View the step-by-step solution to: Analyze the major barriers for entry and exit into the airline

Analyze the major barriers for entry and exit into the airline industry. Explain how each barrier can foster either monopoly or oligopoly. What barriers, if any, do you feel give rise to monopoly that will allow the government to have to get involved to protect consumers?
Chapter_09.pdf

Image Source/SuperStock

9

Perfect Competition
Learning Objectives
By the end of this chapter, you will be able to:
List the assumptions of perfect competition.
Diagram the relationship between a firm and the total market. Calculate profits, given quantity, marginal revenue, marginal cost, average cost, and price. Identify the profit-maximizing level of output.
Define the shutdown point in terms of price and average variable costs or total fixed costs and losses.
Describe the long-run supply curve for a constant cost industry, an increasing cost industry, an
increasing cost industry, and a decreasing cost industry.
Identify the long-run equilibrium for the firm and the industry under perfect competition.
Explain how economic rent might exist in perfect competition, even in long-run equilibrium.

ama80571_09_c09_249-276.indd 249

1/28/13 9:49 AM

Section 9.1

Characteristics of Perfect Competition

CHAPTER 9

Introduction

C

onsider this. . . Some firms, like convenience stores and grocery chains, are open
24 hours a day. Others close at 6:00 or 7:00 P.M. Some bars and restaurants open
at 11:00 A.M. to cater to a lunch crowd, while others dont open until 4:00 P.M. for
the happy hour crowd. Some resorts are open year-round, while others close for business
during the off-peak season.
How can you explain this distinctly different behavior across firms that are in the same
industry? Any firm that makes production decisions will relate potential, or forecasted,
revenues to costs in order to determine output levels. However, the forecasted revenues
will depend on the market conditions faced by the firm. After studying the material in this
chapter you will be able to explain why firms in the same industry make different choices,
whether they choose to close at 7:00 P.M., close for the winter, or close permanently.
This chapter and the next two look at four different models, referred to as market structures. The model discussed in this chapter is perfect competition. Perfect competition is
the market structure in which there are many sellers and buyers, firms produce a homogeneous product, and there is free entry into and exit out of the industry. It is important to
keep in mind that this is a theoretical model. Real data does not exist, and the model does
not precisely describe reality. The model is useful, however, because it provides a point
of reference. It allows the development of tools of analysis that indicate what determines
price and quantity when conditions are close to those of perfect competition. The perfectly
competitive market is the abstract ideal to which we will compare other market structures.

9.1

Characteristics of Perfect Competition

T

here are six basic assumptions for the model of perfect competition. In developing
the theory, we assume that all firms in the market in which the product is sold possess these six characteristics.

The first assumption is that there is a large number of sellers (producers) in the
market. A large number means there are so many sellers of the product that no
single sellers decisions can affect price. For example, no single wheat farmer
can influence the price of wheat. A farmer could sell the entire crop or none of
the crop. The farmers decision wouldnt affect the price of wheat in any perceptible manner because the market for wheat is so large relative to any single
producer.
The second assumption is that there is a large number of buyers (consumers) in
the market. A large number means that no one buyer can affect the price in any
perceptible way. That is, no single purchaser has any market power.
The third assumption is that perfectly competitive firms produce a homogeneous product. Homogeneous means that the product of one firm is no different
from that of other firms in the industry. Since this is the case, purchasers have
no preference for one producer over another. If you are a miller and want to

ama80571_09_c09_249-276.indd 250

1/28/13 9:49 AM

Section 9.1

Characteristics of Perfect Competition

CHAPTER 9

purchase wheat, you dont care if it was produced by Farmer Jones or Farmer
Smitha bushel of No. 1 winter wheat is a bushel of No. 1 winter wheat!
The fourth assumption, a very important assumption, is that there is free entry
into and free exit out of the market. This means that if one firm wishes to go into
business or if another firm wishes to cease production, either can do so without any kind of constraint. This assumption is crucial in distinguishing perfect
competition from monopoly, which we will examine in the next chapter.
The fifth assumption is that there is perfect knowledge. The sixth assumption is
that workers and other resources can easily move in and out of the industry. These
last two assumptions are even more unrealistic than the others because information is costly to acquire and resources are usually costly to move. The effect
of these two assumptions is that when economic profits exist, firms will find
out about these profits and enter the industry. Even though these assumptions
are unrealistic, the resulting model is valuable because it shows what adjustments would take place in an ideal setting.
If these six assumptions are met, a market will be perfectly competitive. These assumptions create a model market in which no firm or individual has the power to exert control
over the market. This means that neither buyer nor seller has any influence over price.
The six assumptions were first stated more than two centuries ago by Adam Smith in a
general outline of the perfectly competitive model in his book, An Inquiry Into the Nature
and Causes of the Wealth of Nations (1776). In the nineteenth century, the model of perfect
competition was the main way of looking at how firms and markets determined price and
output levels. The study of other market structures arose later.

Economics in Action: What Criteria Is Necessary for Perfect Competition?
Looking at the airline industry, the Khan Academy lists the criteria for perfection competition. Find
out how this criteria applies to any market at http://www.khanacademy.org/finance-economics/
microeconomics/v/perfect-competition.

