PERFECTLY COMPETITIVE MARKETS
Chapter 8
Charlie Chaplin's scene from Modern Times (1936), Image Source:[Link] date accessed 8 February, 2017
Competitive firms maximize profits
Profit maximization requires the firm to manage its internal operations
efficiently. Under perfectly competitive assumptions, firms maximizes
profits and are atomistic price-takers. The price-taking assumptions
assures firms are so small relative to its market that it cannot affect the
market price; it simply takes the price as given.
1
Demand curve is perfectly elastic for a competitive firm
P P
S
E
d
Q Q
industry firm
A perfectly competitive industry is populated by firms so small relative to
the market, a firm’s demand is only a tiny segment of the industry. The
firm’s portion of demand is so small that its demand curve looks
horizontal or perfectly elastic.
Perfect competition describes a market structure where
competition is at its greatest possible level
1. Under perfect competition, there are many small firms, each
producing an identical (homogenous) product and each too
small to affect the market price (price taking assumption).
2. The perfect competitor faces a perfectly elastic demand curve.
3. Because the firm sells at the same price, the additional revenue
(MR) gained from each extra unit sold is the market price. The
price is determined by industry market forces.
2
Costs
MC
ATC
AVC
Cost curves are U-shaped because of diminishing
returns. In the short run, variable factors show an
initial phase of increasing followed by diminishing
marginal product. This corresponds to an initial
phase of declining MC, then increasing MC after
Q
diminishing returns have set in.
Consider a perfectly competitive firm
Quantity (Q) 0 1 2 3 4 5
Total cost (TC) 55 85 110 130 160 210
Marginal cost
(MC) 27 22 21 40 60
Average total
cost (ATC) 85 55 43.3 40 42
Price (P) 40 40 40 40 40 40
Total revenue (TR) 40 80 120 160 200
Marginal
revenue (MR) 40 40 40 40
Profit (π) -45 -30 -10 0 -10
3
Under perfect competition assumptions, maximum profit
comes at the output where MC equals price
MC = MR = P = AR
Competitive firm can make additional profit as long as price is
greater than the MC of the last unit. Total profit reaches its peak—is
maximized—when there is no longer any extra profit to be earned
by selling extra output. At profit maximizing output, the last unit
produced brings in an amount of revenue exactly equal to that unit’s
cost, which is the price.
Price
MC
ATC
D=MR=AR= P
A
Short-run profit maximizing conditions for a perfectly
competitive firm. Profit is maximized at Q* when MC is
equal to MR and thus π is positive (abnormal) since revenue
exceeds cost. If MR > MC, firm should make more, as it earns
a profit. If MR < MC, firm should produces less since it makes
a loss on each additional product.
Q
Q*
Cost Revenue
4
A firm will want to shut down in the short run when it
can no longer cover its variable costs.
P < AVC
The firm should not necessarily shut down if it is losing money. It will
be advantageous for the firm to continue operations, with P > MC,
as long as revenue covers variable costs.
Price
MC
ATC
AVC
D=MR=AR= P
C
The firm can continue its operation without maximized
profits as long as it can cover its expenses, up until the
shutdown price, PS. At P<PS, the firm cannot shoulder
PS B
its operational expenses anymore and should shut
down.
Q
Q*
5
In the long run, firms can vary their input factors
The ability to vary the amount of input factors in the long‐run allows
for the possibility that new firms will enter the market and that some
existing firms will exit the market. New firms will be tempted to enter
the market if some of the existing firms in the market are earning
positive economic profits. Alternatively, existing firms may choose to
leave the market if they are earning losses. For these reasons, the
number of firms in a perfectly competitive market is unlikely to remain
unchanged in the long‐run. The entry and exit of firms, which is
possible in the long‐run, will eventually cause each firm's economic
profits to fall to zero (normal profits).
In the long run, above normal economic profits cannot
be sustained
P = min (ATC)
The arrival of new firms or expansion of existing firms in the
market causes the demand curve of each individual firm to shift
downward, bringing down at the same time the P, AR and
MR. The final outcome is that the firm will make only normal
profit, or zero economic profit.
6
In the long run, above normal economic profits cannot
be sustained
P = min (ATC)
If the price is below min(ATC), then quantity supplied is zero. Any firms
that are in the industry would exit if the price stayed that low. If P =
min(ATC), then firms are indifferent between: (i) staying out of the market
and (ii) entering, and producing the quantity ATC is minimum. Thus, any
and all quantities are on the market supply curve at that price. If we have
P > min(ATC), then entry by new firms is profitable. An infinite quantity
would be supplied if the price stayed that high. New firms will enter
and market forces will push down the price until P = min(ATC).
P P
MC MC
ATC ATC
AVC AVC
A
d = MR = AR= P
A
d = MR = AR= P
Q Q
Short run Long run
Cost Revenue
7
Competitive equilibrium maximizes the economic surplus
household firm
Households consume up to the Firms produce to earn revenue
amount where P=MU. Consumers equivalent to the point the P=MC.
afford the price by selling factors of The price then is the utils of leisure lost
production to the firms. because of working to produce
goods.
