Chapter 9: Perfect Competition

•Thus far we have examined how the

consumer and firm attempt to optimize their
decisions

•The results of this optimization depend on

the set-up of the economy

•In this course we will examine the extreme

set-ups: Perfect Competition and Monopoly
1
 Chapter 9: Perfect Competition
In this chapter we will cover:
9.1 Perfect Competition Characteristics
9.2 Economic and Accounting Profit
9.3 PC Profit Maximization
9.4 PC Short Run Supply and Equilibrium
9.5 PC Long Run Supply and Equilibrium
9.6 PC Costs
9.7 Economic Rent
9.8 Producer Surplus
2
1) Fragmented Industry
-Many buyers and sellers
-No one buyer or seller has an effect on the
industry
-Each firm and consumer is a price taker (uses
market price)

2) Homogeneous products
-All firms produce identical products
-No quality differences, no brand loyalty
3
3) Perfect Information
-Buyers and sellers have full information,
especially regarding prices

4) No barriers to entry or exit

-No input is restricted to potential customers
or firms
-Any firm or customer can enter or exit the
market in the long run
4
As a result, we have:

• Many buyers and sellers

• Buying and selling identical goods

At a given, set price.

Note: although we are examining a market for

outputs (goods and services), a similar analysis
can apply to the market for inputs
5
As seen before,

Accounting Costs = Explicit Costs

Economic Costs = Explicit Costs + Implicit Costs

Furthermore,

Accounting Profit = Revenue – Explicit Costs

Economic Profit = Revenue – Explicit Costs
- Implicit Costs
6
Explicit Costs: Costs that involve an exchange of
money
-ie: Rent, Wages, Licence, Materials

Implicit Costs = Opportunity Costs: Costs that

don’t involve an exchange of money; Cost of
giving up the next best opportunity
-ie: Wage that could have been earned
working elsewhere; profitability of a goat if
used mowing lawns instead of for meat 7
7.1.3 Economic and Accounting Costs
Economists are interested in studying how firms make production
& pricing decisions. They include all costs.

Economic Costs = Explicit + Implicit Costs

Accountants are responsible for keeping track of the

money that flows into and out of firms. They focus
on explicit costs.

Accounting Costs = Explicit Costs

Note: Different textbooks define costs differently. Refer to these

notes for our class’ definitions. 8
Implicit Costs are the BEST ALTERNATIVE return
of ALL of an agent’s input (time, money, etc).

Alternately, an agent’s time could earn a wage

elsewhere.
(ie: Work at Simtech for $3000 a month)

An agent’s money both isn’t used currently and

can be used elsewhere.
(ie: Investing $5,000 @ 10% instead of using it
9
to start a business gives an implicit cost of $500)
 Profit: Economists vs Accountants
Economist’s Accountant’s
View View

Economic
Profit Accounting
Profit
Implicit
Revenue Costs Revenue
Economic
Costs
Explicit Explicit
Costs Costs

10
Buck opens his own Bait shop in a store he owns,
which cost $5,000 per month to run, but he makes
$10,000 a month. Buck could have worked for Worms
R Us for $2,000 per month, or rented out the store for
$1,500 per month.

Explicit Costs = $5,000

Accounting Profit = Revenue – Explicit Costs
Accounting Profit = $10,000 - $5,000
Accounting Profit = $5,000 11
Buck opens his own Bait shop in a store he owns,
which cost $5,000 per month to run, but he makes
$10,000 a month. Buck could have worked for Worms
R Us for $2,000 per month, or rented out the store for
$1,500 per month.

Implicit Costs = $2,000 (labour) + $1,500 (capital)

Implicit Costs = $3,500
Econ Profit = Revenue – Explicit Costs – Implicit Costs
Econ Profit = $10,000 - $5,000 - $3,500
12
Econ Profit = $1,500
 Sunk Costs are costs that must be incurred no
matter what the decision. These costs are not
considered when making a future decision.

The Talus Dome was built in

2011 for $600,000. That
cost is now SUNK, and
shouldn’t be considered in
any further analysis.
(ie: Keep cleaning it or get Picture Source: City of Edmonton
rid of it) Webpage (www.edmonton.ca)
Price Source: Edmonton Journal13
While previously we studied cost minimizing, in
reality a firm is more concerned with maximizing
its profits.

