1、PERFECT COMPETITION,11,CHAPTER,Objectives,After studying this chapter, you will able toDefine perfect competitionExplain how price and output are determined in perfect competition Explain why firms sometimes shut down temporarily and lay off workersExplain why firms enter and leave the industry Pred
2、ict the effects of a change in demand and of a technological advanceExplain why perfect competition is efficient,Competition,Perfect competition is an industry in which:Many firms sell identical products to many buyers.There are no restrictions to entry into the industry.Established firms have no ad
3、vantages over new ones.Sellers and buyers are well informed about prices.,Competition,How Perfect Competition ArisesPerfect competition arises:When firms minimum efficient scale is small relative to market demand so there is room for many firms in the industry.And when each firm is perceived to prod
4、uce a good or service that has no unique characteristics, so consumers dont care which firm they buy from.,Competition,Price TakersIn perfect competition, each firm is a price taker.A price taker is a firm that cannot influence the price of a good or service.No single firm can influence the priceit
5、must “take” the equilibrium market price.Each firms output is a perfect substitute for the output of the other firms, so the demand for each firms output is perfectly elastic.,Competition,Economic Profit and RevenueThe goal of each firm is to maximize economic profit, which equals total revenue minu
6、s total cost.Total cost is the opportunity cost of production, which includes normal profit.A firms total revenue equals price, P, multiplied by quantity sold, Q, or P Q.,Competition,A firms marginal revenue is the change in total revenue that results from a one-unit increase in the quantity sold.Fi
7、gure 11.1 illustrates a firms revenue curves.,Competition,Figure 11.1(a) shows that market demand and supply determine the price that the firm must take.,Competition,Figure 11.1(b) shows the demand curve for the firms product, which is also its marginal revenue curve.,Competition,Because in perfect
8、competition the price remains the same as the quantity sold changes, marginal revenue equals price.,Competition,Figure 11.1(c) shows the firms total revenue curve.,The Firms Decisions in Perfect Competition,A perfectly competitive firm faces two constraints:A market constraint summarized by the mark
9、et price and the firms revenue curves A technology constraint summarized by firms product curves and cost curves (like those in Chapter 10).,The Firms Decisions in Perfect Competition,The perfectly competitive firm makes two decisions in the short run:Whether to produce or to shut down.If the decisi
10、on is to produce, what quantity to produce.A firms long-run decisions are:Whether to increase or decrease its plant size.Whether to stay in the industry or leave it.,The Firms Decisions in Perfect Competition,Profit-Maximizing OutputA perfectly competitive firm chooses the output that maximizes its
11、economic profit.One way to find the profit maximizing output is to look at the firms the total revenue and total cost curves.Figure 11.2 on the next slide looks at these curves along with the firms total profit curve.,The Firms Decisions in Perfect Competition,Part (a) shows the total revenue, TR, c
12、urve.,Part (a) also shows the total cost curve, TC, which is like the one in Chapter 10.Total revenue minus total cost is profit (or loss), shown in part (b).,The Firms Decisions in Perfect Competition,Profit is maximized when the firm produces 9 sweaters a day.,At low output levels, the firm incurs
13、 an economic lossit cant cover its fixed costs.,The Firms Decisions in Perfect Competition,At intermediate output levels, the firm earns an economic profit.,At high output levels, the firm again incurs an economic lossnow it faces steeply rising costs because of diminishing returns.,The Firms Decisi
14、ons in Perfect Competition,Marginal AnalysisThe firm can use marginal analysis to determine the profit-maximizing output. Because marginal revenue is constant and marginal cost eventually increases as output increases, profit is maximized by producing the output at which marginal revenue, MR, equals
15、 marginal cost, MC.Figure 11.3 on the next slide shows the marginal analysis that determines the profit-maximizing output.,The Firms Decisions in Perfect Competition,If MR MC, economic profit increases if output increases.,If MR MC, economic profit decreases if output increases.,If MR = MC, economic
16、 profit decreases if output changes in either direction, so economic profit is maximized.,The Firms Decisions in Perfect Competition,Profits and Losses in the Short RunMaximum profit is not always a positive economic profit.To determine whether a firm is earning an economic profit or incurring an ec
17、onomic loss, we compare the firms average total cost, ATC, at the profit maximizing output with the market price. Figure 11.4 on the next slide shows the three possible profit outcomes.,The Firms Decisions in Perfect Competition,In part (a) price equals ATC and the firm earns zero economic profit (n
