Ln23 miller950022 17_ln23

Chapter 23
Perfect
Competition

Introduction
Lithium has become an increasingly important input in
the production of batteries for consumer electronics.
Consequently, the demand for this element has
increased.
Yet, the inflation-adjusted price of lithium has been
declining. What accounts for a falling price in the face
of rising demand?
In this chapter, as you learn about the characteristics of
perfectly competitive markets, you will understand how
the entry of new firms into the industry has caused this
downward trend in prices.

Copyright ©2014 Pearson Education, Inc. All rights reserved.

23-2

Learning Objectives
• Identify the characteristics of a perfectly
competitive market structure
• Discuss the process by which a perfectly
competitive firm decides how much output
to produce
• Understand how the short-run supply curve
for a perfectly competitive firm is
determined


23-3

Learning Objectives (cont'd)
• Explain how the equilibrium price is
determined in a perfectly competitive
market
• Describe what factors induce firms to enter
or exit a perfectly competitive industry
• Distinguish among constant-, increasing-,
and decreasing-cost industries based on the
shape of the long-run industry supply curve


23-4

Chapter Outline
• Characteristics of a Perfectly Competitive Market
Structure
• The Demand Curve of the Perfect Competitor
• How Much Should the Perfect Competitor Produce?
• Using Marginal Analysis to Determine the ProfitMaximizing Rate of Production
• Short-Run Profits


23-5

Chapter Outline (cont'd)
• The Short-Run Breakeven Price and the Short-Run
Shutdown Price
• The Supply Curve for a Perfectly Competitive
Industry
• Price Determination Under Perfect Competition
• The Long-Run Industry Situation: Exit and Entry
• Long-Run Equilibrium
• Competitive Pricing: Marginal Cost Pricing


23-6

Did You Know That ...
• The world’s oldest company that makes wooden
pencils recently celebrated its 350th year of
operations?
• Throughout this time, however, many other pencil
manufacturers have come and gone.
• Low costs of entering and exiting the market
account for this pattern.
• This is one of the characteristics of a perfectly
competitive market, the topic of this chapter.


23-7

Characteristics of a Perfectly Competitive
Market Structure
• Perfect Competition
– A market structure in which the decisions of
individual buyers and sellers have no effect on
market price


23-8

Characteristics of a Perfectly Competitive Market
Structure (cont'd)

• Perfectly Competitive Firm
– A firm that is such a small part of the total
industry that it cannot affect the price of the
product or service that it sells


23-9

Structure (cont'd)

• Price Taker
– A competitive firm that must take the price of its
product as given because the firm cannot
influence its price


23-10

Structure (cont'd)

• Why a perfect competitor is a price taker
1. Large number of buyers and sellers
2. Homogenous products are perfect substitutes
and indistinguishable across firms
3. Both buyers and sellers have equal access to
information
4. No barriers to entry or exit (any firm can enter
or leave the industry without serious
impediments)


23-11

The Demand Curve of the Perfect
Competitor
• Question
– If the perfectly competitive firm is a price taker,
who or what sets the price?


23-12

The Demand Curve of the Perfect
Competitor (cont'd)
• The perfectly competitive firm is a price
taker, selling a homogenous commodity
that is indistinguishable across all firms in
the industry
– Will sell all units for $5
– Will not be able to sell at a higher price
– Will face a perfectly elastic demand curve at the
going market price


23-13

Figure 23-1 The Demand Curve for Magneto
Optical Disks


23-14

How Much Should the Perfect
Competitor Produce?
• Perfect competitor accepts price as given
– Firm raises price, it sells nothing
– Firm lowers its price, it earns less revenues than
it otherwise would

• Perfect competitor has to decide how much
to produce
– Firm uses profit-maximization model


23-15

Competitor Produce? (cont'd)
• The model assumes that firms attempt to
maximize their total profits.
– The positive difference between total revenues
and total costs

• The model also assumes firms seek to
minimize losses
– When total revenues may be less than total
costs


