Chapter 6

Perfect Competition
Perfect Competition
• The model of perfect competition is based on five central assumptions.

• Atomicity: there are many suppliers in the market: Each supplier is so small that its actions have no
significant impact on other suppliers.

• Product Homogeneity: the product supplied by the different firms is the same.

• Perfect information: all agents (firms, consumers) know the prices set by all firms.

• Equal Access: all firms have access to all production technologies.

• Free Entry: any firm may enter or exit the market as it wishes.
Efficiency
• Profit maximizing condition in perfect competition is: p = MC.

• Why?

• Perfect competition implies maximum efficiency in a static sense, that is, for a
given set of available technologies.

• P=MC, so no deadweight loss

• P intersects ATC at its minimum in the long-run

Example for Short-Run Perfectly Competitive Equilibrium

TC(q) = F + q + 0.05q2

Find the profit maximizing q when P = 11.

How do you do this?

Solution:

TC(q) = F + q + 0.05q2 so MC(q) = 1 + 0.1q

P = 11
“MC(q) = P” means 1 + 0.1q = 11, we solve this for q: ➔ q* = 100.
The supply function of the single firm

The profit maxing q is the one at which P = MC(q)

Now we don’t put a numerical value for P but keep P in the “MC(q) = P” equation
as a “parameter”:
1 + 0.1q = P
We solve this for q ➔
qS(P) = 10P – 10 if P > 1,
if p<1, qS(P) = 0
The market supply function

Suppose there are 200 firms in the market.

We let QS(P) denote the market supply. Then
QS(P) = 200 x qS(P)
Remember qS(P)= 10P – 10 if P > 1, 0 if otherwise
QS(P) = 200 x [10P – 10]
= 2000P – 2000 if P > 1, 0 if otherwise.
The market equilibrium price and quantity

Suppose the market demand is QD = 10300 – 50P

The equilibrium price equates supply and demand
QS = 2000P – 2000
QD = 10300 – 50P

QS = QD means 2000P – 2000 = 10300 – 50P

Solve this for P: ➔ The equilibrium price is P* = 6, the equilibrium quantity is Q* = 10,000.
Each firm produces 50 units in equilibrium. (Remember qS(P) = 10P – 10 )
Profit per firm: 125 − F. (Pxq = 300, TC(q) = F + 50 + 0.05x502 = 175, all evaluated at P = 6
and q = 50, TC(q) = F + q + 0.05q2)
The long – run equilibrium

In the short-run equilibrium the number of firms is fixed.

In the long-run equilibrium the number of firms is endogenously determined.

In the long run entry and exit is possible.

The Long-Run Competitive Equilibrium Price

MC
Price
60
AC
50
40
P* = ?
30
20
10
0 2 4 6 8 Quantity
Long-Run Equilibrium

TC(q) = F + q + 0.05q2,
AC=TC/q= F/q + 1 + 0.05q
FOC to find the minimum point of AC:
F
qLR =
-F/q2+0.05=0 -> 0.05

Let’s say F=80, Then q is 40. Then the minimum AC=5.

This means that the long run equilibrium price must be 5!
Long-Run Equilibrium
The market demand is QD = 10300 – 50P.

With P = 5, the equilibrium quantity is 10050.

We have 10050/40 = 251.25, so, there will be 251 firms in the market. (Round
down!)
P=5

q = 40
Are implications consistent with reality?
• Entry and Exit: The long-run equilibrium under perfect competition is a limit
point that industries converge to by means of successive entry and exit. If active
firms make positive profits, then new firms are attracted to the industry. If, on the
contrary, active firms make losses, then some of those firms exit.

• Profits: Because technology (i.e., the cost function) is the same for all firms
(because of the equal access assumption), each firm receives zero supranormal
profits

• Size distribution of firms: All plants must be of the same size in the long run (i.e.,
there is only one output level that minimizes average cost
Profits=0 in the long-run?

• 600 U.S. firms from 1950 to 1972.

• Classified firms in groups of 100 according to average profits in the period from 1950 to
1952

• Computed average profit rates in the whole 23-year period for each of the groups.

• The hypothesis that profits converge to the competitive level in the long run would imply
that inter group differences are insignificant on average.

• However, the data reject that any pair of averages is equal. In other words, average
differences in profitability across the groups persist even after 23 years
Entry-Exit rates
• Firms either enter or exit from an industry in the standard theory. However:
Size of the firms
• Standard theory implies a single size firm. However:
• So the standard theory does not pass through empirical testing.

