Perfect Competition (HL)

Friday, November 15, 2024 10:10 AM

Perfect competition:
A market is perfectly competitive if there are a large number of firms producing facing identical
production costs and in which there are no barriers to entry or exit.

1. There is a large number of firms

The large number means that each firm's output is small in relation to the size of
the market. Also, it means that firms act independently of each other and the
actions of each one do not affect the actions of the others.
2. All firms produce identical, or homogeneous products
The products produced by the firms in each industry are identical, and are
referred to as homogeneous. It is not possible to distinguish the product of one
producer from that of another.
3. There is free entry and exit
Any firm that wishes to enter an industry can do so freely as there is nothing to
prevent it from doing so; similarly, it can also leave the industry freely.
4. There is perfect resource mobility
Resources bought by firms for production are completely mobile. This means that
they can easily and without any cost be transferred from one firm to another, or
from one industry to another.
5. There is perfect (complete) information
• Perfect information means that all firms and all consumers have complete
information regarding products, prices, resources and methods of production.
• This ensures that no firm has access to information not available to others that
would allow it to produce at a lower cost compared to its competitors.
• Also, it ensures that all consumers are aware of the market-determined price, and
therefore will not be willing to pay a higher price for the product
• Real world example: price of gold.

• While perfectly competitive industries are rare in the real world, examples of markets with some
of these characteristics do exist in certain industries：
• Certain agricultural commodities (wheat, corn, livestock)
• Other commodities (silver and gold)
• The foreign exchange market (where currencies are bought and sold)
• Low-tech manufactured goods
• Certain types of low-skilled labor
• Millions of households supplying an identical resource (such as labor)

A firm's short-run cost of production

• A firm increasing its output in the short run may alter its variable resources (labor and
raw materials) while keeping its land and capital inputs constant.

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 raw materials) while keeping its land and capital inputs constant.
• As more labor and raw materials are added to production while the amount of capital
and land are fixed, the output attributable to additional labor beyond a certain point
begins to decline. This explains why a firm’s short-run marginal cost (MC) curve slopes
upward beyond the point at which diminishing marginal returns begins.

• a. The perfectly competitive market; b. a single firm in the market

• The demand curve for a good facing the perfectly competitive firm is perfectly elastic
(horizontal) at the price determined in the market for that good. This means the firm is a
price-taker, as it accepts the price determined in the market.
• No matter how much output the perfectly competitive firm sells, P=MR=AR and these
are constant at the level of horizontal demand curve. This follows the fact that price is
constant regardless of the level of output sold.

Profit maximization in the short run

Short run:
• Short run is the period when the firm has at least one fixed input.
• The number of firms in the industry is also fixed. (to enter or leave an industry, a firm
must be able to vary all its inputs改变所有投入. Since this cannot be done in the short
run, firms cannot enter or leave the industry)
Short-run profit maximization based on the MR and MC curve
• The analysis consists of three steps:
• Compare MR with MC to determine profit-maximizing (or loss-minimizing) level of
output.
• Compare AR (or price) and ATC to determine the amount of profit (or loss) per
unit of output.
Profit = TR-TC

• Find total profit (or total loss)

• At the profit-maximizing level of output Q:
If P > ATC, the firm makes supernormal profit (positive economic profit)
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 • If P > ATC, the firm makes supernormal profit (positive economic profit)
• If P = ATC, the firm breaks even, making zero economic profit, though it is
earning normal profit.
• If P < ATC, the firm makes a loss (negative economic profit).
• When P > ATC at the level of output where MC = MR, the firm earns positive
economic profit (supernormal profit).

• The price P minimum ATC is the firm’s break-even price. At this price the firm is
breaking even: it is making zero economic profit, but is earning normal profit.
• When economic profit=0, P = minimum ATC: this is a break-even price, meaning that at
this price the firm breaks even, so that its TR =TC (implicit plus explicit).

• When ATC > P > AVC at the level of output where MC = MR, the firm is making a
loss but should continue producing because its loss is smaller than its fixed cost.
Graphically, this occurs when the demand curve lies below minimum ATC and above
minimum AVC.

• The price P = minimum AVC is the firm's shut-down price in the short run. At this price,
the firm's total loss is equal to its total fixed cost.
• At the shut-down price, the firm is indifferent between producing Q4, determined by
MC = MR, and not producing at all, because either way it will have a loss equal to fixed
costs.

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 • When price falls below the shut-down price, so that P < minimum AVC, the firm should
shut down in the short run, and will make a loss equal to its fixed costs.

Summary of the perfectly competitive firm's short-run decisions, and the firm's short-
run supply curve
• The short-run supply curve of the perfectly competitive firm is the portion of its marginal
cost curve that lies above the point of minimum AVC
• P = minimum ATC = break-even price: firms makes normal profit, or zero economic
profit.
• P = minimum AVC = shut-down price: firm is indifferent between producing at a loss or
not producing.

