Theory of Perfect Competition

Characteristics:
Many sellers/buyers Firms sell identical product (perfect substitutes) Perfect information for buying/selling decisions No Barriers to Entry/Exit of firms

Digression: Recall Rational (maximizing)

Decision-Making Rule
Take action up to Marginal Benefit (MB) = MC Firm chooses output (action) to max. profit (objective) Must understand MB & MC to producing Last chapter: About costs of producing This chapter: Introduce MB (revenue), then looks at firm behavior in comp. markets

Competitive Firms are Price Takers

Change price/output, no impact on market Sees perfectly elastic demand for its good at market price. Why? Implications:
Firms can sell all they desire at market price Price increase--Buyers substitute to other sellers Price decrease--Firm loses profits

Firms Demand = Marginal Revenue (MR)

MR = extra revenue of selling another unit = (DTR) / (DQ) Firm takes price, decides how much to sell. So firms MR = demand for its product = Market Price
Price Quantity Total Revenue (P) x (Q) 1 $5 2 10 3 15 Marginal Revenue (DTR) / (DQ) $5 5 5

$5 5 5

Firms demand = MR = Market Price

$

$
TYPICAL FIRM
(sees perfectly elastic demand for its product)

MARKET

P=5

d = MR D q
Market Q

Perfect Competition (Short Run)

Firms Profit Maximizing Output
Produce as long as MR > MC
Firm earns marginal profit (on last unit, not all units) Why not stop producing where MR > MC?

Profits maximized by producing up to: MR ( = P) = MC

Graph: Firms Profit-Maximizing Output

$

Marginal Cost

If MR > MC, increase profit with more output

Marg. profit of 70th is $3

qMax maximizes profits: P = MR = MC

d = MR Never produce over qMax

3 2

70 71 qMax

Graphing Firms Profits (example)

Profits = Revenue - Total Cost = (P - ATC) x (q) = (15 - 10) x (100) = 500
$
Profits (shaded area) MC
ATC

15
10

d = MR

qMax = 100

Graphing Firms Losses

Losses = Total Revenue - Total Cost = 720 - 800 = -80
$
Losses (shaded area) MC
ATC

10 9

d = MR

80

A Word on Market Supply Curve

Firm's MC as its Supply Curve Market Supply = Horizontal sum of firms short-run supply (MC) curves Why Market Supply Curve Slopes Up?

Perfect Competition (Long Run)

Firms Enter/Exit Industry (Inputs Variable) Long-Run Equilibrium Conditions:
Firms max profits producing at P (=MR) = MC Zero Econ Profit: P = ATC
No incentive for firms enter/exit industry. Why not? No incentive to change plant size

Firms Produce at Minimum ATC

Long Run Competitive Equilibrium

P = MC = Minimum ATC
$ TYPICAL FIRM
MC ATC

$
MARKET

P1

d = MR

P1 D

q1

Q1

Industry Adjustment to Increase Demand

Market Demand rises, Price rises Raises firms demand/MR Firm raises output (new P = MR = MC) P > ATC, short-run profits attract firms. New firms increase market supply, reducing P This lowers firms demand/MR Firms enter & P falls until 0 econ profit earned Long-run equilibrium achieved Firms profit-seeking drives adjustment process

Long Run Adjustment Process

(Increased Market Demand)
$
$ TYPICAL FIRM
MC

MARKET
D1 D2

S1

P2
a

d2 = MR2

P2 P1
A

ATC
d1 = MR1, d3 = MR3,

P1

S2

q1 q2

Questions
Do higher costs to firm mean higher prices? Do competitive firms advertise? Does competitive industry advertise? Does single industry price mean collusion or competition?

Efficiency Criterion & Perfectly Competitive Markets

(1) Resource Allocative Efficiency Explained
Any firm produces at MR = MC Since MR = P for competitive firm, then P = MC Meaning: Marginal Benefit (demanders) = Marginal Cost (suppliers of using societys resources) Societys marginal value of resources = its opportunity costs of using resources Allocative Efficiency satisfied

Competitive Markets and Allocative Efficiency

Consumer Surplus = area ABPE Supplier Surplus = area CBPE Market Surplus = area ABC Competitive Equilibrium maximizes market surplus What about Q1? A g d MARKET S

PE

f
C

e
Q1 QE

D Q

Efficiency Criterion & Perfectly Competitive Markets (cont.)

(2) Productive Efficiency
Firms produce at Minimum ATC in long-run Firms economizing on resource use If not, competing firm would undercut its price and capture extra profits

Final Thoughts
Competition Provides Incentives to:
Profit Maximize Minimize costs Innovate