• We need to have to change assumptions

• Let’s assume that firms have different cost functions

What happens if firms have different cost
structures?
• If firms have different cost structures then in a long run competitive equilibrium
(with many price-taking firms who are small relative to the overall market), the
least efficient firm (aka the marginal firm) will be the one for which p = AC holds.

• Those firms that have cost advantages will be earning a positive profit, a profit we
refer to as a rent.

• Firms earn rents in competitive markets when their cost function is better than
their rivals'.
Example: Firms have different costs.

All firms in the industry have the same total cost function TC(q) = M + 10q + wq2,
where M is the salary paid to the manager,
and w is the market wage rate for workers.
All firms face an output price of P = 30, and a wage rate of w = 2.

Merlin is like all other managers in this industry except in one respect:
Because of his great sense of humor, people are willing to work for him for half the
market wage rate. Merlin’s salary as a manager is also M.
Example: Firms have different costs.
a. How much output will Merlin’s firm produce? How much output will a regular
firm produce?
b. The market demand is QD(P) = 80 – P. The market is in the short run equilibrium
at P = 30 with N regular firms and Merlin’s firm. Compute N.
c. Compute the value of M so that the output price (P = 30) is the long run
equilibrium price.
Example: Firms have different costs

TC(q) = M + 10q + wq2…

The marginal cost function is MC(q) = 10 + 2wq.
A regular firm pays w = 2, so it has MC = 10 + 2x2xq.
P = MC for that firm is 30 = 10 + 4xq ➔ q* = 5.

Merlin’s firm pays w = 1,

so its MC is 10 + 2xq.
P = MC for Merlin’s firm is 30 = 10 + 2q ➔ qM = 10.
Example: Firms have different costs

Profit of a regular firm

πR = 5x30 – M – 10x5 –2x52 = 50 – M.

Profit of Merlin’s firm

πM = 10x30 – M – 10x10 –1x102 = 100 – M

So, Merlin’s firm makes more profit than other firms. It also has a larger market
share!
Example: Firms have different costs

What value of M will make this price the long-run equilibrium price? How many
firms will there be in the market?
In particular, will Merlin’s firm make 0 profit in the long-run equilibrium?

Let the market demand be QD(P) = 80 – P

Example: Firms have different costs

M = 50.

When M = 50 and P = 30, the regular firms produce q= 5 and make 0 (economic)
profit.
Merlin’s firm will produce q = 10 and make a profit of 50.
At P = 30 quantity demanded is QD(P) = 80 – P = 50.
How many firms will there be in the market?
There will be 8 regular firms (each firm produces q = 5) + Merlin’s firm (produces q
= 10).
Example: Firms have different costs

• Long run profits? ✓

• Simultaneous entry and exit ✓

• Firms with different sizes ✓

Example: Firms have different costs

• What would happen to Merlin’s wage in the long run?

• What would happen to the long-run profit?

• Theorists always seek for better models to explain empirical facts.

Monopolistic Competition
• There are many industries comprising a large number of firms (as in the perfect
competition model) whose products are not exactly identical.

• Examples of this include small restaurants and shampoo. Both of these examples
feature a large number of sellers: Witness, for example, the number of different
shampoo brands typically displayed on a supermarket shelf.

• Moreover, the technology for making shampoo or serving meals is fairly well
known and accessible.

• So the remaining assumptions of perfect competition model are valid.

• Always confused by monopoly! (because of the name)

• Actually it is closer to perfect competition in assumption and to monopoly

in analysis (graphs)

• Perfect Competition assumptions with only one change:

• Products are not homogeneous!

• e.g. hotels, restaurants, jeans, etc.

Short-run equilibrium
Analysis

• The only difference with this graph and monopoly graph is:

• Market demand and the demand faced by the firm is the same in
monopoly

• Market demand and the demand faced by the firm is very different in
monopolistic competition
Analysis

• Which one is more elastic? Market demand or the demand facing the
firm?

• In which market structure, the firm can charge more? Monopoly or

monopolistic competition?
In the long-run.

• Entry if profits are positive

• Exit if profits are negative

Long-run
Long-run

• Which market type produce more? Which market type has lower
prices? Perfect competition or monopolistic competition?

• DWL=0 in perfect competition. How about monopolistic competition?

• Which is better? (Hint: Do you want all your jeans the same???)
Homework

• TC(q) = 40 + q + 0.05q2

• The demand that an individual firm faces is P=10-0.1q. This is a monopolistically competitive firm.

• What is the price in the short-run?

• Is the firm in a long-run equilibrium? Why?