18、ormal profit).,The Firms Decisions in Perfect Competition,In part (b), price exceeds ATC and the firm earns a positive economic profit.,The Firms Decisions in Perfect Competition,In part (c) price is less than ATC and the firm incurs an economic losseconomic profit is negative and the firm does not
19、even earn normal profit.,The Firms Decisions in Perfect Competition,The Firms Short-Run Supply CurveA perfectly competitive firms short run supply curve shows how the firms profit-maximizing output varies as the market price varies, other things remaining the same.Because the firm produces the outpu
20、t at which marginal cost equals marginal revenue, and because marginal revenue equals price, the firms supply curve is linked to its marginal cost curve.But there is a price below which the firm produces nothing and shuts down temporarily.,The Firms Decisions in Perfect Competition,Temporary Plant S
21、hutdownIf price is less than the minimum average variable cost, the firm shuts down temporarily and incurs a loss equal to total fixed cost.This loss is the largest that the firm must bear.If the firm were to produce just 1 unit of output at price below average variable cost, it would incur an addit
22、ional (and avoidable) loss.,The Firms Decisions in Perfect Competition,The shutdown point is the output and price at which the firm just covers its total variable cost.This point is where average variable cost is at its minimum.It is also the point at which the marginal cost curve crosses the averag
23、e variable cost curve.At the shutdown point, the firm is indifferent between producing and shutting down temporarily.It incurs a loss equal to total fixed cost from either action.,The Firms Decisions in Perfect Competition,If the price exceeds minimum average variable cost, the firm produces the qua
24、ntity at which marginal cost equals price.Price exceeds average variable cost, and the firm covers all its variable cost and at least part of its fixed cost.,The Firms Decisions in Perfect Competition,Figure 11.5 shows how the firms short-run supply curve is constructed.If price equals minimum avera
25、ge variable cost, $17 in this example, the firm is indifferent between producing nothing and producing at the shutdown point, T.,The Firms Decisions in Perfect Competition,If the price is $25, the firm produces 9 sweaters a day, the quantity at which P = MC.,The blue curve in part (b) traces the fir
26、ms short-run supply curve.,If the price is $31, the firm produces 10 sweaters a day, the quantity at which P = MC.,The Firms Decisions in Perfect Competition,Short-Run Industry Supply CurveThe short-run industry supply curve shows the quantity supplied by the industry at each price when the plant si
27、ze of each firm and the number of firms remain constant.,The Firms Decisions in Perfect Competition,The quantity supplied by the industry at any given price is the sum of the quantities supplied by all the firms in the industry at that price.,The Firms Decisions in Perfect Competition,At a price equ
28、al to minimum average variable costthe shutdown pricethe industry supply curve is perfectly elastic because some firms will produce the shutdown quantity and others will produces zero.,Output, Price, and Profit in Perfect Competition,Short-Run EquilibriumShort-run industry supply and industry demand
29、 determine the market price and output. Figure 11.7 shows a short-run equilibrium at the intersection of the demand and supply curves.,Output, Price, and Profit in Perfect Competition,A Change in Demand An increase in demand bring a rightward shift of the industry demand curve: the price rises and t
30、he quantity increases.,A decrease in demand bring a leftward shift of the industry demand curve: the price falls and the quantity decreases.,Output, Price, and Profit in Perfect Competition,Long-Run AdjustmentsIn short-run equilibrium, a firm may earn an economic profit, earn normal profit, or incur
31、 an economic loss and which of these states exists determines the further decisions the firm makes in the long run.In the long run, the firm may: Enter or exit an industry Change its plant size,Output, Price, and Profit in Perfect Competition,Entry and ExitNew firms enter an industry in which existi
32、ng firms earn an economic profit. Firms exit an industry in which they incur an economic loss.Figure 11.8 on the next slide shows the effects of entry and exit.,Output, Price, and Profit in Perfect Competition,As new firms enter an industry, industry supply increases.The industry supply curve shifts
33、 rightward.,The price falls, the quantity increases, and the economic profit of each firm decreases.,Output, Price, and Profit in Perfect Competition,As firms exit an industry, industry supply decreases.The industry supply curve shifts leftward.,The price rises, the quantity decreases, and the econo
