MARKET STRUCTURE:

Perfect Competition
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Purpose of this chapter

To explain how competitive markets determine prices, output, and profits
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Structure of the Market

The process by which price and output are determined in the real world is strongly affected by the structure of the market
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Market structure
A classification system for the key traits of a market, including the number of firms, the similarity of the products they sell, and the ease of entry and exit
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Types of Market Structure

1.Perfect Competition 2.Monopoly 3.Monopolistic Competition 4.Oligopoly Types 2, 3 and 4 are referred to as imperfect competition
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Perfect competition
1. many small firms 2. homogeneous product 3. very easy entry and exit 4. price taker 5.economic agents have perfect knowledge of market conditions
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Homogeneous Product
Goods that cannot be distinguished from one another; for example, one potato cannot be distinguished from another potato

Seller is a Price taker

A seller that has no control over the price of the product it sells He can not influence the price

Price determination in PC

Supply and Demand

140 130 120 100 80 60 40 20

P Market Supply and Demand

S DQ
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5 10 15 20 25 30 35 40 45

What determines the individual firms demand curve?

A horizontal line at the market price

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140 130 120 Individual firm demand 100 80 60 40 20 5 10 15 20 25 30 35 40 45

D
Q

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If the firm charges more than this price, it will not sell anything, and it has no incentive to charge less than this price
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Why does the firm have no incentive to charge less than the market price?
It can sell everything it brings to market at the market price
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What does the perfectly competitive firm control?

The only thing it controls is how many units it produces. It can not influence price. It has to sell at the market-clearing price.

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How many units of the product should this firm produce?

The number of units whereby it will maximize its profits, or at least minimize its losses

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There are two methods to determine how many units to produce

TR and TC MR and MC
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The total revenue total cost method

Where the distance between TR and TC is the greatest. Then profit can be maximized.

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TR, TC

Maximize Profit

TR

TC

Quantity of Output
Profit Maximising Output

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Marginal Analysis to determine the profitmaximising level of output

By comparing Marginal Revenue and Marginal Cost

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Marginal revenue

MR = TR / 1 output
Change in total revenue from the sale of one additional unit of output
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Marginal cost

MC = TC / 1 output
Change in total cost from producing one additional unit of output
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The marginal revenue and marginal cost method to profit maximization

MR = MC
The firm maximizes profit by

producing the output where

marginal revenue equals marginal cost

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Why should a firm continue to produce as long as MR > MC?

As long as MR is > than MC, money is being made on that last unit
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Why will a firm not produce that unit where MR < MC?
At the unit of output where MR < MC, money is being lost on that last unit
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80 70 60 50 40 30 20 10

Price & Cost per unit

MR=MC MC

ATC
AVC

P = MR = AR

Profit

1 2 output 4 5 6 7 8 9 3 Profit maximising

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Price & Cost per unit

P
70 60 50 40 30 20 10

MR=MC MC

ATC AVC

Loss

P=MR=AR

1 2 3 4 5 6 7 8 9

Q
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Price & Cost per unit

P
70 60 50 40 30 20 10

Short-Run Shutdown

MC

ATC AVC

Loss

P=MR=AR

MR=MC 1 2 3 4 5 6 7 8 9

Q
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Firm will shut down

Price (MR) is below minimum average variable cost

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Shut down

If the price (average revenue) is below the minimum point on the average variable cost curve, the MR = MC rule does not apply, and the firm shuts down to minimize its losses.
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The perfectly competitive firms short-run supply curve

The perfectly competitive firms short-run supply curve is a curve showing the relationship between the price of a product and the quantity supplied in the short run.

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The perfectly competitive firms shortrun supply curve

The firms marginal cost curve above the minimum point on its average variable cost curve

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P
70 60 50 40 30 20 10

Firms Short-Run Supply Curve

MC AVC
MR3
MR2 MR1

1 2 3 4 5 6 7 8 9

Q
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The industrys supply curve

The summation of the individual firms MC curves that lie above their minimum AVC points

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The industrys supply curve

The perfectly competitive industrys short-run supply curve is the horizontal summation of the short-run supply curves of all firms in the industry

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P
130 120 100 80 60 40 20

Industrys Supply Curve

S = MC

5 10 15 20 25 30 35 40 45

Q
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Normal profit
The minimum profit necessary to keep a firm in operation
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In the long-run, what happens when economic profits are made?

When firms make more than a normal profit, firms enter the industry.As supply increases, a downward pressure is put on prices.
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In the long-run, what happens when losses are made?

When firms make less than a normal profit, firms leave the industry. As supply decreases, an upward pressure is put on prices
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In the long-run, where is equilibrium?

