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The Theory of Perfect Competition
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The theory of perfect competition is built on four assumptions:
1. There are many sellers and many buyers, none of whom is large in relation to total sales or purchases.
2. Each firm produces and sells a homogeneous product.
3. Buyers and sellers have all relevant information with respect to prices, product quality, sources of supply, and so on.
4. Entry into, and exit from, the industry is easy.
1. There are many sellers and many buyers, none of whom is large in relation to total sales or purchases.
2. Each firm produces and sells a homogeneous product.
3. Buyers and sellers have all relevant information with respect to prices, product quality, sources of supply, and so on.
4. Entry into, and exit from, the industry is easy.
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The theory of perfect competition predicts the following
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1. Economic profits will be squeezed out of the industry in the long run by the entry of new firms; that is, zero economic profit exists in the long run.
2. In equilibrium, firms produce the quantity of output at which price equals marginal cost.
3. In the short run, firms will stay in business as long as price covers average variable costs.
4. In the long run, firms will stay in business as long as price covers average total costs.
5. In the short run, an increase in demand will lead to a rise in price;
whether the price, in the long run, will be higher than, lower than, or equal to the original price depends on whether the firm is in an increasing-, decreasing-, or constant-cost industry.
2. In equilibrium, firms produce the quantity of output at which price equals marginal cost.
3. In the short run, firms will stay in business as long as price covers average variable costs.
4. In the long run, firms will stay in business as long as price covers average total costs.
5. In the short run, an increase in demand will lead to a rise in price;
whether the price, in the long run, will be higher than, lower than, or equal to the original price depends on whether the firm is in an increasing-, decreasing-, or constant-cost industry.
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The Perfectly Competitive Firm
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The perfectly competitive firm is a price taker. It sells its product only at the market-established equilibrium price.
The perfectly competitive firm faces a horizontal (flat, perfectly elastic) demand curve. Its demand curve and its marginal revenue curve are the same.
The perfectly competitive firm (as well as all other firms) maximizes profits (or minimizes losses) by producing the quantity of output at which MR=MC
For the perfectly competitive firm, price equals marginal revenue.
The perfectly competitive firm is resource allocative efficient because it produces the quantity of output at which P=MC
The perfectly competitive firm faces a horizontal (flat, perfectly elastic) demand curve. Its demand curve and its marginal revenue curve are the same.
The perfectly competitive firm (as well as all other firms) maximizes profits (or minimizes losses) by producing the quantity of output at which MR=MC
For the perfectly competitive firm, price equals marginal revenue.
The perfectly competitive firm is resource allocative efficient because it produces the quantity of output at which P=MC
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Production in the Short Run
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If , P>ATC(>AVC), the firm earns economic profits and will continue to operate in the short run.
If , P<ATC(<AVC), the firm takes losses. It will shut down because the alternative (continuing to produce) increases the losses.
If , ATC>P>AVC, the firm takes losses. Nevertheless, it will continue to operate in the short run because the alternative (shutting down) increases the losses.
The firm produces in the short run only when price is greater than average variable cost. Therefore, the portion of its marginal cost curve that lies above the average variable cost curve is the firm's short-run supply curve.
If , P<ATC(<AVC), the firm takes losses. It will shut down because the alternative (continuing to produce) increases the losses.
If , ATC>P>AVC, the firm takes losses. Nevertheless, it will continue to operate in the short run because the alternative (shutting down) increases the losses.
The firm produces in the short run only when price is greater than average variable cost. Therefore, the portion of its marginal cost curve that lies above the average variable cost curve is the firm's short-run supply curve.
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Long-run competitive equilibrium exists when there is no incentive for firms
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1. to enter or exit the industry,
> Economic profits are zero. Firms have no incentive to enter or exit the industry.
2. to produce more or less output, and
> Firms are producing the quantity of output at which price is equal to marginal cost. (Firms have no incentive to produce more or less output. After all, when P=MC, it follows that MR=MC for the perfectly competitive firm, and thus the firm is maximizing profits.)
3. to change their plant size.
> SRATC=LRATC at the quantity of output at which P=MC
A perfectly competitive firm exhibits productive efficiency because, in the long run, it produces its output at the lowest possible per-unit cost (lowest ATC).
> Economic profits are zero. Firms have no incentive to enter or exit the industry.
2. to produce more or less output, and
> Firms are producing the quantity of output at which price is equal to marginal cost. (Firms have no incentive to produce more or less output. After all, when P=MC, it follows that MR=MC for the perfectly competitive firm, and thus the firm is maximizing profits.)
3. to change their plant size.
> SRATC=LRATC at the quantity of output at which P=MC
A perfectly competitive firm exhibits productive efficiency because, in the long run, it produces its output at the lowest possible per-unit cost (lowest ATC).
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Industry Adjustment To A Change in Demand
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In a constant-cost industry, an increase in demand will result in a new equilibrium price equal to the original equilibrium price (before demand increased). In an increasing-cost industry, an increase in demand will result in a new equilibrium price higher than the original one. In a decreasing-cost industry, an increase in demand will result in a new equilibrium price lower than the original one.
The long-run supply curve for a constant-cost industry is horizontal (flat, perfectly elastic). The long-run supply curve for an increasing-cost industry is upward sloping. The long-run supply curve for a decreasing-cost industry is downward sloping.
The long-run supply curve for a constant-cost industry is horizontal (flat, perfectly elastic). The long-run supply curve for an increasing-cost industry is upward sloping. The long-run supply curve for a decreasing-cost industry is downward sloping.