23-16

• Total Revenues
– The price per unit times the total quantity sold
– The same as total receipts from the sale of
output


23-17


Profit

π = Total revenue (TR) – Total cost (TC)
TR = P x Q
TC = TFC + TVC

P is determined by the market in perfect competition
Q is determined by the producer to maximize profit


23-18

• For the perfect competitor, price is also
equal to average revenue (AR) because

TR PQ
AR =
=
= P
Q
Q
• The demand curve is the average revenue
curve


23-19

Figure 23-2 Profit Maximization, Panel
(a)


23-20

(b)


23-21

(c)


23-22

• Profit-Maximizing Rate of Production
– The rate of production that maximizes total
profits, or the difference between total revenues
and total costs
– Also, the rate of production at which marginal
revenue equals marginal cost


23-23

Using Marginal Analysis to Determine the ProfitMaximizing Rate of Production

• Marginal Revenue
– The change in total revenues divided by the
change in output

MR =

change in TR
change in Q


23-24

Using Marginal Analysis to Determine the ProfitMaximizing Rate of Production (cont’d)

• Marginal Cost
– The change in total cost divided by the change
in output

MR =

change in TC
change in Q


23-25

Using Marginal Analysis to Determine the ProfitMaximizing Rate of Production (cont'd)

• Profit maximization occurs at the rate of
output at which
– marginal revenue equals marginal cost

MR = MC


23-26

Short-Run Profits
• To find out what our competitive individual
magneto optical disk producer is making in
terms of profits in the short run, we have to
determine the excess of price above
average total cost


23-27

Short-Run Profits (cont'd)
• From Figure 23-2 previously, if we have production
and sales of seven Titanium batteries, TR = $35,
TC = $30, and profit = $5 per hour.
• Now we take info from column 6 in panel (a) and
add it to panel (c) to get Figure 23-3.


23-28

Figure 23-3 Measuring Total Profits


23-29

• Graphical depiction of maximum profits and
graphical depiction of minimum losses
– The height of the rectangular box in the previous
figure represents profits per unit
– The length represents the amount of units
produced
– When we multiply these two quantities, we get
total economic profits


23-30

• Short-run average profits are determined
by comparing ATC with P = MR = AR at the
profit-maximizing Q
• In the short run, the perfectly competitive
firm can make either economic profits or
economic losses


23-31

Figure 23-4 Minimization of Short-Run
Losses


23-32

Short-Run Profits (cont’d)
• We see in the previous Figure 23-4 that the
marginal revenue (d2) curve is intersected (from
below) by the marginal cost curve at an output rate
of 5 batteries per hour
• The firm is clearly not making profits because
average total costs at that output rate are greater
than the price of $3 per battery
• The losses are shown in the shaded area


23-33

The Short-Run Break-Even Price and the
Short-Run Shutdown Price
• What do you think?
– Would you continue to produce if you were
incurring a loss?
• In the short run?
• In the long run?


23-34

The Short-Run Break-Even Price and the ShortRun Shutdown Price (cont'd)

• As long as total revenues from continuing
to produce output exceed the associated
variable costs, the firm will continue to
produce
• A firm goes out of business when the
owners sell its assets; a firm temporarily
shuts down when it stops producing, but is
still in business


23-35


• As long as the price per unit sold exceeds
the average variable cost per unit produced,
the earnings of the firm’s owners will be
higher if it continues to produce in the short
run than if it shuts down.


23-36


• Short-Run Break-Even Price
– The price at which a firm’s total revenues equal
its total costs
– At the break-even price, the firm is just making
a normal rate of return on its capital investment
(it’s covering its explicit and implicit costs).

• Short-Run Shutdown Price
– The price that just covers average variable costs
– It occurs just below the intersection of the
marginal cost curve and the average variable
cost curve.


23-37

Figure 23-5 Short-Run Break-Even and
Shutdown Prices


23-38


• The meaning of zero economic profits
• Question
– Why produce if you are not making a profit?

