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11
PERFECT
COMPETITION
FIGURE 11.1
Key Concepts
Competition
Perfect competition is an industry with many firms,
each selling an identical good; many buyers; no restrictions on entry into the industry; no advantage for existing firms over new firms; and sellers and buyers are
well informed about prices.
Perfect competition occurs when the minimum efficient
scale of a firm is small relative to demand. The minimum efficient scale of a firm is the smallest quantity of
output at which the long-run average total cost is at its
lowest level.
Each perfectly competitive firm is a price taker,
that is, it cannot affect the price of the good.
The market demand curve slopes downward. But
each firm faces a horizontal perfectly elastic
demand curve at the going price. Such a demand
curve is illustrated in Figure 11.1.
Economic profit equals total revenue minus total opportunity cost. Part of the opportunity cost is a normal
profit, the return the firms entrepreneur can obtain in
an alternative business. Total revenue equals the price
of the output times the number sold, TR = P q, with
P the price and q the amount the firm produces.
Marginal revenue,, MR,
MR equals the change in total
revenue from a one-unit increase in the quantity
sold. In terms of a formula, MR = ( TR ) q .
5
4
3
D = MR
2
1
6
Quantity
186
CHAPTER 11
MC
4
ATC
3
D = MR
2
1
6
Quantity
and supply curves. The number of firms in the industry, and their size, is fixed in the short run. In the long
run, the number of firms in the industry, and their size
can adjust.
Changes in the market demand affect the price and
thereby the firms profits. The presence of an economic
profit means that as time passes new firms enter the industry; the presence of an economic loss means that
eventually some existing firms exit. When firms earn a
normal profit, there is no incentive to enter or exit.
Economic profits bring entry by new firms. The industry supply curve shifts rightward and reduces the
market price. The fall in price reduces economic
profit and decreases the incentive to enter the industry. New firms enter until it is no longer possible
to earn an economic profit.
Economic losses lead to exit by existing firms, which
shifts the industry supply curve leftward. The price
rises, and the higher price reduces economic losses.
Firms exit until no firms incur an economic loss.
Firms change their plant size if it increases their profits.
FIGURE 11.3
Long-Run Equilibrium
Price and cost (dollars)
FIGURE 11.2
MC
SRAC LRAC
3
2
D = MR
1
6
Quantity
PERFECT COMPETITION
FIGURE 11.4
187
Consumer
surplus
5
4
3
Producer
surplus
2
1
3
5
6
4
Quantity (thousands of units)
Helpful Hints
1. WHY STUDY PERFECT COMPETITION ? Although
perfectly competitive markets are rare in the real
world, there are three important reasons for developing a thorough understanding of their behavior.
First, many markets closely approximate perfect
competition. This chapter gives direct and useful
insights into the behavior of these markets.
Second, the theory of perfect competition allows us
to isolate the effects of competitive forces that are at
work in all markets, even in those that do not
match the assumptions of perfect competition.
Third, the perfectly competitive model serves as a
useful benchmark for evaluating the efficiency of
different market structures.
2. THE PROFIT MAXIMIZATION RULE, MR = MC :
Profit maximization requires producing where
MR = MC, which might seem odd. Producing
where MR > MC might seem more reasonable be-
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CHAPTER 11
Questions
True/False and Explain
Competition
11. In a perfectly competitive industry many firms produce very similar but slightly different products.
12. The minimum efficient scale of a firm is the smallest level of output at which the long-run average
total cost is at its minimum.
13. In a perfectly competitive industry, no single firm
can significantly affect the price of the good.
14. The market demand curve in a perfectly competitive industry is horizontal.
15. A perfectly competitive firm must decide what price
to charge for its goods.
The Firms Decisions in Perfect Competition
PERFECT COMPETITION
189
Price
(dollars)
100
5.00
101
5.00
190
CHAPTER 11
FIGURE 11.5
MC
4
ATC
3
D = MR
2
1
6
Quantity
PERFECT COMPETITION
191
FIGURE 11.6
D = MR
Quantity
192
27. Which of the following is NOT necessary for a perfectly competitive industry to be efficient?
a. The presence of external benefits.
b. Firms are economically efficient.
c. The sum of consumer surplus plus producer surplus is as large as possible.
d. All of the above answers are necessary for an industry to be efficient.