• In perfect competition in the short run:

• When P > ATC, the firm makes economic profit.
• When P = minimum ATC, the firm makes zero economic profit but earns normal
profit; this P is a break-even price of the firm (at the break-even point).
• When ATC > P > AVC, the firm produces at a loss, but its loss is less than
fixed costs; therefore, it continues to produce.
• When P minimum AVC, the firm’s loss fixed costs; this P is the firm’s short-run
shut-down price.
• When P < AVC, i.e. when price falls below the shut-down price, the firm shuts
down (stops producing); its loss will then be equal to its fixed costs.

Profit maximization in the long run

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Profit maximization in the long run
Long run
• All the firm’s resources are variable; therefore, the number of firms in the industry is no
longer unchanging.
• New firms can enter the industry, existing firms can change their size (increase or
decrease their fixed resources)
• or firms can sell their fixed resources and business and leave the industry altogether

Normal profit in the long run

• In the long-run equilibrium of the perfectly competitive market structure, all firms earn
zero economic profits (they earn normal profit).
The reason behind this principle is that if firms earn supernormal profit or make losses in the
short run, the profits and losses lead to a process of entry and exit of firms that makes the
short-run profits or losses tend to zero.
• In perfectly competitive long-run equilibrium, firms’ economic profits and losses are
eliminated, and revenues are just enough to cover all economic costs so that every firm
earns normal profit.

The firm and industry long-run equilibrium position in perfect competition

• In perfectly competitive long-run equilibrium, firms’ economic profits and losses are
eliminated, and revenues are just enough to cover all economic costs so that every firm
earns normal profit.

Economic (supernormal) profit in the short run to normal profit in the long run
In the long run, the economic profit realized by firms in the industry leads to the entry of new
firms attracted by the prospect of making economic (supernormal) profits. As new firms enter,
the industry supply curve S1 begins to shift to the right to S2, causing industry output to
increase to Q2 and the market price to fall to P2. At P2, the economic profits of the firms
have fallen to zero, and all firms are earning normal profit (where P = minimum ATC). This is
the break-even price, which is the same for the short run and the long run.

Economic loss in the short run to normal profit in the long run
Once they go into the long run and have no more fixed inputs, the firms are free to leave the
industry. As some firms begin to exit, the industry supply curve begins to shift to the left from

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industry. As some firms begin to exit, the industry supply curve begins to shift to the left from
S1 to S2, determining price P2. As the supply curve shifts and price rises, the remaining
firms’ losses get smaller and smaller until at P2 the firms are no longer making losses. P2
represents the firms’ new MR, and by the MC MR rule, firms produce output Q2 and earn
normal profit (where P = minimum ATC).

When the loss-making firm exits the market in the long run
We have just seen that the price P2 is again the break-even price, but note that P2 is also the
shutdown price in the long run. In other words, in the long run, the break-even price and the
shut-down price are the same. The reason is that in the long run, any loss-making fi rm facing a
price lower than minimum ATC will shut down and leave the industry.

In the long run, a loss-making

firm shuts down and exits the
market when price falls below
minimum ATC.

Explaining the appearance of short-run profits and losses

• Changes in demand: e.g. tastes
• Changes in technology or resource prices: cost curves (downward shift)

The shut-down price and the break-even price

• Shutting down in the short run and the long run: the shut-down price.
In the short run, you still have to go on paying the rent (your fixed costs) until your rental
contract expires. Even though you are not producing, you cannot exit the industry. It is
only when your rental contract expires and you no longer have any fixed costs, that you
can go into the long run and leave the industry altogether.
But suppose that the price of your product had not fallen so low, and that instead it was
above minimum AVC, though it was below minimum ATC. In this case, you would not
shut down in the short run, even though you would be making a loss.
However, since you are making a loss, you do not want to stay in this industry forever.
As soon as your rental contract expires and you can move into the long run, you will
choose to ‘shut down’ in the sense that you will sell your business and leave the industry
completely.
Once you are in the long run, you will make this decision for any price that is below
minimum ATC, as P = minimum ATC is the lowest price you would be willing to accept
in order to remain in the business.

The short-run shut-down price is P = minimum AVC: the firm shuts down (stops
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• The short-run shut-down price is P = minimum AVC: the firm shuts down (stops
producing) when price falls below minimum AVC.
• The long-run shut-down price is P = minimum ATC: the firm shuts down (leaves the
industry) when price falls below minimum ATC.

• The break-even price, or the price at which total revenues are exactly equal to total
costs, occurs at the firm’s break-even point. It is the same for both the short run and the
long run, and is where P = minimum ATC. This is the price at which the firm earns
normal profit (zero economic profit).
• In the long run, the break-even price is the same as the shut-down price. If price falls
below this level, the firm is no longer covering all its costs, and will therefore shut down in
the sense that it will exit the industry.

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