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Perfect Competition
I
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For now we will focus on the first two market structures, which are at
the extremes of a continuum of market structures
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Monopoly

Perfect
Competition
Let us begin by defining both perfect competition and monopoly:
Perfect Competition
1
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All firms are small relative to the
market
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Homogenous product
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Free entry and exit from market
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Lots of buyers only one seller
2
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3
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4
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A comparison of the characteristics of both market structures illustrates that perfect
competition and monopoly are, in fact, polar opposites
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That is, market demand has similar characteristics as any
other market demand curve
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Thus, it is the individual consumers who
determine their own demand and, hence, market demand
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However, market demand is downward sloping as
shown in Figure 1
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As shown
in Figure 1, the interaction of market demand and supply set the equilibrium market
price, PM
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Perfectly competitive firms are price takers
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If the firm attempts to raise their price above the market price, then
no consumer would buy their product
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This means that the perfectly
competitive firm has a demand curve that is perfectly elastic at the market price as
shown in Figure 1
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Short-run Pricing and Output
●

How do Firms maximize profits (π ) in the short-run?
The most straightforward method of answering this question is to simply examine
what we know about profit:
o

π = TR – TC
ƒ Total Revenue (TR) = Price * Quantity = P*Q
ƒ Total Cost (TC) = Average Total Cost * Quantity = P*ATC
ƒ Hence, π = P*Q – P*ATC = (P – ATC)Q

We will use two approaches to show perfectly competitive firms maximize profits in
the short-run
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The second
one (MC/MR) is less intuitive but will, in fact, be the most useful approach
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In the previous
chapter, we derived TC and it is again shown in Figure 1
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The
shape of TC simply reflects the law of diminishing returns
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Thus, when quantity is zero, total revenue is also zero
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2

In Figure 2, areas A and C show
where TC exceeds TR and, therefore,
the firm is operating at a loss
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TC

P
A

However, although profit is only
positive in area B, where is profit
maximized? Given that profit equals
the difference between TR and TC,
maximum profit occurs where the
distance between the two curves is at
its largest, which occurs at q*
...

Again, in areas A and C, profit is
negative while only in area B is profit
positive
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TR

B

C

q*

q

Figure 2
π

A

B

C

q*

q

π
Figure 3

o

Marginal Cost and Marginal Revenue approach
Just as we had already derived Total Cost, the same is true for marginal cost
...

Similarly:
Marginal Revenue = the extra revenue of producing one more unit of output =
Δ TR / Δ q
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What does MR look like for a perfectly competitive firm? Recall that a perfectly
competitive firm is a price taker, as shown above in Figure 1
...
Thus,
every time the firm produces another unit of output they can always sell it for the
market price
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3

Figure 4 illustrates the MC/MR approach to profit maximization
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P
To the left of the dotted line MR
MC
exceeds MC
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At
this level of output, MR equals 5
PM = 5
DF = MR
(as it always does) while MC
equals 3
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As a result
a profit maximizing unit will always
produce such a unit
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Consider now a firm that is producing to the right of the dotted line where MR =
MC
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For example, at the 30th unit of output
MC equals $10 while MR is still $5
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Our second insight into profit maximization suggests that:
•

A profit maximizing firm will always decrease output whenever MC > MR
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It is important to understand that both the TC/TR and MC/MR methods of finding
the profit maximizing output will yield the same answer
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o Graphical Analysis – Questions to be
answered using Figure 5
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At what q is π maximized?
Recall from above that all profit
maximizing firms produce at the
quantity where MR = MC
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2
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Hence, in Figure 5, the
market price is P = MR = D
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What does π equal?
Obviously firms are primarily interested in their profits
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All of these are calculated at
the profit maximizing output, q1
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•

P = MR = MC = distance 0 to p
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o

AVC = distance 0 to e
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•

Recall that Total Revenue equals price times quantity
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Graphically, multiplying two sides of a
right angle together gives the area of the resultant rectangle defined by
the points, 0 – p – c – q1
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•

Similarly for the three total costs:

•

•

o

ATC = TC/q
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o

AVC = TVC/q
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o

ACF = TFC/q
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And, finally, profit
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o