34、mic profit of each firm increases.,Output, Price, and Profit in Perfect Competition,Changes in Plant SizeFirms change their plant size whenever doing so is profitable.If average total cost exceeds the minimum long-run average cost, firms change their plant size to lower costs and increase profits.Fi
35、gure 11.9 on the next slide shows the effects of changes in plant size.,Output, Price, and Profit in Perfect Competition,If the price is $25, firms earn zero economic profit with the current plant.,Output, Price, and Profit in Perfect Competition,But if the LRAC curve is sloping downward at the curr
36、ent output, the firm can increase profit by expanding the plant.,Output, Price, and Profit in Perfect Competition,As the plant size increases, short-run supply increases, the price falls, and economic profit decreases.,Output, Price, and Profit in Perfect Competition,Long-run equilibrium occurs when
37、 the firm is producing at the minimum long-run average cost and earning zero economic profit.,Output, Price, and Profit in Perfect Competition,Long-Run EquilibriumLong-run equilibrium occurs in a competitive industry when:Economic profit is zero, so firms neither enter nor exit the industry.Long-run
38、 average cost is at its minimum, so firms dont change their plant size.,Changing Tastes and Advancing Technology,A Permanent Change in DemandA decrease in demand shifts the demand curve leftward. The price falls and the quantity decreases.,Changing Tastes and Advancing Technology,Starting from a pos
39、ition of long-run equilibrium, the fall in price puts the price below each firms minimum average total cost and firms incur an economic loss.,Changing Tastes and Advancing Technology,Economic losses induce exit, which decreases short-run supply and shifts the short-run industry supply curve leftward
40、.,Changing Tastes and Advancing Technology,As industry supply decreases, the price rises and the market quantity continues to decrease.,Changing Tastes and Advancing Technology,With a rising price, each firm that remains in the industry increases production in a movement along the firms marginal cos
41、t curve (short-run supply curve).,Changing Tastes and Advancing Technology,A new long-run equilibrium occurs when the price has risen to equal minimum average total cost so that firms do not incur economic losses, and firms no longer leave the industry.,Changing Tastes and Advancing Technology,The m
42、ain difference between the initial and new long-run equilibrium is the number of firms in the industry.,Changing Tastes and Advancing Technology,In the new equilibrium, a smaller number of firms produce the equilibrium quantity.,Changing Tastes and Advancing Technology,A permanent increase in demand
43、 has the opposite effects to those just described and shown in Figure 11.9.An increase in demand shifts the demand curve rightward. The price rises and the quantity increases.Economic profit induces entry, which increases short-run supply and shifts the short-run industry supply curve rightward.As i
44、ndustry supply increases, the price falls and the market quantity continues to increase.,Changing Tastes and Advancing Technology,With a falling price, each firm decreases production in a movement along the firms marginal cost curve (short-run supply curve).A new long-run equilibrium occurs when the
45、 price has fallen to equal minimum average total cost so that firms do not earn economic profits, and firms no longer enter the industry.The main difference between the initial and new long-run equilibrium is the number of firms in the industry. In the new equilibrium, a larger number of firms produ
46、ce the equilibrium quantity.,Changing Tastes and Advancing Technology,External Economics and DiseconomiesThe change in the long-run equilibrium price following a permanent change in demand depends on external economies and external diseconomies.External economies are factors beyond the control of an
47、 individual firm that lower the firms costs as the industry output increases.External diseconomies are factors beyond the control of a firm that raise the firms costs as industry output increases.,Changing Tastes and Advancing Technology,In the absence of external economies or external diseconomies,
48、 a firms costs remain constant as industry output changes.Figure 11.11 illustrates the three possible cases and shows the long-run industry supply curve, which shows how the quantity supplied by an industry varies as the market price varies after all the possible adjustments have been made, includin
49、g changes in plant size and the number of firms in the industry.,Changing Tastes and Advancing Technology,Figure 11.11(a) shows that in the absence of external economies or external diseconomies, the price remains constant when demand increases.,Changing Tastes and Advancing Technology,Figure 11.11(b) shows that when external diseconomies are present, the price rises when demand increases.,Changing Tastes and Advancing Technology,Figure 11.11(c) shows that when external economies are present, the price falls when demand increases.,