Total Revenue: TR(Q)=PQ

Total Cost: TC(Q) as found in previous chapters
ie: TC(Q)=100+2Q

Profit =Total Revenue – Total Cost:

π(Q)=TR(Q)-TC(Q)
14
TC(Q) in general is derived as follows:

Originally: TC=wL+rK (1)

Tangency Condition: L=f(K) (2)
Production Function: Q=f(L,K) (3)
(2) + (3) Q=f(L) and
L=f(Q) (4)
(2) + (4) K=f(Q) (5)
(1) + (4) + (5) TC=wf(Q)+rf(Q)
TC=f(Q)
15
For Example:

Originally: TC=wL+rK (1)

Tangency Condition: L=K (2)
Production Function: Q=2(LK)1/2 (3)
(2) + (3) Q=2L and
L=Q/2 (4)
(2) + (4) K=Q/2 (5)
(1) + (4) + (5) TC=wQ/2+rQ/2
TC=(w+r)Q/2
16
Definition: Marginal revenue is the change in revenue when
output changes

Marginal revenue is the slope of the total revenue curve.

Since the PC firm is a price taker, the additional revenue

gained from 1 additional output is EQUAL TO PRICE.
TR (Q)
MR(Q)  P
Q
17
As seen previously, marginal cost changes as production
increases.

If for the next unit, MR>MC, that unit should be produced,

as it yields profit.

If for the last unit, MC>MR, that unit should not have been
produced, as it decreases profit.

Therefore profit is maximized where MC=MR=P 18

 Total Cost, Total Revenue, Total Profit ($/yr)

Total revenue = pq
Total Cost
Example: Profit Maximization Condition

15 Total profit
q (units per year)

MC
15 P, MR

19
6 30 q (units per year)
The previous curves are expressed by:

TC(q) = 242q - .9q2 + (.05/3)q3

MC(q) = 242 - 1.8q + .05q2
P = 15
At profit maximizing point: 1) P = MC

But this occurs twice. At one point, profit is

maximized, at another minimized. Therefore, in
order to MAXIMIZE profit:

2) MC must be rising
20
In the paper industry, MC=20+2Q (which is always
rising), where Q=100 reams of paper. Find the cost-
maximizing quantity if P=30 or P=40

Solution: P=MC
30=20+2Q
5=Q

P=MC
40=20+2Q
21
10=Q
In the short run, the firm either produces or
temporarily shuts down, thus facing costs:

STC(Q) = SFC + NSFC + TVC(q) when q > 0

= SFC when q = 0

SFC: Sunk Fixed costs – unavoidable sunk costs

NSFC: Non-sunk Fixed costs – fixed costs that are
avoidable if the firm temporarily shuts down
TVC: Total Variable Costs; depends on output 22
Definition: The firm’s Short run supply curve
tells us how the profit maximizing output changes
as the market price changes.

HOWEVER, if the market price is too low, the

firm will not operate in the short run.

Ps = Shut down price (minimum market price

where a firm will still operate)
23
A firm will only operate if it can cover its NON
SUNK COSTS.
-ie: A sandwich shop will only stay open if it can
pay its employees cover daily operating costs.

3 Cases:

Case 1: all fixed costs are sunk

Case 2: all fixed costs are non-sunk
Case 3: some fixed costs are sunk
24
$/yr Case 1: Shut down price where SMC=AVC
(all fixed costs are sunk – worst situation)

SMC
SAC

AVC

Ps

Quantity (units/yr)
25
$/yr This firm may operate at a loss if P<SAC
(Because operating has less loss than shutting down)

SMC
SAC

AVC

Ps

Quantity (units/yr)
26
 $/yr Case 2: Shut down Price where SMC=SAC
(all costs are non-sunk – best case scenario)
(This firm will never operate at a loss)
SMC
SAC

Ps AVC

Quantity (units/yr)
27
$/yr Case 3: Shut down price between SAC and AVC
(sometimes called ANSC – Average non-sunk cost)
(This firm operates at a loss if P<SAC)
SMC
SAC

ANSC
AVC
Ps

Quantity (units/yr)
28
 At prices below SAC but above AVC, profits
are negative if the firm produces…but the firm
loses less by producing than by shutting down
because of sunk costs.
Example:

STC(q) = 100 + 20q + q2

SFC = 100 (nb: this is sunk)

TVC(q) = 20q + q2
AVC(q) = 20 + q
SMC(q) = 20 + 2q
29
 a. Calculate The Firm’s Supply Curve,
P = SMC
P = 20+2q
qs = ½P - 10

b.If Market Price=$25, calculate firm

production
qs = ½P - 10
qs = ½(25) – 10
qs = 2.5

30
b.If Market Price=$25, calculate firm
profit/losses

qs = 2.5

π=TR-TC
π=Pq-(100 + 20q + q2)
π=($25)2.5-(100 + 20(2.5) + (2.5)2)
π=62.5-(100 + 50 + 6.25)
π=-$93.75

