Chapter 10: Perfectly Competitive Markets - Notes

Four Market Models

• Economists categorize industries into four market structures:
  • Perfectly Competitive
  • Monopoly
  • Monopolistic Competition
  • Oligopoly
• These models differ based on:
  • Number of firms in the industry
  • Homogeneity or differentiation of products
  • Ease of entry into the industry

Characteristics of Each Market Model

• Perfectly Competitive
  • Large number of firms
  • Homogenous products
  • Easy entry and exit
• Monopoly
  • Single seller constitutes the entire industry
  • Single product with no close substitutes
• Monopolistic Competition
  • Many sellers
  • Differentiated products (competing on features, not price)
  • Easy entry and exit
• Oligopoly
  • Few firms
  • Similar or unique products
  • Firms are affected by rival's decisions and must consider rival strategies when determining price and quantity

Perfect Competition

• Characteristics
  • Rare in the real world but found in farming and basic metals industries
  • Serves as a useful model for analyzing efficiency and pricing
  • Large number of independently acting sellers
  • Large national or international markets
  • Standardized (homogenous) product, meaning no product differentiation is needed
  • Consumers are indifferent between sellers if the price is the same
  • Buyers view products from different firms as perfect substitutes
  • Firms are "price takers" and must accept the market price
  • Each firm produces a small fraction of the total output, so it has no influence on the market price
  • If a firm sets a price higher than the market price, no one will buy from it
  • If a firm sets a price lower than the market price, it will not be maximizing profit since the firm can sell as many units as it wants at the market price (it picks the amount that maximizes profit)
  • Free entry and exit with no significant legal, technological, financial, or other obstacles

Perfectly Elastic Demand

• Each firm offers a negligible fraction of total market supply, so it must accept the market price, making it a price taker, not a price maker
• Demand schedule is perfectly elastic (horizontal) at the market price
• Total Revenue (TR) increases at a constant rate
  • Example: If Price = $131, then TR increases by $131 for every quantity sold
• Price in Perfect Competition is set by market demand and supply
• Firms are price takers and accept the market price
• Example: At a market price of $131, a firm can produce and sell as many or as few units as it likes

Average, Total, and Marginal Revenue

• Total Revenue (TR) is calculated as: TR = P \cdot Q
• The firm's demand schedule is also its average-revenue schedule
• Average Revenue (AR) is calculated as: AR = \frac{P \cdot Q}{Q} = P
  • Example: If P = $131, AR = $131
  • Average Revenue tells us how much income per unit we are earning
• Marginal revenue (MR) is the change in total revenue from selling one more unit of output
  • Example: If TR0 = $0 and TR1 = $131, then MR = $131
• In perfect competition, marginal revenue and price are equal

Profit Maximization: Total Revenue – Total Cost Approach

• Perfectly competitive firm is a price taker and can only control how much it outputs
• In the short run, plant size is fixed, and firms can only use resources more intensively
• Firms attempt to maximize profit by adjusting output
• Two approaches to determining profit-maximizing output:
  • Total Revenue (TR) - Total Cost (TC) Approach
  • Marginal Revenue (MR) = Marginal Cost (MC) Approach
• Both methods apply to all market types

TR-TC Approach Steps

• Firms ask:
  • Should we produce this product?
  • If so, in what amount?
  • What economic profit (or loss) will we realize?
• Costs firms face: TC = FC + VC (Reflects explicit and implicit costs)
• Profit is calculated as: \pi = TR - TC
• Determine the output level that maximizes profit by finding the largest difference between TR and TC

TR – TC Graph

• TR is a straight line (price is constant)
• TC rises with output
• Slope of TC varies with resource use and efficiency
• Diminishing Returns:
  • Early output: increasing returns, TC rises slowly
  • Later output: diminishing returns, TC rises faster
  • Each added input gives less output
• Two break-even points: an output at which a firm makes a normal profit (zero economic profit)
• Maximum profit occurs where the distance between TR and TC is greatest

Profit Maximization: Marginal Revenue = Marginal Cost Approach

• Compare MR and MC for each unit
  • If MR > MC, the next unit increases profit
  • If MR < MC, the next unit decreases profit
• Stages of production:
  • MR > MC: Profitable to produce, keep producing
  • MR = MC: Stop producing
  • MR < MC: Produced too much, should produce less
• Profit is maximized (or Loss minimized) when MR = MC (only applies if producing is better than shutting down)
• Maximize profit when MR = MC applies to:
  • Perfectly Competitive Firms
  • Monopoly
  • Oligopoly
  • Monopolistic Competition
• For Perfectly Competitive Firms: P = MR, thus max profit when P = MC
• MR = MC Rule Tips:
  • If MR = MC at a fraction, produce the last full unit where MR > MC
  • Only apply the rule if P ≥ min AVC, or else shut down
• Example: Assume P = $131. This means MR = $131
• Profit maximized at the last unit where MR ≥ MC

Profit-Maximizing Case

1. Find P = MC
2. Establish Q
3. From Q, go up to ATC
4. Establish ATC
5. Calculate Profit: \pi = (P - ATC)Q

• Graphically:
  • \pi = TR - TC
  • \pi = P \cdot Q - ATC \cdot Q
  • \pi = (P – ATC) Q
  • (P – ATC) = per-unit profit
• We can also calculate profit using:
  • \pi = TR - TC
  • TR = P \cdot Q
  • TC = ATC \cdot Q
  • \pi = TR - TC
• Goal: maximize total profit, not per-unit profit
• Per-unit profit might be highest at a lower quantity, but producing more units can increase total profit

Profit-Maximizing Case: Long Run

• If profits exist in the short-run, new firms will enter the market
• Supply will shift to the right
• Competition will drive prices down until P = ATC
• \pi = (P - ATC)Q
• When P = ATC, \pi = 0
• In the long run, all firms will earn a normal profit (zero economic profit)

Loss-Minimizing Case

• Assume too many firms entered the market, and the market price is lower
• Even if the firm is making a loss, it might still be better to produce
• Early production: high MC due to low marginal product, so (P – MC) improves as production increases
• Calculate the loss by comparing ATC and Price at the quantity where P=MC
  • Average Loss: (ATC - P)
  • Total Loss: (P – ATC)Q
• It is better to produce at a loss than to shut down if producing covers some of the fixed costs

Shutdown Case

• If the market price is so low that at every output level, the firm’s average variable cost is greater than the price, the firm should shut down
• A competitive firm will maximize profit or minimize loss in the short run by producing that output at which MR (= P) = MC, provided that market price exceeds minimum average variable cost

Competitive Markets Are Efficient

• Adam Smith argued that everyone pursuing their own interests will maximize the interests of society if markets are competitive
• Total Surplus (CS+PS) is maximized

Short-Run Supply Curve

• In the short run, a firm will continue producing so long as price is greater than minimum AVC
• P = min AVC is known as the shutdown point

Long-Run Supply Curve

• In the long run, a firm must make at least a normal profit (zero economic profit)
• This is where P = min ATC, known as the break-even point
• Firms making economic profit in the market attracts new firms, increasing competition and driving the price down to P = min ATC

How Competitive Are Markets?

• Real-world examples illustrate that even in situations where demand surges (e.g., hand sanitizer during COVID-19), it can take time for new suppliers to enter the market and increase supplies.