1

University of Essex Session 20011-12

Department of Economics Autumn Term

EC111: INTRODUCTION TO ECONOMICS

PERFECT COMPETITION

Perfect competition is one characterisation of the marketthe case where there are
many buyers and sellers. It is an extreme case but very useful. The assumptions are:

Firms sell a standardised (or homogenous) product.

Firms are price takers (each is very small relative to the total market).

In the long run firms can freely enter or exit the market.

Buyers have perfect information on prices.

This characterisation is where buyers and sellers are essentially anonymous; there is
no scope for strategic interaction among them.

One consequence of these assumptions is that the individual firm can sell as much as
it likes at the going price. The demand curve facing the firm is perfectly elastic.





















This price is determined by total supply and total demand in the market.

P





P
1
q

2

The perfectly competitive firm in the short run

Total revenue and total cost






















Total Revenue (TR) is a straight line because every unit can be sold at price P.
Marginal revenue, MR = P is the slope of the TR function.

Total cost TC, is Fixed Cost, F, plus Variable Cost, VC. We assume that TC gets
flatter and then steeper.

The slope of the TC function is Marginal Cost MC

The vertical difference is profit. = TR TC.

Maximum profit is where the two curves are parallel. This is where MC = MR = P.


[Note: this is all in the short run but I have dropped the SR prefix]







q* q

TC

TR,
TC




TR

Slope = MC

Slope = MR

3

Marginal Cost Average Costs, and Marginal Revenue























This is exactly the same situation depicted using Total Revenue and Total Cost but
here in terms of MR and MC

Note that:

MC crosses AC from below at the minimum of AC. Q: why is this?

The firm maximises its profit where MR = P = MC.

Profit is the area (P AC)q.

As the price increases the firm moves up its marginal cost curve; output and
profits increase.

If P falls to the minimum of AC the firm makes zero profit.
Q: will it continue to produce anything?

The firms supply curve is its marginal cost curve down to AVC.
Q: why is that?



P, AC,
MC




P
1
AC
1
q* q
AVC

AC

MC

4

Marginal and average costs in the long run























This diagram for the long run looks very similar to that of the short run, but note:

In the long run the firm can adjust both its labour and its capital; the
average and marginal cost curves are drawn on the assumption that the firm
is minimising the cost of producing at each output level.

We might expect the cost curves to be flatter in the long run because both
factors are being adjusted.

As drawn, the average cost curve slopes down and then up. This means that
there must be economies of scale at low levels of output and diseconomies of
scale at higher levels of output.

The long run average cost curve need not be this shape, see next page.

In the long run the firm will shut down if it fails to cover its total costit
cannot sustain losses in the long run. In the long run the firm ceases to
produce at all if the price falls below the minimum of average cost.

Here the firm would like to move along its LRMC curve in order to maximise
profits at q*
LR
. But it may not get the opportunity to do this. Q: Why not?
[see further below].
P





P
1

LRAC
q*
LR
q
LRAC

LRMC

5

Long run cost curves













Economies of scale over a wide range of output; LRMC below LRAC. Likely to
result in a concentrated industry with few firms












Diseconomies of scale set in at low output levels; LRMC above LRAC. Likely to lead
to many firms each with small market share.














Constant returns to scale over the range of output; LRAC = LRMC.

LRAC
LRMC
q
LRAC
LRMC
LRMC
LRAC
q
LRMC
LRAC
LRAC
LRMC
q
LRAC = LRMC
6

Entry and exit from the industry

Consider the case where we have an industry made up of identical firms with U
shaped short-run and long run average cost curves. For the typical firm in the short
run:






















Assume that originally the price is P
1
and that the firm is at the minimum of its
SRAC, making zero profit.

Then the price increases to P
2
. In the short run the firm increases its output to q*
2
.
The firm is now making super-normal profits.

In the long run it would increase its output beyond q
*
2
because its marginal cost
curve is flatter in the long run that in the short run.

But two things happen:

All existing firms increase their output in the short run. Total industry
supply is the sum of firms marginal cost curves.

Seeing a profitable opportunity, in the long run new firms enter the industry.

As a result, the increase in supply drives the price back down to P
1
, and all firms are
back at the original equilibrium, making zero (normal) profits.

P





P
2


P
1
q*
1
q
*
2
q
AVC

AC

MC

7

Long run equilibrium with identical firms and U shaped cost curves
























In the long run, entry or exit ensures that firms make only normal (zero)
profits.