(remember that shutting down would have

fixed costs of $100.) 31
P

s P
q   10
SMC 2
SAC

AVC
Loss = $93.75

P* = $25
Ps = $20

Q 32
q* = 2.5
 A firm will produce
If
It can cover its Non-Sunk Costs

33
Thus far we have seen that the individual firm’s
short run supply curve comes from their marginal
cost curve.
Definition: The market supply at any price is the
sum of the quantities each firm supplies at that
price.
The short run market supply curve is the
HORIZONTAL sum of the individual firm supply
curves. (Just as market demand is the
HORIZONTAL sum of individual demand curves)
34
Example: From Short Run Firm Supply Curve to Short Run Market Supply Curve

Typical firm: Market:

Individual supply curves
per firm. 1000 firms of each
type SMC3
$/unit SMC2 $/unit
SMC1
Market supply
30

24
22
20

0 300 400 500 0 1.2

35 mill
q (units/yr) Q (m units/yr)
Definition: A short run perfectly competitive
equilibrium occurs when the market quantity
demanded equals the market quantity supplied.

ni=1 qs(P) = Qd(P)

Qs(P)= Qd(P)

and qs(P) is determined by the firm's

individual profit maximization condition.
36
 Example: Short Run Perfectly Competitive Equilibrium

Typical firm: Market:

$/unit $/unit

Supply

SMC
SAC
P*
AVC Demand
Ps

q* Units/yr Q* 37
m. units/yr
300 identical firms

Qd(P) = 60 – P
STC(q) = 0.1 + 150q2
SMC(q) = 300q
NSFC = 0
AVC(q) = 150q

38
a. Short Run Equilibrium

Individual Firm:

P = SMC
P = 300q
qs= P/300

Industry:

Qs = 300(qs)
Qs = P (for industry)
39
a. Short Run Equilibrium

Market Price:
Qs(P) = Qd(P)
P = 60 – P
P*= 30

Quantities:
q* = P/300= 30/300
q* = 0.1

Q* = P
Q* = 30 40
b. Do firms make positive profits at the
market equilibrium?

SAC = STC/q
SAC = 0.1/q + 150q
SAC = 0.1/0.1 + 150(0.1)
SAC = 16

Therefore, P* > SAC so profits are positive.

41
 Comparative Statics in the
Short Run

•As seen in previous chapters, the entry or exit of

firms or consumers, among other things, can shift
the market demand and supply curves

•Shifts in the market demand and supply curves

will shift the equilibrium quantity as seen in
chapters 1 and 2

42
In the short run, capital is fixed and firms may
temporarily operate under an economic profit
or loss.

In the long run, capital can change and firms can

enter and leave the market, resulting in zero
economic profit.

Remember that in the long run, all costs are

nonsunk (they are all avoidable at zero output)
43
 Just as in the short run the firm operated at:
P=SMC

In the long run the firm operates at

P=MC

SMC≠MC (in general) since costs are reduced in

the long run.
Only at LR profit maximization is SMC=MC
(because the short run is operating at the LR
44
optimal capital point: Point A next slide)
 $/unit In the long run, this firm has an incentive to change
plant size to level K1 from K0:
MC

SMC0 SAC0 A AC
P •
SAC1

SMC1

q (000 units/yr)
45
1.8 6
In the long run, a firms supply curve is
The firm’s LR MC curve above AC.

For if P>AC, Profits>0.

Since Profits = (PxQ)-(ACxQ)

As in the short run, market supply is the

horizontal sum of individual firm supply.

46
 $/unit Long Run Supply Curve:

MC
S AC
P

SMC1

q (000 units/yr)
47
1.8 6
Long Run Perfectly Competitive Equilibrium
occurs when:

1) Each firm maximizes profit with regards to

output and capital (P=MC)
2) Each firm’s economic profit is zero (as firms
keep entering until the price is pushed down to
zero profits) (P=AC)
3) Market Demand=Market Supply
48
 Long Run Perfectly Competitive Equilibrium
Typical Firm Market
$/unit $/unit

MC Market demand
SAC AC

P*

SMC

q*=50,000 q Q*=10M. 49
Q
•to increase production, a firm must increase inputs

•Increasing MARKET output could change costs,

therefore changing equilibrium price

•A CONSTANT COST INDUSTRY is an industry

where changes in output do not affect the price of
inputs

50
-Demand increases to D2, Price rises to P2
-New firms enter, Supply increases to S2,
lowering price back to P1
$/unit $/unit

SMC S1
SAC S2
P2

P1
D2

D1

Typical Firm q Market 51

Q
•Industry-specific inputs are scarce inputs used
primarily by one industry
-ie:Plutonium is only used in the nuclear industry

