Department of Economics

Lecture Notes for Chapter 21
Perfect Competition
ECON 210, Spring 2001
Dr. Edward L. Millner
Phone: 828-1717
email: elmillne@vcu.edu
URL: www.people.vcu.edu/~emillner/eco210

• p = TR - TC
• Realism of the profit maximization assumption is a matter of some debate
• Said to be realistic because owners have an incentive to see that the firms maximize profit
• Said to be unrealistic because owners of large corporations are unable to direct the activities of those firms with much precision
• The profit maximization assumption is retained because it yields more accurate predictions for free market outcomes than any other behavioral assumption
• Other assumptions predict better in regulated and other "nonfree" markets

• Number of sellers
• Number may range from 1 to many
• The number of sellers is many if no individual seller can affect the market price by increasing or decreasing output
• Each seller produces a small fraction of the total market output
• Wheat farmers and banks offering mortgages are two examples
• The number of sellers is few if the actions of one firm have an impact on the other firms in the market
• In increase in output by one firm reduces the price or quantity demanded for other firms in the market
• Automobiles and cigarettes at the manufacturing level are two examples
• The working assumption is that the number of buyers is large
• Extent of product differentiation
• Product differentiation (or heterogeneity) is any attribute that makes consumers willing to pay more for one firm's output than the price charged by a competing firm
• Physical Differences
• Location
• Services
• Credit terms
• Convenience
• Warranties
• Product Image
• Brand name
• Assurance for quality
• Automobiles and cigarettes at the retail level are two examples
• No product differentiation means that the products are homogeneous
• Products are perfect substitutes in the minds of the consumers
• Buyers always prefer seller with the lowest price
• Grade A red durum wheat and shares of IBM stock are two examples
• In which of the following markets are the goods differentiated? How?
• Automobiles at the retail level (Dominion Chevrolet is a seller.)
• Cigarettes at the retail level (The 7-11 at the corner of Harrison and Main is a seller.)
• Grade A red durum wheat (A Kansas farmer is a seller.)
• Shares of IBM stock (A mutual fund is a seller.)
• The stock market (A mutual fund is a seller.)
• Information costs
• What cost does a consumer (or firm) pay to learn price charged by a firm
• Ease of entry into and exit from the market
• Entry is not free is new firms face costs or disadvantages that are not borne by incumbents
• Exit is not free if a firm must pay a cost to exit a market
• Freedom of entry and exit means that Entrants (new firms) are on equal footing with incumbents (old firms) and that no expenses must be paid to exit the market
• Entry and exit costs are often the result of legal restrictions
• Medical services
• Cable TV in Henrico County
• Electricity
• These elements determine in which of four market structures a firm operates

• If Q = 0 then TC = FC
• If a firm shuts down it loses all of its revenues but "saves" only its variable costs
• If TR < VC then TR / q < VC / q and P < AVC
• If P < AVC then the firm's profit would increase if it shuts down
• Complete the following table

• Would the owner of the firm prefer to produce 100 units of output or 0 units of output? Why?
• Would the owner of the firm prefer to produce 500 units of output or 0 units of output? Why?
• Implications
• Ignore fixed costs when deciding whether or not to shut down
• If P is everywhere below AVC then the firm maximizes profit (minimizes its loss really) by shutting down
• If P is greater than AVC for some range of output, the firm can earn more profit by producing output than by shutting down

• One way to determine if the firm is maximizing profit is to compute profit at all possible levels of output
• Complete the following table

• TR = P * q
• TC = ATC * q
• p = TR - TC
• A second and easier way to determine whether the firm is maximizing profit is to examine the relationship between marginal cost and marginal revenue
• MC = D TC / D q
• Measures how much extra cost the firm incurs when it produces and sells an additional unit of output
• MR = D TR / D q
• Measures how much extra revenue is produced when the firm produces and sells an additional unit of output
• Differs from average revenue, AR = TR / q
• Complete the following table

• If price is constant, then P = MR
• Applies to a Mid-western wheat farmer
• Applies to perfectly competitive firms (Chapter 21)
• If the firm must lower price to sell more, then P > MR
• Applies to Saudi Arabia and oil
• Applies to monopolies and firms with market power (Chapters 22-23)

• Complete the following table

• If MR > MC then q ­ Þ p ­
• If MR < MC then q ¯ Þ p ­
• To maximize profit, the firm must produce the level of output that makes MC = MR

• If the firm shuts down, then
• p = - FC
• If the firm produces where MC = MR, then
• p = TR - TC = P * q - ATC * q = (P - ATC) * q
• If P > ATC then p > 0
• If P < ATC then p < 0
• For each row in the following table, determine whether 10 is the profit maximizing quantity. If so, what is the maximum profit. If not, what type of change in the firm's output would you recommend.

Problem 12, p. 490

• Homogeneity and free information Þ a market price will exist
• Buyers always prefer to purchase from the seller with the lowest price
• Charge more than the market price Þ Q sold = 0
• Charge less than the market price Þ can raise P and not affect Q sold
• Large number of sellers Þ no individual seller can affect the market price
• Any firm can sell as little or as much as it wants at the market price
• P = MR for the firm
• The firm's demand curve is also its MR curve
• Problem 11, Chapter 21. Also determine the maximum profit the firm could earn in the short run if P=$6.5.