At the market price that enables firms to make a normal profit
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long-run perfectly competitive equilibrium

P = MR = SRMC = SRATC = LRAC

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P
70 60 50 40 30 20 10

Long-Run Competitive Equilibrium Equilibrium SRMC

SATC LRAC

MR

1 2 3 4 5 6 7 8 9

Q
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Three different types of industries can exist in the long-run

Constant-cost Decreasing-cost Increasing-cost
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Constant-cost industry
An industry in which the expansion of industry output by the entry of new firms has no effect on the firms cost curves
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The long-run supply curve in a constantcost industry

It is perfectly elastic, which is horizontal
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Increase in demand sets a higher equilibrium price Entry of new firms increases supply Initial equilibrium price is restored Perfectly elastic long-run supply curve
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A decreasing-cost industry
An industry in which the expansion of industry output by the entry of new firms decreases the firms cost curves
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The long-run supply curve in a decreasingcost industry

It is downward sloping

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Increase in demand sets a higher equilibrium price Entry of new firms increases supply Equilibrium price and AC decrease Downward sloping long-run supply curve
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An increasing-cost industry
An industry in which the expansion of industry output by the entry of new firms increases the firms cost curves. Input usage increasesthe price of dome inputs rise.
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The long-run supply curve in a increasingcost industry

It is upward sloping

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Increase in demand sets a higher equilibrium price Entry of new firms increases industry supply Equilibrium price and AC increase Upward sloping long-run supply curve
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Summary

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Market structure consists of three market characteristics: (1) the number of sellers, (2) the nature of the product, (3) the case of entry into or exit from the market.

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Perfect competition is a market structure in which an individual firm cannot affect the price of the product it produces. Each firm in the industry is very small relative to the market as a whole, all the firms sell a homogeneous product, and firms are free to enter and exit the industry.
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A price-taker firm in perfect competition faces a perfectly elastic demand curve. It can sell all it wishes at the marketdetermined price, but it will sell nothing above the given market price. This is because so many competitive firms are willing to sell at the going market price.
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The total revenue-total cost method is one way the firm determines the level of output that maximizes profit. Profit reaches a maximum when the vertical difference between the total revenue and the total cost curves is at a maximum.
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P
500

Maximize Profit

TR

400
300 200

TC

100
Quantity of Output

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The marginal revenue equals marginal cost method is a second approach to finding where a firm maximizes profits. Marginal revenue is the change in total revenue from a one-unit change in output. Marginal revenue for a perfectly competitive firm equals the market price.
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The MR = MC rule states that the firm maximizes profit or minimizes loss by producing the output where marginal revenue equals marginal cost. If the price (average revenue) is below the minimum point on the average variable cost curve, the MR = MC rule does not apply, and the firm shuts down to minimize its losses.
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80 70 60 50 40 30 20 10

Price & Cost per unit

MR=MC MC

ATC
AVC

P = MR = AR

Profit

1 2 3 4 5 6 7 8 9

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Price & Cost per unit

P
70 60 50 40 30 20 10

MR=MC MC

ATC AVC

Loss

P=MR=AR

1 2 3 4 5 6 7 8 9

Q
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Price & Cost per unit

P
70 60 50 40 30 20 10

Short-Run Shutdown

MC

ATC AVC

Loss

P=MR=AR

MR=MC 1 2 3 4 5 6 7 8 9

Q
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The perfectly competitive firms short-run supply curve is a curve showing the relationship between the price of a product and the quantity supplied in the short run.

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The individual firm always produces along its marginal cost curve above its intersection with the average variable cost curve. The perfectly competitive industrys short-run supply curve is the horizontal summation of the short-run supply curves of all firms in the industry.

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P
130 120 100 80 60 40 20

Industry Equilibrium

S = MC

5 10 15 20 25 30 35 40 45

Q
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Long-run perfectly competitive equilibrium occurs when the firm earns a normal profit by producing where price equals minimum long-run average cost equals minimum short-run average total cost equals shortrun marginal cost.
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Long-Run Competitive Equilibrium Equilibrium

70 60 50 40 30 20 10

SRMC SATC LRAC

MR

1 2 3 4 5 6 7 8 9

Q
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A constant-cost industry is an industry whose total output can be expanded without an increase in the firms average total cost. Because input prices remain constant, the long-run supply curve in a constant-cost industry is perfectly elastic.
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A decreasing-cost industry is an industry in which lower input prices result in a downwardsloping long-run supply curve. As industry output expands, the firms average total cost curve shifts downward, and the long-run equilibrium market price falls.
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An increasing-cost industry is an industry in which input prices rise as industry output increases. As a result, the firms average total cost curve rises, and the long-run supply curve for an increasingcost industry is upward sloping.

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END
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