Perfect Competition Notes

Perfect Competition

Requirements for Competition

• What is required for competition in a market system?

• How would firms behave in a market characterized by extreme or perfect competition?

Characteristics of Perfect Competition

• No Barriers to Entry or Exit

  • Firms can enter or exit the market with zero transaction costs.

• Infinite Number of Sellers

  • Each seller is infinitesimally small.

• Homogeneous Products

  • No differentiation; products are perfect substitutes.

• Perfect Information

  • All sellers know all market information.

How Perfect Competition Arises

• The firm’s minimum efficient scale is small relative to market demand, allowing room for many firms.

• Each firm produces a good or service with no unique characteristics; consumers are indifferent to which firm's product they buy.

• There are no transaction costs for firms entering or exiting the market.

Price Takers

• Firms are “Price Takers.”

  • No single firm can influence the market price; it must “take” the market price.

• Each firm’s output is a perfect substitute for other firms' output.

• Demand for each firm’s output is perfectly elastic.

  • Firms can sell at a lower price, but they are giving profits away.

  • Firms can ask for a higher price, but no one will pay it.

Demand Curve

• The firm’s demand curve is horizontal.

• Sellers are price takers.

• Marginal Revenue = Price.

Market and Firm Demand

• (a) Market Demand:

  • Market demand and market supply determine the market price that the firm must take.

  • The market demand curve is downward sloping.

• (b) Firm Demand:

  • The firm’s demand curve (MR) is horizontal.

Key aspects

• Marginal Revenue = Price

• All Sellers are Price Takers

• Demand Curve is Horizontal

• Marginal Costs Decrease, Eventually Increase

• Diminishing Marginal Returns

• Average Total Cost

  • U-Shaped

  • Intersects MC @ lowest point

• Firms make zero economic profit in the long run

Output, Price, and Profit in the Short Run

• (a) Break-Even:

  • No Economic Profit or Economic Loss

• (b) Economic Profit

• (c) Economic Loss

Firm Decisions

• Firms Decide Output, Not Price

  1. What quantity to produce at the market price

  2. How to produce at the minimum cost (ATC)

  3. Whether to enter or exit a market

Profit Maximization

• Profit is maximized by producing an output where marginal revenue equals marginal cost.

  • MR = MC

• Profit decreases if the output changes in either direction.

Market Entry and Exit

• Firms Decide: Enter or Exit the market?

Stay, Exit, or Shut Down

• The firm’s goal is to maximize profit, minimize losses.

• If the firm makes an economic loss, it must decide to stay or exit the market.

• To stay in the market, a firm must cover its Average Variable Costs (AVC).

• If the firm cannot cover its AVC, it will shut down, at least temporarily.

Covering Variable Costs

• Firm Must Cover Variable Costs

• If the market price = $5, the firm incurs a loss, but it covers its AVC.

• If the price is between $5 and $7, the firm incurs a smaller loss and covers all its variable costs and some fixed costs.

• If the price is below $5, the firm does not cover its AVC and must shut down.

Short-Run Profit and Loss

• In the short run, a firm can break even, make an economic profit, or incur an economic loss, depending on the market price.

Long-Run Equilibrium

• In the long run, firms in perfect competition can only break even because firms can enter or exit the market at zero cost.

  • If firms are making an economic profit, new firms enter the market, eliminating economic profits.

  • If firms are making an economic loss, existing firms exit the market, eliminating economic losses.

Changes in Demand and Market Response

• An increase in demand brings a higher price and quantity.

  • Firms increase production.

• A decrease in demand brings a lower price and quantity.

  • Firms decrease production.

• Changes in Demand create Profits & Losses in the short run

Market Process with Economic Profits - Increase in Demand

• The demand curve shifts rightward.

• The price rises, and quantity increases; firms are now making economic profits.

• Economic profit induces entry, which increases supply, shifting the market supply curve rightward.

• As the market supply increases, the price falls and the market quantity increases.

• With a falling price, each firm decreases its output as it moves along its marginal cost curve (supply curve).

• A new long-run equilibrium occurs when the price has fallen to equal minimum average total cost.

• Firms make zero economic profit and no longer have an incentive to enter the market.

• The difference between the initial and new long-run equilibrium is the number of firms: a larger number of firms produce the equilibrium quantity.

Market Process with Economic Losses - Decrease in Demand

• The demand curve shifts leftward

• The price falls, and the quantity decreases

• The market price is now below each firm’s minimum average total cost, so firms incur economic losses.

• Economic losses cause some firms to exit, which decreases the market supply, and the price rises.

• As the price rises, the quantity produced by all firms decreases as more firms exit, but each firm remaining in the market increases its quantity.

• A new long-run equilibrium occurs when the price has risen to equal minimum average total cost.

• Since firms make zero economic profits and are no longer making economic losses, firms stop exiting the market.

• The main difference between the initial and new long-run equilibrium: Fewer firms produce the equilibrium quantity.