The representative firm will be at the minimum of its long run average cost
curve.

For every point on the LRAC there is an associated SRAC and SRMC curve
(SRAC is just tangent to LRAC).

Even after an increase in demand, each of the existing firms ends up
producing the original amount. All of the increase in industry supply is due
to the entry of new firms.









SRMC

P







P
1
q*

q
SRAC

LRAC

LRMC

8

The industry























Here is what happens to supply and demand at the industry level. Note that:

In the short run the industry supply curve is the sum of the marginal cost
curves of all the existing firms.

They supply nothing at a price below P
0
, which is the minimum of AVC for
each firm. At the original price P
1
firms make zero profit.

When demand shifts out to D
2
firms move along their SRMC curves to
produce output Q
2
at price P
2
.

New firms enter until output expands to Q
3
and price falls back to P
1
.

The long run the supply curve is perfectly elastic. All firms are producing the
original amount but there are now more firms.

There is an upward sloping short run supply curve associated with each
point on the long run supply curve.

Q: What would have happened if demand had shifted to the left?


Q
1
Q
2
Q
3
Q
P





P
2


P
1




P
0
S
LR
S
SR
D
2
D
1
9

Note that if the supply curve is perfectly elastic there is no producer surplus in the
long run. Could the supply curve be upward sloping in the long run?

Case 1: Less than perfectly elastic supply of factors of production.























As new firms enter, and industry output expands, the demand for factors of
production increases. If the price of factors increases then costs will rise at a given
level of output for each firm.

This shifts upwards the average and marginal cost curves (both long run and short
run). Firms now need a higher price to make zero profit.

In this case the supply curve is upward sloping because higher industry output
means higher average and marginal costs for each firm at a given level of its output.

But all firms are just earning the opportunity cost of their factors of production.

Q: Why is there no producer surplus even though the supply curve is upward
sloping. Alternatively, who is receiving the producer surplus?





P





P
2


P
1
q*

q
AC
1
MC
1
AC
2
MC
2
10

Case 2: Firms with different productivities.

Some firms have higher productivity than others. This means that their average cost
curves are lower than those for other firms. Q: What are the possible sources of
these productivity differences?

Suppose we line up all the individual firms in the industry, with the highest
productivity firms on the left, lowest productivity on the right.






















The long run industry supply curve is upward sloping; the short run supply curve
(the SRMC of all the existing firms) is steeper.

The least efficient firm in the industry (the one with the highest costs) just makes
zero profit. The intra-marginal firms earn economic rent; in long run equilibrium
they earn more than the opportunity costs of the factors that they employ.

If demand shifted to the right then the new firms that would enter have higher costs
than those that are already in the industry. The marginal firm, making zero profit,
is further to the right.

Producer surplus in this industry is the area below the price down to the long run
supply curve.

Q: Are the intra-marginal firms producing at the minimum of their long run
average cost curves?
Q
1
Q
P







P
1




S
LR
S
SR

D

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Application: The imposition of a tax.

Return to the case where the firms are identical, so that long run industry supply is
perfectly elastic.























At the original long run equilibrium price is P
0
and quantity is Q
0
.

When the tax is imposed, the short run industry supply curve shifts up by T, from
S
SR0
to S
SR1.
Firms move down their short run supply curves; industry output falls
to Q
1
and the price (faced by consumers) rises to P
1
.

Firms are now making losses so some of them exit the industry; short run supply
shifts to S
SR2.
. Long run equilibrium is restored with price at P
2
and output at Q
2
.

Q: Who bears the burden of the tax (a) in the short run, and (b) in the long run?









Q
2
Q
1
Q
0
Q
P




P
2


P
1


P
0

S
LR0
S
SR1

D

S
SR0
S
SR2
S
LR1
T

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Now look at the same thing from the point of view of the individual firm.




























In the initial equilibrium the price is P
0
and the firm is producing q
*
0
.

After the tax is imposes the firm moves down its short run marginal cost curve, the
dashed line SRMC
1
, to produce q
*
1
. The firm is now making a loss.

In the long run the price rises to P
2
and the firm produces the same amount as
originally: q
*
0
. The firm returns to zero profit.

Q: What else could have happened to this firm?


P


P
2


P
1


P
0
q*
1
q
*
0
q
LRMC
0
LRAC
0
SRMC
0
LRMC
1
LRAC
1
SRMC
1