farm Corporate Farms

Market forces would drive market prices to P* < ATCF for


family farms and P* = ATCC for corporate farms.
It appears as if subsidizing corporate farms also benefits family
farms!
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Figure 11.21: The Short-Run Effect
of Agricultural Price Supports

As seen, agricultural support prices benefit corporate farms more than
family farms!
Bigger positive profits for corporate farms invites more entry by corporate
farming entities: bid up the price of agricultural land or the rent and drive out
more families from farming.
As the scale of farms increases, so does technological needs – often beyond
the capacity of family farms. With technological progress more family farms
will be lost to large scale agriculture. 11-22
Figure 11.22: The Effect of a Tax on the
Output of a Perfectly Competitive Industry

Politicians often target corporations for a tax increase. Without taxes, Q*1 is
produced. Assume a horizontal industry S curve so that P* is taken by the
typical firm as given. A tax of T imposed on firms increases both the SMC and
LAC by T so the level of output for the firm is unchanged at Q*1.
However, the S shifts to SLR + T which reduces the industry output from Q*1
to Q*2. That is, firms have completely shifted the incidence of T to consumers!
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