8

The Firm and the Industry Under Perfect Competition

Competition . . . brings about the only . . . arrangement of social production which is possible. . . . [Otherwise] what guarantee [do] we have that the necessary quantity and not more of each product will be produced, that we shall not go hungry in regard to corn and meat while we are choked in beet sugar and drowned in potato spirit, that we shall not lack trousers to cover our nakedness while buttons flood us in millions?
FRIEDRICH ENGELS (THE FRIEND AND CO-AUTHOR OF KARL MARX)

Contents
Perfect Competition Defined The Competitive Firm The Competitive Industry Perfect Competition and Economic Efficiency

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Perfect Competition Defined

Four Principal Market Types
Perfect competition Monopolistic competition Oligopoly Pure monopoly

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Perfect Competition Defined

Perfect competition
Many small firms and customers Homogeneous product Free entry and exit Well-informed producers and consumers

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The Competitive Firm

Perfect competition
Firm is a price taker. Price is set in the market. Firm is too small to affect the market.

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The Competitive Firm

The Firms Demand Curve under Perfect Competition
Horizontal Can sell as much as it wants at the market price.

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8-1 Demand Curve for a Firm under Perfect Competition

FIGURE
D Price per Bushel in Chicago

Industry supply curve

E

A $3

C $3 Firms demand curve S

Industry demand curve

100 200 300 400

Total Sales in Chicago in Thousands of Truckloads per Year (b)

Truckloads of Corn Sold by Farmer Jasmine per Year (a)

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The Competitive Firm

Short-Run Equilibrium for the Perfectly Competitive Firm
Marginal revenue = price Profit-maximizing level of output: marginal cost = price MC = MR

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8-1 Revenues, Costs, and Profits of a Competitive Firm

TABLE

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The Competitive Firm

D = MR = AR at all levels of output Short-Run Equilibrium at the equilibrium D = MR = AR = MC level of output

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8-2 S-R Equilibrium of the Competitive Firm

FIGURE
Revenue and Cost per Bushel MC B $3.00 2.25 1.50 0 50,000 Bushels of Corn per Year A AC

D = MR = AR

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Short-Run Profit: Graphic Representation

The MC = P condition does not show if the firm is making a profit or incurring a loss. Compare price (average revenue) with average cost to calculate profit or loss per unit. The profit-maximizing output may lead to a loss, but if so it is the minimum possible loss.
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8-3 S-R Equilibrium of Competitive Firm w/Lower Price

FIGURE
Revenue and Cost MC AC

per Bushel

A 1.50

$2.25 B D = MR = P

30,000 Bushels of Corn per Year

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Short-Run Profit: Graphic Representation

The MC = P condition does not show if the firm is making a profit or incurring a loss. Compare price (average revenue) with average cost to calculate profit or loss per unit. The profit-maximizing output may lead to a loss, but if so it is the minimum possible loss.
Copyright 2003 South-Western/Thomson Learning. All rights reserved.

Shutdown and Break-Even Analysis

Rule 1: The firm will make a profit if total revenue (TR) > total cost (TC) Should not plan to shut down in either the short run or the long run.

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Shutdown and Breakeven Analysis

Rule 2: Even if TR < TC, the firm should continue to operate in the short run as long as TR > TVC. If TR > TVC, the firm can at least pay some of its fixed costs. The firm should close in the long run if TR < TC.
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8-2 The Shutdown Decision

TABLE

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Shutdown and Breakeven Analysis

The competitive firm will produce nothing unless price lies above the minimum point on the AVC curve.

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FIGURE

8-4 Shutdown Analysis

MC AC AVC

P3 Price P2 P1 B

P3 P2 P1

0 Quantity Supplied
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The Competitive Firms Short-run Supply Curve

Horizontal individual supply curves market supply curve Method analogous to the construction of a market demand curve from individual demand curves.

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8-5 Derivation of the Industry Supply Curve

FIGURE
s Price per Bushel Price per Bushel S

$3.00 2.25 s c

$3.00 2.25 S C

45 50 Quantity Supplied in Thousands of Bushels (a)

45 50 Quantity Supplied in Millions of Bushels (b)

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The Competitive Industry

The Competitive Industrys Short-Run Supply Curve
A competitive industry has a stable equilibrium at the output where supply equals demand. The competitive industry (unlike the competitive firm) faces a downward sloping demand curve.

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8-6 Supply-Demand Equil. of a Competitive Industry

FIGURE
S D Price per Bushel $3.75 E 3.00 C A D S 0 45 50 Quantity of Corn in Millions of Bushels
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2.25

72

The Competitive Industry

Industry Equilibrium in the Short Run
Economic costs include opportunity costs, so zero economic profit means that firms are earning the normal, economy-wide rate of profit. Freedom of entry and exit guarantee this result in the long run under perfect competition.

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The Competitive Industry

Industry and Firm Equilibrium in the Long Run
In the long run, firms enter or exit the industry in response to profits or losses. This shifts the supply curve and the price until profits are zero. In long-run, competitive equilibrium, P = MC = AC.
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8-7 A Shift in the Industry Supply Curve

FIGURE
(1,000 firms) S0 Price per Bushel D (1,600 firms) S1

$3.00
A 2.25 S1

S0

50

72 80

Quantity of Corn in Millions of Bushels

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8-8 The Competitive Firm and the Competitive Industry

FIGURE
Firm MC AC Price per Bushel Price per Bushel Industry (1,000 firms) S0

D E
(1,600 firms) S1 A 2.25 S0 S1 D

$3.00 2.25 a

D0 D1

$3.00

40 45 50 Quantity of Corn in Thousands of Bushels (a)

50 Quantity of Corn in Millions of Bushels (b)

72

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8-9 L-R Equilibrium of the Competitive Firm and Industry

FIGURE
Firm MC Price per Bushel Price per Bushel D (2,075 firms) S2 M Industry AC

$1.87

D2

$1.87
S2 D

40 Quantity of Corn in Thousands of Bushels (a) Quantity of Corn in Millions of Bushels (b)

83

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The Competitive Industry

The Long-Run Industry Supply Curve
The long-run supply curve of the competitive industry is also the industrys long-run average cost curve. The industry is driven to that supply curve by the entry or exit of firms and by the adjustment of firms already in the industry.

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8-10 S-R Industry Supply and L-R Industry Average Cost

FIGURE
Price, Average Cost per Bushel S LRAC

$2.62 S 1.50

70 Output in Millions of Bushels of Corn

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Perfect Competition and Economic Efficiency

In the long run, competitive firms are driven to produce at the minimum point of their average cost curves. In this case, output is produced at the lowest possible cost to society.

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8-3 Avg. Cost for the Firm and Total Cost for the Industry
TABLE

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Which is Better to Cut Pollution: Carrot or Stick?

The analysis of perfect competition can be used to show that, if firms are offered a subsidy to reduce their polluting emissions, the industry is likely to increase its emissions, because of free entry.

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8-11 Taxes vs Subsidies as Incentives to Cut Pollution

FIGURE
T Price, Average Cost D X B E A T X D S

Qb Output

Qe

Qa

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