• If P > the minimum ATC (click here for a graph), then
• P > the minimum AVC
• The firm's demand curve intersects the AVC curve
• Maximum p > 0
• The firm maximizes profit by producing where MR=MC
• MR=MC where the firm's demand curve intersects its MC curve
• Maximum p = the area of a rectangle between the firm's demand curve, the profit maximizing quantity, its ATC curve, and the vertical axis
• The length of the rectangle is the profit maximizing quantity, q
• The height is (P - ATC), the profit per unit
• The (P - ATC) x q = the area of the rectangle AND p
• Click here for a graph
• If P = minimum ATC (click here for a graph), then
• The firm's demand curve intersects the AVC curve
• Maximum p = 0
• The firm maximizes profit by producing where MR=MC
• MR=MC where the firm's demand curve intersects its MC curve
• This is also where MC= ATC
• This is also where ATC is minimized
• This is also where the firm's demand is tangent to its ATC curve
• Click here for a graph
• If the minimum ATC > P > the minimum AVC (click here for a graph)then
• The firm's demand curve intersects the AVC curve
• Maximum p < 0
• The firm minimizes loss by producing where MR=MC
• MR=MC where the firm's demand curve intersects its MC curve
• Minimum loss = the area of a rectangle between the firm's demand curve, the loss minimizing quantity, its ATC curve, and the vertical axis
• The length of the rectangle is the loss minimizing quantity, q
• The height is (ATC - P), the loss per unit
• The (ATC - P) x q = the area of the rectangle AND the loss suffered
• Click here for a graph
• If P < the minimum AVC (click here for a graph), then
• The firm's demand curve is always below the AVC curve
• Maximum p < 0
• The firm maximizes profit (or minimizes loss) by shutting down in the short run
• Loss = FC
• Click here for a graph
• See exhibit 3 and exhibit 6. (Exhibit 3 is also a graphing tutorial.)
• Complete the following table for a perfectly competitive firm.

• Using the information from the table above, graph the average total, average variable, and marginal cost curves for the firm, and the demand curve facing the firm. What are the relationships between P, the minimum ATC, and the minimum AVC? Use the graph to determine the profit maximizing actions and the maximum profit (or minimum loss).

• P >minimum AVC Þ produce where P = MC
• The industry supply curve is the horizontal summation of the firms' supply curves, the horizontal summation of marginal cost curves
• See exhibit 7
• Click on the Graphing Tutorial, "Deriving the Short-Run Supply Curve", on the McEachern web site
• Click on the Graphing Tutorial, "Short-Run Profit Maximization and Market Equilibrium" on the McEachern web site

• WSJArticles\LRSeagate2-99.htm
• WSJArticles\LRTrucking10-99.htm
• WSJArticles\VentureCapital.html

• Freedom of entry and exit insures that  = 0 in the long run
• If p > 0 then entry will occur
• If p < 0 then exit will occur
• Therefore, long run equilibrium occurs only when P = minimum ATC
• The firm's demand is tangent to its ATC curve
• Read WSJArticles\InternetEntry.html. The article claims states that "the 'barriers to entry' on the Internet are all but nonexistent." What does this claim imply about the long-run profitability of Amazon.com?

• Increasing cost
• Typical of most markets
• Entry Þ cost curves shift up
• Entry Þ increased competition for resources and resource prices ­
• Exit Þ cost curves shift down
• Exit Þ reduced competition for resources and resource prices ¯
• Constant cost
• Entry has no effect on cost curves
• Exit has no effect on cost curves
• Decreasing cost
• Entry Þ cost curves shift down
• Exit Þ cost curves shift up
• Economies of scale in resource markets may create

• Assume that firms begin in long-run equilibrium
• p = 0
• P = minimum ATC
• What happens if demand increases
• P_E, Q_E, q, and p increase in the short run
• p > 0 in the short run
• p > 0 Þ entry in the long run
• Long-run effects depend upon whether the firm operates in an increasing cost industry, a constant cost industry, or a decreasing cost industry
• Entry drives price back down to its original level if the industry's costs are not affected by entry (constant cost)
• The long-run supply curve (combinations of long-run P_E and Q_E) is perfectly elastic
• Click on the graphing tutorial, "Long-Run Adjustment to an Increase in Demand", on the McEachern web site
• Entry drives price below its short-run value but not to its original value if the industry's costs increase with entry (increasing cost)
• The long-run supply curve is upward sloping but more elastic than the initial short-run supply curve
• Click on the graphing tutorial, "Long-Run Adjustment of an Increasing-Cost Industry", on the McEachern web site
• Entry drives price below its original value if the industry's costs decrease with entry (decreasing cost)
• The long-run supply curve is downward sloping
• Problems 13 and 14, Chapter 21

• Perfectly competitive industries tend to produce output at the minimum possible cost
• Minimum cost Þ maximum profit
• In the long run, each firms produces at the minimum point on its average cost curve
• Perfectly competitive industries tend to produce the allocationally efficient level of output
• If P=MC then level of output is allocationally efficient
• The price paid by consumers measures the marginal valuation of the last unit sold
• The marginal cost paid by producers measures the marginal opportunity cost
• If P > MC then the value of an additional unit of output exceeds its cost
• The value of an additional unit exceeds its cost
• An increase in output would increase social welfare
• If P < MC then the value of an additional unit of output is less than its cost
• The cost of an additional unit exceeds its value
• A decrease in output would increase social welfare
• For profit maximizing perfectly competitive firms, P = MR
• A perfect competitor maximizes profit by producing where MR = MC
• P=MR and MR = MC Þ P = MC
• The level of output produced maximizes social welfare