Perfect Competition Review
Perfect Competition: Comprehensive Study Notes
Learning Outcomes
Define and discuss market structure.
Identify and explain different market structures.
Discuss the characteristics and assumptions of perfect competition.
Analyze the relationship between price, marginal cost, marginal revenue, and profit under perfect competition.
Discuss profit-maximizing and shut-down rules for perfect competition using both total and marginal approaches.
Discuss and analyze short-run and long-run equilibriums for perfect competition.
Introduction to Market Structure
Goal of a Company: To maximize its profits.
Profit Formula: Profits = Total Revenues - Total Costs of Production.
Costs of Production: Principles affecting costs are generally the same for all firms, regardless of industry.
Revenues: Vary significantly by industry due to the firm's power to affect product price.
Market Structures Classification: Industries are grouped into four types based on the firm's power to influence product price.
Types of Market Structures
Imperfect Markets:
Monopoly
Oligopoly
Monopolistic Competition
Monopsony (buyer-side market power)
Perfect Market:
Perfect Competition
Perfect Competition Overview
Perfect competition represents one extreme of the market spectrum.
Market structures are classified by:
The number of firms in the market.
The ease of entry and exit for firms.
The firms' ability to differentiate their products.
Characteristics and Assumptions of Perfect Competition
Many Sellers and Buyers (Price Takers):
No single seller or buyer can affect the market price by themselves.
Both sellers and buyers passively accept the market-determined price.
Perfect Information/Knowledge:
All buyers and sellers have complete information about prices, competitors' charges, and all relevant product features.
Freedom of Entry and Exit:
Any company can easily enter or leave the industry without barriers.
Homogenous Products:
One firm's product is identical to another firm's product.
There are no perfect real-world examples, but agriculture is often considered the closest approximation.
Individual vs. Market Demand in Perfect Competition
Market Demand and Supply: The overall market determines the equilibrium price, P, and quantity, Q.
Individual Firm Demand: An individual perfectly competitive firm faces a perfectly elastic (horizontal) demand curve at the market price, P, because it is a price taker. It can sell any quantity at that price.
Output Decisions of Perfectly Competitive Firms
Firm's Objective: To produce the level of output that will maximize profit.
Profit (oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{π}}}): Defined as total revenue (R) minus total cost (C).
R = P imes Q, where P is selling price and Q is quantity sold.
C = AC imes Q, where AC is average cost and Q is quantity produced.
Alternatively, Profit (oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{oldsymbol{}oldsymbol{oldsymbol{oldsymbol{oldsymbol{π}}}}) = (P - AC) imes Q.
Revenue Structure of the Competitive Firm
Price-Taking Firm: The firm takes the price from the market equilibrium.
Total Revenue (TR): Since the price (P) is constant, total revenue is directly proportional to quantity sold (Q), resulting in an upward-sloping straight line from the origin on a TR curve. Example: If P = ext{ extdollar}25, then TR for Q=1 is ext{ extdollar}25, for Q=2 is ext{ extdollar}50 etc.
TR = P imes Q
Approaches to Finding Profit Maximization Outputs
A. Totals Approach
Rule: Maximize profit by finding the largest gap between Total Revenue (TR) and Total Cost (TC).
Example (Rakes per Minute Data):
Output (Q)
TR ( extdollar)
Short-run TC (STC) ( extdollar)
Profit (TR - STC) ( extdollar)
0
0.00
36
-36
1
25.00
44
-19
2
50.00
48
2
3
75.00
51
24
4
100.00
56
44
5
125.00
63
62
6
150.00
72
78
7
175.00
84
91
8
200.00
101
99
9
225.00
126
99
10
250.00
166
84
Observation: Maximum profit of ext{ extdollar}99 occurs at both Q=8 and Q=9. Typically, firms choose to produce more if profit is the same.
Graphical Representation: The profit-maximizing quantity is where the vertical distance between the TR curve and the STC curve is largest.
B. Marginal Approach
Rule: Produce where Marginal Revenue (MR) is equal to Marginal Cost (MC).
Marginal Revenue (MR):
The addition to total revenue from producing and selling one more unit of a good.
Formula: MR = rac{ ext{Change in Total Revenue}}{ ext{Change in Quantity Produced}}.
In a perfectly competitive market, marginal revenue is always equal to the market price (MR = P).
Marginal Cost (MC):
The addition to total cost from producing and selling one more unit.
Formula: MC = rac{ ext{Change in Total Cost}}{ ext{Change in Quantity Produced}}.
Decision Rules:
If MR > MC, increase total profits by producing more.
If MR < MC, increase total profits by producing less.
Maximize profit where MR = MC.
Example (Rakes per Minute Data):
Output (Q)
Price (P) ( extdollar)
MR ( extdollar)
Short-run MC (SMC) ( extdollar)
Profit ( extdollar)
0
25
-
-
-36
1
25
25
8
-19
2
25
25
4
2
3
25
25
3
24
4
25
25
5
44
5
25
25
7
62
6
25
25
9
78
7
25
25
12
91
8
25
25
17
99
9
25
25
25
99
10
25
25
40
84
Observation: At Q=9, MR = P = ext{ extdollar}25 and SMC = ext{ extdollar}25. Therefore, profit is maximized at Q=9. The profit is ext{ extdollar}99.
Computing Profit
Profit per unit: Revenue per unit - Cost per unit (P - AC).
Total Profit: (P - AC) imes Q.
Example: If P = ext{ extdollar}25, average cost (AC) at Q=9 is ext{ extdollar}14. Then profit per unit is ext{ extdollar}25 - ext{ extdollar}14 = ext{ extdollar}11.