• Answer
– Distinguish between economic profits and
accounting profits
– Remember when economic profits are zero a
firm can still have positive accounting profits


23-39

The Supply Curve for a Perfectly
Competitive Industry
• Question
– What does the short-run supply curve for the
individual firm look like?

• Answer
– The firm’s short-run supply curve in a
competitive industry is its marginal cost curve at
and above the point of intersection with the
average variable cost curve


23-40

Figure 23-6 The Individual Firm’s
Short-Run Supply Curve


23-41

Competitive Industry (cont'd)
• The Industry Supply Curve
– The locus of points showing the minimum prices
at which given quantities will be forthcoming
– Also called the market supply curve


23-42

Figure 23-7 Deriving the Industry
Supply Curve


23-43

Example: Vets Respond to Higher
Market Prices of Treatments for Fido
• Despite slight differences between
veterinary clinics, the 16,000 veterinary
practices in the U.S. approximate a perfectly
competitive industry.
• The demand for veterinary services has
increased over the past decade, causing
average fees to rise by 50 percent.
• Clinics have responded by providing more
pet care services, thereby moving up along
their individual supply curves.

23-44

Competitive Industry (cont'd)
• Factors that influence the industry supply
curve (determinants of supply)
– Firm’s productivity
– Factor costs (wages, prices of raw materials)
– Taxes and subsidies
– Number of sellers


23-45

Price Determination Under Perfect
Competition
• Question
– How is the market, or “going,” price established
in a competitive market?

• Answer
– This price is established by the interaction of all
the suppliers (firms) and all the demanders
(consumers)


23-46

Price Determination Under Perfect
Competition (cont'd)
• The competitive price is determined by the
intersection of the market demand curve
and the market supply curve
– The market supply curve is equal to the
horizontal summation of the supply curves of the
individual firms


23-47

Figure 23-8 Industry Demand and Supply Curves
and the Individual Firm Demand Curve, Panel (a)


23-48

Figure 23-8 Industry Demand and Supply Curves
and the Individual Firm Demand Curve, Panel (b)


23-49

What If . . . The government mandated that
prices stay at long-run equilibrium levels?

• If the government were to restrict price
variations by keeping prices at long-run
equilibrium levels, they would be unable to
adjust to short-run changes in demand or
supply.
• The result would be shortages or surpluses
of certain products.


23-50

The Long-Run Industry Situation:
Exit and Entry
• Profits and losses act as signals for
resources to enter an industry or to leave
an industry


23-51

Exit and Entry (cont'd)
• Signals
– Compact ways of conveying to economic
decision makers information needed to make
decisions
– An effective signal not only conveys information
but also provides the incentive to react
appropriately


23-52

• Exit and entry of firms
– Economic profits
• Signal resources to enter the market

– Economic losses
• Signal resources to exit the market


23-53

• Allocation of capital and market signals
– Price system allocates capital according to the
relative expected rates of return on alternative
investments.
– Investors and other suppliers of resources
respond to market signals about their highestvalued opportunities.


23-54

Example: For Many Hamburger Sellers,
the Exit Signal is Flashing Red
• Increased demand and higher incomes led
many firms to enter the hamburger fast
food market in the 2000s.
• As demand and incomes have declined in
the current economic slowdown, prices of
hamburgers have remained unchanged,
even though beef prices have increased.
• This has resulted in negative economic
profits for some sellers, and many firms
have chosen to exit the market.

23-55

• Tendency toward equilibrium (note that
firms are adjusting all of the time)
– At break-even, resources will not enter or exit
the market
– In competitive long-run equilibrium, firms will
make zero economic profits


23-56

Example: Economic Profits Attract OnlineDaily-Deals Entrants in Droves
• For a few years, Groupon and LivingSocial
were the only firms providing daily deals on
the Internet.
• Since 2011, however, there have been new
entrants into the industry, including
Facebook, Google, TravelZoo, and Yipit.
• Thus, positive economic profits have
generated substantial entry of new firms.