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Market Structure
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The environment whose characteristics influence a firm's pricing and output decisions.
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Price Taker
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A perfectly competitive firm is a price taker, which is a seller that does not have the ability to control the price of its product; in other words, such a firm "takes" the price determined in the market.
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Marginal Revenue (MR)
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If P=MR, then the marginal revenue curve for the perfectly competitive firm is the same as its demand curve.
A demand curve plots price against quantity, whereas a marginal revenue curve plots marginal revenue against quantity. If price equals marginal revenue, then the demand curve and marginal revenue curve are the same
A demand curve plots price against quantity, whereas a marginal revenue curve plots marginal revenue against quantity. If price equals marginal revenue, then the demand curve and marginal revenue curve are the same
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Profit Maximization Rule
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Profit is maximized by producing the quantity of output at which MR=MC
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Resource Allocative Efficiency
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The situation in which firms produce the quantity of output at which price equals marginal cost: P=MC
1. The perfectly competitive firm produces the quantity of output at which MR=MC.
2. For such a firm, P=MR.
3. If the perfectly competitive firm produces the output at which MR=MC and if, for this firm, MR=MC, then the firm produces the output at which P=MC.
In short, the perfectly competitive firm is resource allocative efficient.
1. The perfectly competitive firm produces the quantity of output at which MR=MC.
2. For such a firm, P=MR.
3. If the perfectly competitive firm produces the output at which MR=MC and if, for this firm, MR=MC, then the firm produces the output at which P=MC.
In short, the perfectly competitive firm is resource allocative efficient.
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Short-Run (Firm) Supply Curve
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The short-run supply curve is that portion of the firm's marginal cost curve that lies above the average variable cost curve
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Short-Run Market (Industry) Supply Curve
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The horizontal sum of all existing firms' short-run supply curves.
Is used along with the market demand curve to determine equilibrium price and quantity.
Is used along with the market demand curve to determine equilibrium price and quantity.
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Long-Run Competitive Equilibrium
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1. Economic profit is zero; that is, price (P) is equal to short-run average total cost (SRATC): P=SRATC
>For long-run equilibrium to exist, there can be no incentive for firms to enter or exit. This condition is brought about by zero economic profit (normal profit), which is a consequence of the equilibrium price being equal to short-run average total cost.
2. Firms are producing the quantity of output at which price (P) is equal to marginal cost (MC): P=MC
3. No firm has an incentive to change its plant size to produce its current output; that is, at the quantity of output at which P=MC, the following condition holds: SRATC=LRATC
Long-run competitive equilibrium exists when P=MC=SRATC=LRATC
>For long-run equilibrium to exist, there can be no incentive for firms to enter or exit. This condition is brought about by zero economic profit (normal profit), which is a consequence of the equilibrium price being equal to short-run average total cost.
2. Firms are producing the quantity of output at which price (P) is equal to marginal cost (MC): P=MC
3. No firm has an incentive to change its plant size to produce its current output; that is, at the quantity of output at which P=MC, the following condition holds: SRATC=LRATC
Long-run competitive equilibrium exists when P=MC=SRATC=LRATC
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Productive Efficiency
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A firm produces its output at the lowest possible per-unit cost (lowest ATC).
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Long-Run (Industry) Supply (LRS) Curve
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A graphic representation of the quantities of output that an industry is prepared to supply at different prices after the entry and exit of firms are completed.
(a) constant costs: input costs remain constant as output increases, so the firms' cost curves do not shift. Profits fall to zero through a decline in price. This scenario implies that, in a constant-cost industry, the supply curve shifts rightward by the same amount as the demand curve shifts rightward
(b) increasing costs: input costs increase as output increases. Profits are squeezed by a combination of rising costs and falling prices. The new equilibrium price for an increasing-cost industry is higher than the old equilibrium price
(c) decreasing costs: input costs decrease as output increases. The new equilibrium price for a decreasing-cost industry is lower than the old equilibrium price
(a) constant costs: input costs remain constant as output increases, so the firms' cost curves do not shift. Profits fall to zero through a decline in price. This scenario implies that, in a constant-cost industry, the supply curve shifts rightward by the same amount as the demand curve shifts rightward
(b) increasing costs: input costs increase as output increases. Profits are squeezed by a combination of rising costs and falling prices. The new equilibrium price for an increasing-cost industry is higher than the old equilibrium price
(c) decreasing costs: input costs decrease as output increases. The new equilibrium price for a decreasing-cost industry is lower than the old equilibrium price
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Constant-Cost Industry
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In a constant-cost industry, average total costs (unit costs) do not change as output increases or decreases when firms enter or exit the industry.
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Increasing-Cost Industry
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In an increasing-cost industry, average total costs (unit costs) increase as firms enter the industry and output increases; average total costs decrease as firms exit the industry and output decreases. If market demand increases for a good produced by firms in an increasing-cost industry, price will initially rise and then finally fall to a level above its original level.
is characterized by an upward-sloping long-run supply curve.
is characterized by an upward-sloping long-run supply curve.
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Decreasing-Cost Industry
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In a decreasing-cost industry, average total costs (unit costs) decrease as firms enter the industry and output increases; average total costs increase as firms exit the industry and output decreases. If market demand increases for a good produced by firms in a decreasing-cost industry, then price will initially rise and then finally fall to a level below its original level.
is characterized by a downward-sloping long-run supply curve.
is characterized by a downward-sloping long-run supply curve.
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