Changes to a Firm's Costs

• A change in the firm’s costs in perfect competition will also create economic profits or losses in the short run.

• When external economies are present

  • a new production technology that lowers costs (ATC) for all firms that adopt it, the market process forces firms in perfect competition to implement the new technology in the long run, resulting in lower costs and lower prices.

• When external diseconomies are present

  • new environmental regulations that raise costs (ATC) for all firms as production increases, the market process forces firms in perfect competition to adjust to the new regulations in the long run, resulting in higher costs and higher prices.

Technology & Regulation

• Technology improvements lower ATC and can lower Minimum Efficient Scale

• Increased Regulations increase ATC and can increase Minimum Efficient Scale

Market Process with External Economies

• A new technology enables firms to produce at a lower average total cost and a lower marginal cost; the firm’s cost curves shift downward.

• Firms that adopt the new technology make an economic profit.

• Firms that do not adopt the new technology make economic losses.

• Firms using the new technology enter the market.

• Firms using old technology exit or adopt the new technology.

• Industry supply increases, and the industry supply curve shifts rightward.

• The price falls, and the quantity increases.

• Eventually, a new long-run equilibrium emerges where all firms use the new technology, the price equals minimum average total cost, and each firm makes zero economic profit.

External Economies and Market Outcomes

• When external economies are present, firms have lower costs, and there is a lower price and higher quantity in the long run after the market process plays out.

• A new technology lowers the ATC for firms that implement it, causing them to make economic profits.

• New firms enter the market and also implement the new technology; supply increases, and eventually, firms break even.

• Firms that do not implement the new technology have a higher ATC, break even at first, but eventually incur economic losses.

New Technology Lowers Costs

• When external economies are present, a new technology brings a lower price and a higher quantity in the long run.

• Firms that use the new technology have lower costs and break even at a lower price and a higher quantity.

• An Industry with Decreasing Costs

Market Process with External Diseconomies

• A new regulation requires all firms to follow new environmental procedures, adding costs to the firm’s production process.

• After implementing the new procedures, firms produce at a higher average total cost and a higher marginal cost; the firm's cost curves shift upward.

• Firms have to implement the new procedures or exit the market.

• Firms that implement the new procedures make economic losses.

• Some firms exit.

• Industry supply decreases, and the industry supply curve shifts leftward.

• The price rises, and the quantity decreases.

• Eventually, a new long-run equilibrium emerges where all firms follow the new environmental procedures, the price equals the higher minimum average total cost, and each firm makes zero economic profit.

Market Process with External Diseconomies

• New regulations increase the Average Total Costs (ATC) for the firms that implement it, causing them to make economic losses.

• Firms exit the market, supply decreases, and eventually, firms break even, with a higher price and a lower quantity in the long run.

New Regulations Increase Costs

• When external diseconomies are present, new regulations bring a higher price and a lower quantity in the long run.

• Firms must implement the new regulations and have higher costs, so they break even at a higher price and lower quantity.

• An Industry with Increasing Costs

Long-Run Competitive Equilibrium

• In equilibrium, resources are used efficiently:

  • The quantity demanded equals the quantity supplied, so marginal social benefit equals marginal social cost.

• The gains from trade for consumers, measured by consumer surplus, and the gains from trade for producers, measured by producer surplus (=Total Gains from Trade), are maximized in the long run.

• The firms produce the highest output, produce at the lowest costs, and sell at the lowest prices.

• There is a tendency toward equilibrium.

• Perfect Competition is Efficient.

Efficient Allocation

• Perfect Competition is Efficient

• S = MSC

• D = MSB

Perfect Competition Summary

1. Unlimited Number of Sellers

2. Identical Product

3. No Restrictions to Entry/Exit

4. Perfect Information

   • Firm Demand Curve is Horizontal

   • Sellers are Price Takers, firms do not decide the price

   • Firms decide the output level creates the most profit (MR=MC), and what production process has the lowest ATC.

   • In the Short Run, they may break even, make economic profit or loss but must at least cover AVC

   • In the Long Run, there are No Economic Profits or losses because firms enter and exit until economic profit = zero

   • Perfect Competition is efficient because it creates the highest output and the lowest prices.

Long-Run Market Supply Curve - Absence of External Economies

• Absence of external economies or external diseconomies, an increase in demand does not change price in the long run.

• The long-run market supply curve LSC is horizontal.

• An Industry with Constant Costs

Long-Run Market Supply Curve - With External Economies

• When external economies are present, an increase in demand brings a lower price in the long run (because every firm’s cost structure is lower).

• The long-run market supply curve LSD is downward sloping.

• An Industry with Decreasing Costs

Long-Run Market Supply Curve - With External Diseconomies

• When external diseconomies are present, an increase in demand brings a higher price in the long run (because every firm’s cost structure is higher).

• The long-run market supply curve LSI is upward sloping.

• An Industry with Increasing Costs