Competition

• What is perfect competition?
• How are price and output determined in a competitive industry?
• Why do firms enter and leave an industry?
• How do changes in demand and technology affect an industry?
• Why is perfect competition efficient?

Perfect Competition

• Perfect competition arises when:
  • There are many firms, each selling an identical product.
  • There are many buyers.
  • There are no restrictions on entry into the industry.
  • Firms in the industry have no advantage over potential new entrants.
  • Firms and buyers are completely informed about other firms' prices.

The Firm Has No Control Over the Price It Charges

Since each firm produces a small fraction of total industry output and the products are identical, no firm has any control over price.

Firms are price takers in perfectly competitive markets. A price taker is a firm that cannot influence the price of a good or service.

Examples of Highly Competitive Markets

• Wheat farms Fisheries Paper pulpers and millers Photo finishers Sweater knitters!!
• A key element is that buyers cannot distinguish your product from that supplied by any other producer.

Elasticity of Industry
and Firm Demand

A price taker firm faces a demand curve that is perfectly elastic (horizontal) because wheat from farm A is a perfect substitute for wheat from farm B.

• However, the market demand curve will still slope downward; elasticity will be positive, but not infinite.

Competition in
the Real World

• In reality, there are no markets that are absolutely perfectly competitive.
• Competition in some industries is so fierce that the model of perfect competition predicts how firms will behave.

Profit

• The goal of a firm is to maximize profit.
• Economic profit is equal to total revenue minus total cost.
• Total cost means all opportunity cost, including a normal profit.

Revenue

• Total revenue is the dollar market value of the firm's sales.
• Average revenue is total revenue per unit sold - in other words, price.
• Marginal revenue is the change in total revenue divided by the change in quantity sold.
• In a perfectly competitive market, marginal revenue will equal price.

Analyzing Revenue

The Firm's Decisions in Perfect Competition

• Firms in a perfectly competitive industry face a given market price and have the revenue curves we've just studied.
• Firms also have a technology constraint, described by their product and cost curves.
• The firm tries to maximize profit.

Short-Run Decisions

• Whether to produce or to temporarily shut down.
• If they decide to produce, what quantity of output to produce.

Long-Run Decisions

• Whether to increase or decrease plant size.
• Whether to stay in the industry or to leave it.

Profit-Maximizing Output

• A perfectly competitive firm maximizes profit by choosing its output level.

Profits are maximized if the firm produces and sells the quantity of output that creates the largest difference between total revenue and total cost.

Maximizing Swanky's Profit

Break-even Output

• An output at which total cost equals total revenue is called a break-even point.
• Even though economic profit is zero at break-even output, the firm still earns a normal profit.
• Remember, normal profit is part of total (opportunity) cost.

• Another way of finding the profit-maximizing output is to use marginal analysis.
• To use marginal analysis, the firm compares marginal revenue with marginal cost.
• As output increases, MC increases while MR is constant.

Using Marginal Analysis to Maximize Profits

• If MR > MC, the revenue from selling one more unit is greater than cost. Selling that unit will increase profit.
• If MR < MC, the revenue from selling one more unit is less than cost. Not selling that unit will increase profit.
• Profit is maximized when MR = MC.

Using Marginal Analysis

Economic Profit
in the Short Run

• Maximizing economic profit does not guarantee that profits will be positive.
• Economic profit can be positive, negative or zero.
• To calculate total profit, we must subtract total cost from total revenue.

Price, Average Total Cost, and Profit

• Price is revenue per unit.
• Average total cost is total cost per unit.
• P - ATC is profit per unit.
• That means we can calculate total profit as (P - ATC)(Q).

Three Possible
Profit Outcomes

• P > ATC: profits are positive.
• P < ATC: profits are negative.
• P = ATC: the firm is breaking even.

• A perfectly competitive firm's short-run supply curve shows how its profit-maximizing output varies as market price changes.
• Since price must equal marginal cost, the marginal cost curve is also the supply curve.

Temporary Plant Shutdown

• A firm cannot avoid incurring its fixed costs but it can avoid variable costs.
• A firm that shuts down and produces no output incurs a loss equal to its total fixed cost.
• A firm's shutdown point is the level of output and price where the firm is just covering its total variable cost.

Production Decisions

• When price is below the minimum point of the AVC curve, the firm will shut down and supply zero output.

When price is above the lowest point of the AVC curve, the firm will produce the level of output where price equals marginal cost.

• The short-run supply curve is the MC curve above the AVC curve.