28. Resource use is efficient when
a. the goods and services produced are those that
are most highly valued.
b. it is impossible to make someone better off without making someone else worse off.
c. production is such that marginal benefit equals
marginal cost.
d. All of the above answers are correct.
29. Which of the following statements is true?
a. If there are no external benefits, a competitive
market is cannot use its resources efficiently.
b. Resource use is efficient when marginal benefit
exceeds marginal cost by as much as possible.
c. In a perfectly competitive market, at the efficient
level of output the price equals consumers marginal benefit and producers marginal cost.
d. All of the above are all true statements.
30. Which of the following is NOT an obstacle to efficiency?
a. External benefits or external costs.
b. Monopoly.
c. Competition.
d. Public goods.
Short Answer Problems
1. Why will a firm in a perfectly competitive industry
choose not to charge a price either above or below
the equilibrium price?
2. Rudy runs a rutabaga farm. Rudy relishes the idea
of maximizing his profit, so he must decide how
many acres to farm. He receives a price of $2,000
per ton of rutabagas grown. Table 11.2 shows
Rudys total cost and total revenue for different
amounts of tons grown.
a. Based on Table 11.2, how many tons of rutabagas should Rudy farm? What is his total economic profit ?
CHAPTER 11
TABLE 11.2
Total cost
(dollars)
Total revenue
(dollars)
1,000
2,000
2,500
4,000
5,000
6,000
8,500
8,000
13,000
10,000
18,500
12,000
b. Complete Table 11.3, which gives Rudys marginal cost and marginal revenue schedules. Note
that both marginal costs and marginal revenues
relate to changes in production, so they are located between the quantities of tons grown.
That is, the first marginal cost and marginal
revenue figures apply to the cost and revenue of
changing from 1 ton grown to 2 tons.
TABLE 11.3
Marginal revenue
(dollars)
____
____
____
____
____
____
____
____
____
____
PERFECT COMPETITION
193
TABLE 11.4
FIGURE 11.7
Rudys MC and MR
6
Quantity
Total variable cost Total cost
(sweaters sold per day)
(dollars)
(dollars)
5
4
3
40
100
60
120
90
150
130
190
180
240
240
300
2
TABLE 11.5
5
6
Quantity (tons)
Average
Quantity
(sweaters sold variable cost
(dollars)
per day)
Average
total cost
(dollars)
____
____
____
____
____
____
____
____
____
____
____
____
Marginal cost
(dollars)
____
____
____
____
____
5
4
3
2
1
60
50
40
30
20
10
5
6
Quantity (tons)
3
5
6
4
Quantity (sweaters per day)
194
CHAPTER 11
TABLE 11.6
Quantity
(sweaters per day)
25
____
35
____
45
____
55
____
ATC2 ATC3
Quantity
PERFECT COMPETITION
Answers
True/False Answers
Competition
195
196
15. d In the long run, perfectly competitive firms produce at the minimum ATC, but that is not necessarily the case in the short run.
16. c The possibility of earning an economic profit
leads to entry into the industry.
17. c The entry of new firms lowers the price and
economic profits, thereby driving the industry
toward its long-run equilibrium.
18. b Free entry and exit into the industry mean that
only a normal profit is possible in the long run.
19. d Figure 11.6 illustrates the long-run equilibrium
for a perfectly competitive firm.
20. d MR = MC means that the firm is maximizing its
profit; P = minimum LRAC occurs because
competition forces firms to produce as efficiently
as possible; P = ATC means that the firm is
earning only a normal profit.
Changing Tastes and Advancing Technology
21. b When the price falls, each firm moves down its
MC curve and produces less. This response
each firm producing less accounts for the re-
CHAPTER 11
22. b
23. d
24. b
25. a
26. d
duction in the quantity supplied along the market supply curve when the price falls.