23-57

• Long-Run Industry Supply Curve
– A market supply curve showing the relationship
between prices and quantities after firms have
been allowed time to enter or exit from an
industry, depending on whether there have been
positive or negative economic profits


23-58

• Constant-Cost Industry
– An industry whose total output can be increased
without an increase in long-run per-unit costs
– Its long-run supply curve is horizontal.


23-59

Figure 23-9 Constant-Cost, Increasing-Cost, and
Decreasing-Cost Industries, Panel (a)


23-60

• Increasing-Cost Industry
– An industry in which an increase in industry
output is accompanied by an increase in longrun per unit costs
– Its long-run industry supply curve slopes upward


23-61

Decreasing-Cost Industries, Panel (b)


23-62

• Decreasing-Cost Industry
– An industry in which an increase in industry
output leads to a reduction in long-run per-unit
costs
– Its long-run industry supply curve slopes
downward.


23-63

Decreasing-Cost Industries, Panel (c)


23-64

Long-Run Equilibrium
• In the long run, the firm can change the
scale of its plant, adjusting its plant size in
such a way that it has no further incentive
to change; it will do so until profits are
maximized
• In the long run, a competitive firm produces
where price, marginal revenue, marginal
cost, short-run minimum average cost, and
long-run minimum average cost are equal


23-65

Figure 23-10 Long-Run Firm
Competitive Equilibrium


23-66

Competitive Pricing: Marginal Cost
Pricing
• Marginal Cost Pricing
– A system of pricing in which the price charged is
equal to the opportunity cost to society of
producing one more unit of the good or service
in question
– The opportunity cost is the marginal cost to
society.


23-67

Competitive Pricing: Marginal Cost
Pricing (cont'd)
• Market Failure
– A situation in which an unrestrained market
operation leads to either too few or too many
resources going to a specific economic activity


23-68

You Are There: Looking to Enter a Competitive
Online Market? Rent a Desk!
• A company called Plug and Play Tech Centers rents
shared workspaces consisting of desks and Internet
access points.
• This allows an online service provider to have
access to about 20 square feet of office space at a
very low cost.
• This makes entry and exit very easy for someone
who provides professional services online.


23-69

Issues & Applications: A Decreasing-Cost, “White
Gold” Industry
• During the past two decades, new firms have
entered the lithium industry by using a technology
that extracts the element from ancient lakebeds.
• One result is that input prices for lithium producers
have declined.
• Figure 23-11 on the next page shows the market
price of lithium since 1952.
• The decline in the price of lithium following the
entry of more firms shows that it is a decreasingcost industry.


23-70

Figure 23-11 Index Measure of the InflationAdjusted Price of Lithium since 1952

Source: U.S. Geological Survey.

23-71

Summary Discussion of Learning
Objectives
• The characteristics of a perfectly
competitive market structure
1. Large number of buyers and sellers
2. Homogeneous product
3. Buyers and sellers have equal access to
information
4. No barriers to entry and exit


23-72

Objectives (cont'd)
• How a perfectly competitive firm decides
how much to produce
– Economic profits are maximized when marginal
cost equals marginal revenue as long as the
market price is not below the short-run
shutdown price, where the marginal cost curve
crosses the average variable cost curve


23-73

Objectives (cont'd)
• The short-run supply curve of a perfectly
competitive firm
– The rising part of the marginal cost curve above
minimum average variable cost

• The equilibrium price in a perfectly
competitive market
– A price at which the total amount of output
supplied by all firms is equal to the total amount
of output demanded by all buyers


23-74

Objectives (cont'd)
• Incentives to enter or exit a perfectly
competitive industry
– Economic profits induce entry of new firms
– Economic losses will induce firms to exit the
industry


23-75

Objectives (cont'd)
• The long-run industry supply curve and constant-,
increasing-, and decreasing-cost industries
– The relationship between price and quantity after firms
have been able to enter or exit the industry
– Constant-cost industry
• Horizontal long-run supply curve

– Increasing-cost industry
• Upward-sloping long-run supply curve

– Decreasing-cost industry
• Downward-sloping long-run supply curve


23-76

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