The short-run industry supply curve shows how the quantity supplied by the industry varies as the market price varies when the plant size of each firm and the number of firms in the industry remain the same.

• The industry supply curve is the sum of the supply curves of the individual firms.

• Equilibrium price and output are determined by industry supply and demand.
• The firm takes the market price as given and decides how much output to produce using that price and its marginal cost curve.

In short-run equilibrium, a firm might make an economic profit, incur an economic loss, or break even (make a normal profit). Only one of these situations is a long-run equilibrium.

• In the long run:
  • The number of firms in an industry changes.
  • Firms change the scale of their plants.

Economic Profit and Economic Loss as Signals

If an industry is earning above normal profits (positive economic profits), firms will enter the industry and begin producing output.

• This will shift the industry supply curve out, lowering price and profit.

Economic Loss as a Signal

• If an industry is earning below normal profits (negative economic profits), some of the weaker firms will leave the industry.
• This shifts the industry supply curve in, raising price and profit.

• In long-run equilibrium, firms will be earning only a normal profit. Economic profits will be zero.
• Firms will neither enter nor exit the industry.

Changes in Plant Size

• A firm changes its plant size if, by doing so, its economic profit increases.

However, if all firms change their plant sizes in the same way, the industry supply curve will shift and the equilibrium price will change.

Changing Tastes and Advancing Technology

• A competitive industry is rarely in a long-run equilibrium.
• What happens in a competitive industry when there is a permanent increase or decrease in the demand for its product?
• What happens in a competitive industry when technological change lowers its production costs?

A Permanent Change
in Demand

• A permanent decrease in demand will cause the short-run equilibrium price and quantity to fall.

In the long run, firms will leave the industry (because economic profits are negative), raising price enough to restore a normal level of profit.

• The difference is the number of firms in the industry.

• The increase in demand causes industry price and profits to rise.
• Firms enter the industry, increasing market supply and eventually lowering price to its original level.
• However there are now more firms in the industry.

Long-Run Changes in Price

What determines whether a permanent change in demand will cause the long-run equilibrium price to rise, fall, or remain the same?

• External economies cause the firm's average cost to fall as industry output rises.
• External diseconomies cause the firm's costs to rise as industry output rises.

Long-Run Industry Supply

A long-run industry supply curve shows how the quantity supplied by an industry varies as the market price varies after all the possible adjustments have been made, including changes in plant size and changes in the number of firms in the industry.

Technological Change

• Technological improvements lower average cost of production.
• Most technological improvements cannot be implemented without investment in new plant and equipment.
• This means it takes time for a technological advance to spread through an industry.

Technological Change and Equilibrium Price

• A technological improvement that affects all firms will shift the industry supply curve down and to the right.
• This lowers equilibrium price and raises output.

Technological Change and Equilibrium Profit

• Implementing a technological improvement causes the marginal cost curve for each firm to shifted.
• Economic profits may not be affected in the long run.
• In the long run, the firms that survive will be those that adopted the new technology early.

Competition and Efficiency

• Allocative efficiency occurs when no resources are wasted.
• This means no individual can be made better off without making someone else worse off.

Allocative Efficiency

• Three conditions must be met to achieve allocative efficiency:
  • Producer efficiency
  • Consumer efficiency
  • Exchange efficiency

Producer Efficiency

Producer efficiency occurs when firms cannot decrease the cost of producing a given output by changing the factors of production used.

• Producer efficiency requires both:
  • Technological efficiency
  • Economic efficiency.

Consumer Efficiency

Consumer efficiency occurs when consumers cannot make themselves better off - cannot increase utility - by reallocating their budget.

• Consumer efficiency is achieved at all points along a demand curve.

Exchange Efficiency

Exchange efficiency occurs when the price at which a transaction takes place equals marginal social cost and also equals marginal social benefit.

Marginal Social Cost and
Marginal Social Benefit

• Marginal social cost is the cost of producing one additional unit of output including external costs.

Marginal social benefit is the dollar value of the benefit from one additional unit of consumption including any external benefits.

External Costs and
External Benefits

• External costs are costs not borne by the producer but borne by other members of society.
  • Pollution imposes external costs.
• External benefits are benefits accruing to people other than the buyer of a good.
  • Public gardens confer external benefits.

• Allocative efficiency occurs when marginal social cost is equal to marginal social benefit.
• Perfect competition delivers allocative efficiency if there are no external costs or benefits.

Obstacles to Efficiency

• The two main obstacles to achieving allocative efficiency are:
  • External costs and benefits
  • Monopoly power
• Monopoly power is the absence of competition.