Firms continue to leave as long as they incur an
economic loss, thereby driving the price higher
and reducing the survivors economic losses.
Answer (d) defines external economies.
In the short run, both the price and quantity fall,
and firms incur an economic loss. The economic
loss means that firms leave the industry and as
the supply decreases, the price rises from its initial fall, but the amount of the industry output
continues to decrease.
The diseconomies mean that, as the industry expands its output, firms costs rise. As a result, in
the long run the price, which equals the (higher)
average total cost, is higher than it was initially.
New technology creates economic profits, giving
firms the incentive to adopt the technology. The
increased competition from these firms ultimately eliminates the economic profit.
27. a Presence of external benefits means that a perfectly competitive industry will not be efficient.
28. d All the answers correctly characterize an efficient
use of resources.
29. c Efficiency is achieved when P = MB = MC.
30. c Competition increases the likelihood that a market uses resources efficiently because, as we see in
the next chapter, the lack of competition usually
leads to inefficiency.
Answers to Short Answer Problems
1. If a firm in a perfectly competitive industry charged
a price even slightly higher than the going equilibrium market price, it would lose all of its sales. So, it
will not charge a price above the equilibrium price.
Because it can sell all it wants at the going price, the
firm would not be able to increase its sales by lowering its price. So, the firm will not charge a price
below the market price because such a lower price
would decrease its total revenue and thereby decrease its profits.
2. a. Table 11.2 shows that Rudys profit-maximizing
quantity of rutabagas is 2 tons. Rudys economic
profit when growing 2 tons of rutabagas is
$1,500 (Rudys total revenue of $4,000 minus
PERFECT COMPETITION
197
TABLE 11.7
Marginal cost
(dollars)
Marginal revenue
(dollars)
1,500
2,000
2,500
2,000
3,500
2,000
4,500
2,000
5,500
2,000
2
3
FIGURE 11.11
MC
5
4
3
MR
2
1
4
5
FIGURE 11.12
b. Table 11.7 shows the marginal cost and marginal revenue schedules. Marginal cost is defined
as (TC ) q, with TC the change in total
cost and q the change in quantity. The marginal cost from 1 to 2 tons grown equals
($2,500 $1,000) (2 1), or $1,500. Marginal
revenue can be calculated two ways. First, for a
perfectly competitive firm, marginal revenue
equals price. Hence marginal revenue is $2,000.
Alternatively, the definition of marginal revenue
is (TR ) q , where TR is the change in total
revenue. Using this formula, the marginal revenue from 1 to 2 tons is ($4,000 $2,000) (2 1)
= $2,000.
c. Figure 11.11 shows the MC and MR curves.
d. Table 11.7 shows that Rudy should grow 2 tons
of rutabagas. The marginal cost of increasing
from 2 tons to 3 tons is $2,500, which exceeds
the marginal revenue of the increase. So increasing from 2 to 3 tons would reduce Rudys
profit. Similarly, Figure 11.11 shows that the
marginal revenue and marginal cost curves intersect at 2 tons, also indicating that Rudy should
grow 2 tons of rutabagas.
e. The answers in parts (a) and (d) are the same:
Rudy grows 2 tons of rutabagas. Note the important point that the analysis based on marginal
revenue and cost, in part (d), gives the same answer as the analysis based on total revenue and
cost, in part (a).
5
6
Quantity (tons)
MC
5
4
MR
3
2
1
5
6
Quantity (tons)
198
CHAPTER 11
FIGURE 11.13
MC
60
50
40
30
20
10
TABLE 11.8
Average
variable cost
(dollars)
Average
total cost
(dollars)
40.00
100.00
30.00
60.00
30.00
50.00
32.50
47.50
36.00
48.00
Marginal
cost
(dollars)
3
5
6
4
Quantity (sweaters per day)
TABLE 11.9
30.00
Price
(dollars per sweater)
Quantity supplied
(sweaters per day)
25
35
45
55
50.00
60.00
40.00
20.00
40.00
50.00
PERFECT COMPETITION
199
FIGURE 11.16
60
50
40
30
FIGURE 11.14
MC
ATC
AVC
D = MR
20
10
3
5
6
4
Quantity (sweaters per day)
Economic
profit
MC
ATC
AVC
P
D = MR
FIGURE 11.17
FIGURE 11.15
MC
Economic
loss
Quantity
Quantity
ATC
AVC
D= MR
Quantity
c. Figure 11.17 illustrates the case of a firm that incurs an economic loss but continues to operate.