•Changes in production will have an impact on

the market for industry-specific inputs

•An INCREASING COST INDUSTRY is an

industry where increases in output increase the
price of inputs 52
-Demand increases to D2, Price rises to P2
-New firms enter, Supply increases to S2,
increasing costs and lowering price to P3 (>P1)
$/unit $/unit

SMC3
SMC1 S1 S2
SAC3

P2
P3
P1
SAC1
D2

D1

Typical Firm q Market 53

Q
•Some industries require a small amount of an
expensive/rare input
-ie: Liquid Nitrogen computer cooling

•An increase in input demand may drive down

input prices by reducing input AC

•A DECREASING COST INDUSTRY is an

industry where increases in output decrease the
price of inputs 54
-Demand increases to D2, Price rises to P2
-New firms enter, Supply increases to S2,
decreasing costs and lowering price to P3 (<P1)
$/unit $/unit

SMC1 S1
SMC3
SAC1
P2 S2

P1 SAC3

P3 D2

D1

Typical Firm q Market 55

Q
Although economic profit is possible in
the short run,

In the long run the entry of firms will

push economic profit to zero

This entry could increase, decrease,

or not change the equilibrium price.
56
• In general, we assume that all workers are
identical.
• In reality, some workers are masters; they are
more productive than their peers.

• The cost savings of a master worker is their

ECONOMIC RENT

57
Joe is an amazing worker that works in a button
factory. While most workers can only press
one or two buttons at a time, Joe can press a
dozen.

A normal worker produces buttons at an average

cost of 5 cents, but Joe can make buttons at
an average cost of 1 cent each. If Joe
produced buttons at a cost of 5 cents each,
he’d be hired to produce 900 a day.
58
 Economic Rent = Cost Savings
ER = (0.05-0.01)900
ER = $36

The economic rent from a master worker (Joe) is

$36 a day.

59
• If a firm is able to employ a master worker at
a normal worker’s wage, that worker’s
economic rent becomes the firm’s economic
profit
• In a perfectly competitive industry, in all
likelihood a master worker will be stolen by
other firms at higher wages until his wage
matches his productivity
• Master workers therefore often provide no
profit in perfect competition 60
Definition: Producer Surplus is the area above
the supply curve and below the price. It is a
monetary measure of the benefit that producers
derive from producing a good at a particular price.

Note that the producer earns the price for

every unit sold, but only incurs the SMC for
each unit. This is why the difference
between the P and SMC curve measures the
total benefit derived from production.
61
$/yr Producer Surplus, Individual Firm

SMC

ANSC

P
Producer
Surplus

Quantity (units/yr)
62
Further, since the market supply curve is simply
the sum of the individual supply curves…which
equal the marginal cost curves…the difference
between price and the market supply curve
measures the surplus of all producers in the
market.

Note that producer’s surplus does not deduct

fixed costs, so it does not equal profit!

63
 Market Producer Surplus
P

Market Supply Curve

50

Producer Surplus = (1/2)BH

PS=(1/2)800(40)
PS=16,000
10

Q 64
800
Producer surplus is the difference between total
revenue and total nonsunk costs;

Producer Surplus=TR-NSFC-TVC

In the short run, if Producer

Surplus>SFC, economic profit is
possible.
65
In the long run, no costs are fixed,

Therefore Producer Surplus = Economic Profit

BUT

In the long run, Economic Profit=0

How?
66
An industry has an upward sloping supply if it
employs scarce resources (increasing cost
industry – master growers)

Producer Surplus is therefore the economic rent

captured by the master worker or owner of the
input

In the LR PC: Producer Surplus=Economic Rent

67
 Long Run Producer Surplus =
P Economic Rent

LS

50
Economic
Rent

D
10

Q 68
800
 Chapter 9 Key Concepts
Perfect competition features:
Many buyers and sellers
Homogeneous products
Perfect Information
No Barriers to Entry
Perfect competition results in a single,
equilibrium price that no one consumer or
firm can influence
Economists include implicit costs in their
economic profits (Accountants do not)
69
 Chapter 9 Key Concepts
Total cost (TC) depends on total output (Q)
Marginal revenue is the change in total
revenue from one additional output (Q)
A firm will produce where MR=MC
MR=P in Perfect Competition
A firm’s supply curve is its MC curve above
its shut-down point
A firm will operate if it can cover its
variable costs
In the SR, this could cause a loss
70
 Chapter 9 Key Concepts
In the LR, costs can vary with the entry of
firms
This can affect equilibrium price
Skilled workers produce economic rent,
which is often captured by higher wages
Producer Surplus is the area between price
and the supply curve
This is before fixed costs
In the long run, Producer Surplus is captured
by skilled workers
Economics > Accounting
71