π = TR – TC = p*q – ATC*q = (p – ATC)q
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P – ATC = distance a – p while q = distance p –
c, which again yields the area of rectangle p-a-b-c
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5

o

Loss Minimization and the Short-Run Shutdown Point
When considering what profit equals for a given firm there are clearly three
possibilities:
• π > 0, which occurs whenever P > ATC
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• π = 0, which occurs whenever P = ATC
...
)
• π < 0, which occurs whenever P < ATC
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For illustration we will
assume that:
•

q1 = 1000
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•

π = TR – TC = p*q – ATC*q = 5000 – 7000 = - 2000
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This
is true because the firm is in the short-run, with fixed costs that must still be
paid when the firm shuts down
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Thus, if the firm produces it loses $2,000 and if it shuts down it loses its TFC
or $4,000
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How low must the price go before the firm will shut down?
•

Essentially, the key concept here is for the firm to only shut down if it
cannot cover those costs that it can avoid by shutting down – the total
variable costs
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Notice that fixed costs are irrelevant
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•

To prove this algebraically consider the breakeven point where profits
if the firm produces equals profits if they shutdown:
o

TR – TC = – TFC or

o

TR – TVC – TFC = – TFC or

o

TR – TVC = 0 (Notice that TFC cancels out because the firm
must pay them whether producing or not) or

o

TR = TVC, thus we breakeven when total revenue equals total
variable costs
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This is called the short-run shutdown point
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Figure 6
shows the MC and AVC for a perfectly
competitive firm
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P

MC

AVC

P1
PM

A

Likewise, if the price rises to P1 then the
firm produces q2, where the new price
equals the MC curve
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Thus, the MC curve
is the firm’s supply curve
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In that case, recall that
the firm will shut-down in the short-run
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Recall that the law of supply requires an upward sloping supply curve, when
price increases so does quantity supplied
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And as we learned before, MC is upward sloping
because of the law of diminishing returns
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If at a price of $10 a perfectly
competitive firm produces 4,000 units of output and there are 1,000 similar firms,
then total industry output is 4 million
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Since the firm supply curves are their MC
curves (above AVC), then the industry short-run supply curve is also a measure
of industry MC
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Long-run Pricing and Output
o

The long-run equilibrium in perfectly competitive markets:
• if π > 0, the positive profits attract firms to the market in the long-run
o More firms increases market supply
o Increased supply decreases price
o This process continues until π = 0
• If π < 0, the negative profits cause some firms to go out of business / leave
industry in the long-run
o Fewer firms decreases supply
o Decreased supply increases price
o This process continues until π = 0
• Thus in the long-run π must equal 0

7

Market Shocks – What is the Long-run Market Supply?

o

Now consider what happens in the long-run with a shock in the market, such as
an increase or a decrease in market demand
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Profit is zero because
price equals ATC
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Initially market price equals P1 while firm
output is q1 and market output is Q1
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What happens in both the short and the long run as a result?
Short-run Impact

Long-run Impact

P↑ (to P2)

With π > 0 => entry occurs and the
short run S shifts right (to S2)

q ↑ (to q2)

P↓ (back to P1)

Q ↑ (to Q2)

q ↓ (back to q1) while Q ↑ (to Q3)
...
Thus, in the long-run profit is always equal to
zero which is caused by either entry (if D increases) or exit (if D decreases)
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The only change in the long-run with an
increase or decrease in market D is that total output rises or falls, respectively
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•

Long Run Market Supply Curve

8

o
o
o

Assumes that π = 0
Shows market Q given market P
Three possible types of long-run supply curves exist: Constant cost, Increasing
cost, and Decreasing cost
industry
...
Essentially, if
scarcity does not apply, then
LRSC
with entry the demand for
P1
resources ↑ but the price of
resources remains constant
and the cost of inputs is also
constant
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o Assumes neither market entry nor exit affects production costs
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If scarcity does apply
then with entry demand for
resources ↑, price of resources
↑, and costs of production ↑
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Q
Therefore the price must rise
with increasing output (entry) in
Figure 9
the long-run to keep profit equal
to zero
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9

•

Decreasing Cost – Figure 10
illustrates a decreasing cost
industry
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This can only
happen for relatively short periods
of time and occurs for two primary
reasons: (1) economies of scale in
a new industry and (2) new
technology that decreases costs
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10



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