The firm suffers an economic loss because, at the
profit-maximizing (loss-minimizing) level of
output q, P < ATC. But the firm minimizes its
loss by operating because P > AVC.
200
CHAPTER 11
FIGURE 11.19
ATC1
ATC2 ATC3
Price (dollars)
FIGURE 11.18
Psr
T Tsr
Tlr
Time
Tlr
Time
Quantity
FIGURE 11.20
Q
Qsr
Qlr
T Tsr
PERFECT COMPETITION
201
D
Q
Quantity
Remember that the word marginal means additional. So, marginal revenue means additional
revenue, and marginal cost means additional cost.
Now, suppose that MR is larger than MC. For instance, suppose that a wheat farmer finds that the
marginal revenue from growing an additional acre
of wheat is $5,000 and that the marginal cost of
doing so is only $3,000. Then, growing the additional acre of wheat adds more to the farmers revenue than it adds to the cost, so this acre will add to
the farmers total profit. In particular, this acre adds
$2,000 (marginal revenue of $5,000 minus marginal cost of $3,000) to the farmers total profit.
The farmer will want to grow this additional acre of
wheat.
Next, suppose that the next acre still has a marginal
revenue of $5,000, but that it has a marginal cost of
$4,000. MR still is larger than MC, so this acre will
continue to add to the farmers total profit. It adds
less (only $1,000), but the key point is that it adds.
So the farmer will plant this acre, too.
Now look, I know that the added profit from the
second acre isnt as much as the added profit from
the first acre. But who cares? As long as the acre
adds to the profit, the farmer, who wants to get the
maximum possible total profit, will still grow the
second acre of wheat. The deal is that as long as the
acre adds to total profit, the farmer will grow more
wheat. In other words, as long as MR > MC, the
additional acre adds additional profit, so the farmer
will put the acreage into production. Only when
MR = MC does the additional acre not add to
profit. So the farmer simply stops adding acres when
MR = MC.
2. At first thought, it does seem weird that a business
would continue to produce even though its losing
money. I couldnt get the point, either, until I
thought about it a bit. Heres the idea: Whenever
the price of output falls below the break-even point
(the minimum average total cost) but remains above
the shutdown point (the minimum average variable
cost), the firm continues to produce even though its
incurring an economic loss. The key here is that the
firms owner, when suffering an economic loss,
wants to make the loss as small as possible.
If the owner shuts down, the firm still must pay its
fixed costs. (Recall that fixed costs are independent
of output; whether the firm produces 10 million
units or 0 units, fixed costs remain the same.) So if
202
the owner shuts down, the total loss will equal the
total fixed cost. The owner compares this loss to the
loss incurred by operating. If the price exceeds the
average variable cost, the owner loses less by operating the business. When P > AVC, the firm earns
enough revenue to pay all its variable costs and have
some revenue left over to cover part of its fixed
costs. In this case, by operating the business, the
owner loses less than the total amount of the fixed
CHAPTER 11
PERFECT COMPETITION
Chapter Quiz
11. In perfect competition, the product of a single firm
a. has an infinite elasticity of demand.
b. is sold under many different brand names.
c. is unique to that firm and cannot be copied by
others.
d. has many perfect complements.
203
19. In a perfectly competitive industry, a permanent increase in demand creates a temporary economic
____ and ____ by some firms.
a. profit; entry
b. profit; exit
c. loss; exit
d. loss; entry
10. A perfectly competitive firm ____ earn an economic
profit in the short run and ____ earn an economic
profit in the long run.
a. can; can
b. can; cannot
c. cannot; can
d. cannot; cannot
204