Perfectly Competitive Market
ETP Economics 101
Characteristics
A perfectly competitive market has the
following characteristics:
There are many buyers and sellers in the market. The goods offered by the various sellers are largely the same. Firms can freely enter or exit the market.
Outcomes
As a result of its characteristics, the perfectly
competitive market has the following outcomes:
The actions of any single buyer or seller in the market have a negligible impact on the market price. Each buyer and seller takes the market price as given.
Price Takers
A competitive market has many buyers and
sellers trading identical products so that each buyer and seller is a price taker.
Buyers and sellers must accept the price determined by the market.
Total Revenue
Total revenue for a firm is the selling price
times the quantity sold. TR = (P Q) Total revenue is proportional to the amount of output.
Average Revenue
Average revenue tells us how much revenue
a firm receives for the typical unit sold. Average revenue is total revenue divided by the quantity sold. In perfect competition, average revenue equals the price of the good.
Average Revenue=Price
Total revenue Average Revenue = Quantity Price Quantity Quantity Price
Marginal Revenue
Marginal revenue is the change in total
revenue from an additional unit sold. MR =TR/ Q
For competitive firms, marginal revenue
equals the price of the good.
P=AR=MR
For competitive firms,
Price (P)= Average Revenue (AR) = Marginal Revenue (MR)
Numerical Example
Goal of a Competitive Firm: Profit Maximization
The goal of a competitive firm is to maximize
profit. This means that the firm will want to produce the quantity that maximizes the difference between total revenue and total cost. Profit maximization occurs at the quantity where marginal revenue equals marginal cost.
Conditions for Profit Maximization
When MR > MC, increase Q
When MR < MC, decrease Q
When MR = MC, Profit is maximized.
Numerical Example: MR=MC
Figure 1 Profit Maximization for a Competitive Firm
Costs
an d Revenue The firm maximizes profit by producing the quantity at which marginal cost equals marginal revenue.
MC
MC2
ATC
P = MR1 = MR2 AVC P = AR = MR
MC1
Q1
QMAX
Q2
Quantity
Copyright 2004 South-Western
Shutdown or Exit?
A shutdown refers to a short-run decision not
to produce anything during a specific period of time because of current market conditions. Exit refers to a long-run decision to leave the market.
Sunk Costs
The firm considers its sunk costs when
deciding to exit, but ignores them when deciding whether to shut down.
Sunk costs are costs that have already been committed and cannot be recovered.
Short-Run Shut Down Decision
The firm shuts down if the revenue it gets
from producing is less than the variable cost of production.
Shut down if TR < VC Shut down if TR/Q < VC/Q Shut down if P < AVC
Figure 3 The Competitive Firms Short Run Supply Curve
Costs If P > ATC, the firm will continue to produce at a profit. Firms short-run supply curve MC
ATC If P > AVC, firm will continue to produce in the short run.
AVC
Firm shuts down if P < AVC 0
Quantity
Copyright 2004 South-Western
Short-Run Supply Curve
The portion of the marginal-cost curve that
lies above average variable cost is the competitive firms short-run supply curve.
Long-Run Exit Decision
In the long run, the firm exits if the revenue it
would get from producing is less than its total cost.
Exit if TR < TC Exit if TR/Q < TC/Q Exit if P < ATC
A firms Entry Decision
A firm will enter the industry if such an action
would be profitable.
Enter if TR > TC Enter if TR/Q > TC/Q Enter if P > ATC
Figure 4 The Competitive Firms Long-Run Supply Curve
Costs
Firms long-run supply curve MC = long-run S
Firm enters if P > ATC
ATC
Firm exits if P < ATC
Quantity
Copyright 2004 South-Western
Long-Run Supply Curve
The competitive firms long-run supply curve
is the portion of its marginal-cost curve that lies above average total cost.
Summary
Short-Run Supply Curve
The portion of its marginal cost curve that lies above average variable cost. The marginal cost curve above the minimum point of its average total cost curve.
Long-Run Supply Curve
Figure 5 Profit as the Area between Price and Average Total Cost
(a) A Firm with Profits Price MC Profit P ATC
ATC
P = AR = MR
Quantity Q (profit-maximizing quantity)
Copyright 2004 South-Western
Figure 5 Profit as the Area between Price and Average Total Cost
(b) A Firm with Losses Price
MC
ATC
ATC P Loss P = AR = MR
Q (loss-minimizing quantity)
Quantity
Copyright 2004 South-Western
Short-Run Market Supply with a fixed number of firms
For any given price, each firm supplies a
quantity of output so that its marginal cost equals price. The market supply curve reflects the individual firms marginal cost curves.
Figure 6 Market Supply with a Fixed Number of Firms
(a) Individual Firm Supply Price Price
(b) Market Supply
MC
Supply
$2.00
$2.00
1.00
1.00
100
200
Quantity (firm)
100,000
200,000 Quantity (market)
Copyright 2004 South-Western
Long-Run Market Supply Curve
Firms will enter or exit the market until profit is
driven to zero. In the long run, price equals the minimum of average total cost. The long-run market supply curve is horizontal at this price.
Figure 7 Market Supply with Entry and Exit
(a) Firms Zero-Profit Condition Price Price
(b) Market Supply
MC ATC P = minimum ATC Supply
Quantity (firm)
Quantity (market)
Copyright 2004 South-Western
Long-Run Equilibrium
At the end of the process of entry and exit,
firms that remain must be making zero economic profit. The process of entry and exit ends only when price and average total cost are driven to equality. Long-run equilibrium must have firms operating at their efficient scale.
Why do competitive firms stay in business if zero profit?
Profit equals total revenue minus total cost.
Total cost includes all the opportunity costs of
the firm. In the zero-profit equilibrium, the firms revenue compensates the owners for the time and money they expend to keep the business going.
Short-Run and Long-Run Effects of a Shift in Demand
An increase in demand raises price and
quantity in the short run. Firms earn profits because price now exceeds average total cost.
Figure 8 An Increase in Demand in the Short Run and Long Run
(a) Initial Condition Firm Price Price Market
MC
ATC A P1
Short-run supply, S1 Long-run supply Demand, D1
P1
Quantity (firm)
Q1
Quantity (market)
Figure 8 An Increase in Demand in the Short Run and Long Run
(b) Short-Run Response Firm Market
Price
Price
Profit P2 P1
MC
ATC P2 A P1
S1
D2 D1 0 Quantity (firm) 0 Q1 Q2
Long-run supply
Quantity (market)
Copyright 2004 South-Western
Figure 8 An Increase in Demand in the Short Run and Long Run
(c) Long-Run Response Firm Price Price Market
MC P1
ATC P2 A P1
S1 S2 C D2 D1 Long-run supply
Quantity (firm)
Q1
Q2
Q3 Quantity (market)
Copyright 2004 South-Western
Why a Long-Run Supply Curve Might Slope Upward?
Some resources used in production may be available
only in limited quantities. Price of resources rises (falls) when production scale or number of firms increases (decreases). Firms may have different costs. Firms average cost curve is higher (or lower) when production scale or number of firms increases (decreases).
