Chapter 13: perfect competition

characteristics of a perfectly competitive market

• Many buyers and sellers

• Identical (homogeneous) products

• No barriers to entry or exit

• Perfect information

• Firms are price takers: no single firm can influence market price

• In the long run, firms make zero economic profit

Rule of thumb for profit maximization in any market

1. a firm maximizes profit where MR = MC

2. in perfect competition, MR = market price

3. produce the largest quantity where MR >= MC

Market power

• The ability of a firm to influence or control the price of its product

• Firms with unique products or fewer competitors (e.g., monopolies, oligopolies) have market power

• Perfectly competitive firms have no market power

Constraints faced by firms

1. technological constraints

2. market constraints

3. cost constraints

4. firms must choose output where profit is maximized, given these limits

Profit maximization in perfect competition

1. set output where price = marginal cost P=MC

2. Since P = MR in perfect competition, this is also where MR = MC

3. if p >ATC: POSITIVE PROFIT

4. if p = ATC zero profit

5. if P< Atc loss

total revenue

price times quantity sold

average revenue

TR / Q

marginal revenue

Change in total revenue/ change in quantity

P =

MR = AR

Shut down short run

• Short run: Shut down if Price < AVC (can’t cover variable costs)

Long run

Long run: Exit if Price < ATC (can’t cover total costs)

Shutting down means producing zero output but still paying fixed costs in the short run

Short run shutdown decision

1. If P < AVC, firm shuts down immediately

2. If P ≥ AVC, keep operating to cover some costs

3. Still pays fixed costs, but avoids additional variable losses

Long run exit decision

1. Exit if Price < ATC in the long run

2. In long-run equilibrium, Price = minimum ATC

3. Firms that can’t cover total costs will exit, and new firms may enter if profits exist

Firm and market supply curves

1. Firm supply curve is the portion of the MC curve above the AVC

2. Market supply curve is the horizontal sum of all individual firms’ supply curves

3. In long run, market supply is more elastic, adjusting for entry and exit

when a firm shut down production it avoids

incurring variable costs

1. fixed costs remain and are sunk in the short run

2. bc fixed costs are sunk, they are irrelevant in deciding whether to shut down iin the short run

short run decision to produce depends

on variable costs not fixed costs

the long run decision to produce depends

on the total cost, since all costs are variable in the long run

reading ATC graphically

U-shaped curve above AVC, intersects MC at ATC’s minimum

AVC graphically

U-shaped curve below ATC, intersects MC at AVC’s minimum

MC graphically

Intersects ATC and AVC at their minimum points

Short run supply graphically

MC curve above AVC

shutdown point graphically

Minimum point of AVC (MC = AVC)

Exit point graphically

Minimum point of ATC (MC = ATC)

long run graphically

Horizontal line at min ATC if in a constant cost industry

Short run Exit/shutdown rule

In the short run, firms must decide whether to produce or shut down temporarily. Fixed costs are sunk (already paid), so the decision is based on variable costs.

🔹 Rule:

• Shut down if:

  Price (P)<Average Variable Cost (AVC)\text{Price (P)} < \text{Average Variable Cost (AVC)}Price (P)<Average Variable Cost (AVC)

• Stay open (produce) if:

  Price (P)≥AVC\text{Price (P)} \geq \text{AVC}Price (P)≥AVC

Long run exit rule

In the long run, all costs are variable, and firms can enter or exit the market.

🔹 Rule:

• Exit the market if:

  Price (P)<Average Total Cost (ATC)\text{Price (P)} < \text{Average Total Cost (ATC)}Price (P)<Average Total Cost (ATC)

• Stay in (or enter) if:

  Price (P)≥ATC\text{Price (P)} \geq \text{ATC}Price (P)≥ATC

🔑 Reason: In the long run, a firm must at least cover all its costs (both fixed and variable) to survive. If it can't, it will exit permanently.

Long run supply

the key difference between short run and long run supply is that firms are able to enter and exit the market in the long run

if positive economic profits exist

1. P >ATC

2. new firms enter to gain profits

3. the market supply curve shifts outward until P = ATC

4. economic profits go to 0 for all firms

If negative economic profits exist

1. P< ATC

2. some firms exit the market

3. the market supply curve shifts inward until P = ATC

4. economic profits go to zero for all forms

long run economic profits

• In the long run, economic profits trend toward zero due to free entry and exit.

• If firms are earning positive profits, new firms enter, increasing supply and driving down price.

• If firms face losses, some exit, decreasing supply and raising price.

• Long-run equilibrium is reached when:

  Price=Minimum ATCandEconomic Profit=0\text{Price} = \text{Minimum ATC} \quad \text{and} \quad \text{Economic Profit} = 0Price=Minimum ATCandEconomic Profit=0

Market entry due to changing production costs

• Falling production costs (e.g., tech improvements or cheaper inputs) → lower ATC → firms enter market due to potential profits.

• Rising production costs → higher ATC → some firms exit, reducing supply.

• In constant-cost industries, long-run supply remains horizontal.

• In increasing-cost industries, entry causes upward pressure on input prices → upward-sloping long-run supply curve.

Responding to shifts in demand (long run)

• Demand increases → short-run price rises → firms earn positive profit → new firms enter → supply increases → price falls back to min ATC.

• Demand decreases → short-run price drops → firms incur losses → some exit → supply contracts → price rises back to min ATC.

• In both cases, the market reaches a new long-run equilibrium with zero economic profit.