Total Profit = ( ext{ extdollar}25 - ext{ extdollar}14) imes 9 = ext{ extdollar}11 imes 9 = ext{ extdollar}99.
Break-Even Point
Occurs when price (P) is equal to the minimum of the Short-run Average Total Cost (SATC).
At this point, the firm makes zero economic profit (no profit, no loss), covering all its expenses.
The Shut-Down Decision (Short-Run)
Context: A firm might be making a loss but needs to decide whether to continue operating or shut down temporarily.
Basis for Decision: Variable costs (operating costs).
Rules (using price and average variable cost):
If P > AVC, the firm should continue to operate. It is covering its operating costs and contributing towards fixed costs, minimizing its loss.
If P ext{ is right at the minimum of } AVC, the firm should shut down. It cannot cover even its operating costs.
The shut-down point is where the firm is indifferent between operating and shutting down, occurring at the minimum of the Average Variable Cost (AVC).
Rules (using total revenue and total variable cost):
If TR > TVC, the firm should continue to operate.
If TR ext{ Equal to or Less than } TVC, the firm should shut down.
Example: If price drops to ext{ extdollar}9 and the average variable cost (AVC) of producing 6 rakes is ext{ extdollar}6.
Since P ( ext{ extdollar}9) > AVC ( ext{ extdollar}6), the firm continues to operate.
Even though it's suffering a loss (P < SATC), it covers full variable costs and part of the fixed costs, minimizing the loss compared to shutting down completely.
The Competitive Firm's Short-Run Supply Curve
Definition: For any price above the shut-down price, the firm adjusts output along its marginal cost curve.
Location: The firm's short-run supply curve is its Short-run Marginal Cost (SMC) curve rising above the minimum point on the Short-run Average Variable Cost (SAVC) curve.
Below Shut-down Price: If the price falls below the shut-down price (minimum SAVC), the quantity supplied by the firm equals zero.
Short-run Market Supply Curve: Shows the relationship between market price and the quantity supplied by all firms in the short run.
The Long-Run Equilibrium in Perfect Competition
A market reaches long-run equilibrium when three conditions hold:
Quantity supplied equals quantity demanded.
Each firm in the market maximizes its profit given the market price.
Each firm in the market earns zero economic profit, meaning there's no incentive for other firms to enter or existing firms to leave the market.
Zero Economic Profit Explained:
In the long run, if firms are earning positive economic profit, new firms will enter the industry, increasing market supply and driving down the price until economic profit is zero.
If firms are making economic losses, existing firms will exit the industry, decreasing market supply and driving up the price until economic profit is zero.
Therefore, in long-run equilibrium: P = MR = MC = SATC.
Zero Accounting Profit: This does not mean zero accounting profit. Zero economic profit means that firms are earning a normal rate of return on their capital, which is included as part of explicit or implicit costs.
Long-Run Supply Curve for an Increasing-Cost Industry
Definition: An industry in which the average cost of production increases as the total output of the industry increases.
Reasons for Increasing Average Cost:
Increasing Input Prices: As the industry expands, it demands more inputs, driving up their prices.
Less Productive Inputs: New entrants or expanded operations might employ less efficient labor or utilize less optimal resources.
Slope: The long-run industry supply curve for an increasing-cost industry is positively-sloped (upward sloping).
Example (Rake Industry): As industry output increases from 7 to 14 units, the average cost of production per unit rises from ext{ extdollar}10 to ext{ extdollar}14 (e.g., total cost of 7 rakes is ext{ extdollar}70, average cost ext{ extdollar}10. With 150 rakes (1,050 total cost), average cost becomes ext{ extdollar}14).
Effect of Increased Demand: An increase in demand initially pushes up price, leading to short-run profits and new firm entry. In the long run, equilibrium settles at a higher price than before the demand increase because of the rising average costs associated with increased industry output.
Long-Run Supply Curve for a Constant-Cost Industry
Definition: An industry in which firms continue to buy inputs at the same prices, regardless of industry output.
Slope: The long-run supply curve for a constant-cost industry is horizontal at the constant average cost of production.
Effect of Increased Demand: An increase in demand for the product (e.g., ice) raises the price in the short run. New firms enter, but since input costs do not rise, the industry eventually settles at the same long-run equilibrium price as before the demand increase. Only the quantity supplied increases.
Summary of Key Rules and Concepts
Profit Maximization Rules
Totals Approach: Maximize profit where the gap between the Total Revenue (TR) curve and the Short-run Total Cost (STC) curve is the largest.
Marginal Approach: Maximize economic profits where Marginal Revenue (MR) equals Marginal Cost (MC).
Shut-Down Rules (If economic loss in the short-run)
Continue to Produce: If Total Revenue (TR) ext{is greater than or equal to} Total Variable Cost (TVC), or if Price (P) ext{is greater than} Short-run Average Variable Cost (SAVC).
Shut Down: If Total Revenue (TR) ext{is less than or equal to} Total Variable Cost (TVC), or if Price (P) ext{is less than or equal to} Short-run Average Variable Cost (SAVC).
Firm's Short-Run Supply Curve
The firm's short-run supply curve is its Short-run Marginal Cost (SMC) curve rising above the minimum point on its Short-run Average Variable Cost (SAVC) curve.
Long-Run Equilibrium Conditions
Quantity demanded = Quantity supplied.
Each firm in the market maximizes profit.
Economic profit = 0.
Increasing-Cost Industry:
Average cost of industry production rises as total industry quantity increases.
Reasons: Increasing input prices and less productive inputs.
Has an upward-sloping long-run supply curve.
Constant-Cost Industry:
Average cost of industry production stays constant as total industry output rises.
Has a horizontal long-run supply curve.