Large Numbers on the Buyers Side
This chapter concentrates on developing a theory of firms in perfect competition, or competition on the sellers side of the market. Keep in mind, however, that we also assume
large numbers of buyersso many that no single firm possesses market power.
Concentrating on the firm should not obscure the importance of competition on the buyers side of the market. In order for markets to be competitive, there must be enough buyers that none can affect the market price by withholding purchases. Note also that perfect
competition and free markets are not necessarily the same. A free market means a market
that is free of government regulationthus a perfectly competitive market could also be
a free market, but the reverse is typically not the case.

ama80571_09_c09_249-276.indd 251

1/28/13 9:49 AM

Section 9.2

Competitive Adjustment in the Short Run

CHAPTER 9

Check Point: Perfect Competition Assumptions







9.2

Many sellers
Many buyers
Homogenous product
Free entry to/exit from the market
Perfect knowledge
Resources move freely

Competitive Adjustment in the Short Run

S

ince the perfectly competitive firm is small relative to the market and its product is
the same as that of other firms, this firm views itself as having no influence on market
price. If the perfectly competitive firm wants to sell any of its output, it must sell at
the market price. A firm in perfect competition is referred to as a price taker because it has
no influence on price. It can sell any amount at the market-clearing price. The firm takes
that price as its selling price. If it sets a higher price, none of its output will be sold because
buyers will be able to purchase an identical product at the lower market price elsewhere.
On the other hand, it makes no sense to sell below the market price because the firm can
sell all it produces at that market price.

The market demand and supply curves and the firms resultant demand curve are
shown in Figure 9.1. (The graphs in this chapter are based on models first developed by
nineteenth-century British economist Alfred Marshall.) Market demand (D) and supply
(S) curves are such that the market equilibrium price is P1. If the market is in equilibrium, the perfectly competitive firm can sell as much of its product as it wishes at price
P1. From the firms viewpoint, the demand curve is perfectly elastic at price P1.

ama80571_09_c09_249-276.indd 252

1/28/13 9:49 AM

Section 9.2

CHAPTER 9

Competitive Adjustment in the Short Run

Figure 9.1: Elastic demand at market equilibrium
(a) Firm

(b) Market

Price

Price
S

D = P = AR = MR

P1

P1

D
0

x1

x2

x3

x 4 Quantity/
Time Period

0

Quantity/
Time Period

In perfect competition, a firms demand curve is perfectly elastic at the market equilibrium price.

The demand schedule a firm faces is also its average revenue schedule. If, for example, the
price consumers pay in the market is $15, the average revenue a seller receives per unit
sold is also $15. As price changes along a market demand curve, the average revenue that
sellers receive will also change. Total revenue of a firm is the price times the quantity sold
(TR 5 P 3 Q). Average revenue (AR) is total revenue divided by the quantity sold. It is the
revenue per unit sold, or the price of the product. A demand curve is an average revenue
curve. With perfect competition, price does not vary with output. Thus, AR 5 (P 3 Q)/Q
5 P is a constant. The firms perfectly elastic demand curve in Figure 9.1 is also a perfectly
elastic average revenue curve.

The Level of Output
Recall that a profit-maximizing firm always produces that quantity for which marginal
revenue is equal to marginal cost. Thus, we need to determine what the competitive firms
marginal revenue curve looks like. Marginal revenue for the nth unit is the change in total
revenue from selling one more unit:
MRn 5 TRn 3 TRn21

ama80571_09_c09_249-276.indd 253

1/28/13 9:49 AM

Section 9.2

CHAPTER 9

Competitive Adjustment in the Short Run

In Figure 9.1, the change in total revenue if sales increase from x1 to x2 (where x2 is one unit
more than x1) is P1(x2 2 x1). If sales increase from x2 to x3 the change in total revenue is P1
(x3 2 x2). In other words, in the case of a perfectly elastic demand curve, such as the firms
demand curve in Figure 9.1, D 5 P 5 AR 5 MR. The marginal revenue curve associated
with a perfectly elastic demand curve is the same as the demand curve. The demand curve
is always the average revenue curve for any market structure. The demand curve is equal
to the marginal revenue curve only in perfect competition. Remember the relationship
between average and marginal valuesif the average value doesnt change, the marginal
value must be the same as the average.
Using marginal cost and marginal revenue, we now can determine how a perfectly competitive firm will adjust its output to changed prices in the short run. The demand curves
for the market and a representative firm are depicted in Figure 9.2. A representative firm
is a typical firm in perfect competition, one of the many similar firms in this market. In Figure 9.2, the representative firms marginal cost curve is also shown. This firm maximizes
profit by producing quantity x1 when the price per unit is P1 because at that output level,
MR1 5 MC. Now assume the market demand increases to D2. The market price rises to P2.
The firms demand curve, average revenue curve, and marginal revenue curve change to
D2 5 AR2 5 MR2. The firm responds by increasing its output level to x2, where MR2 5 MC.

Figure 9.2: Profit maximization
(a) Firm
Price,
Cost

(b) Market
Price
MC

D2 = AR 2 = MR 2

P2

D1 = AR 1 = MR 1

P1

S

P2
P1

D1
0

x1

x2

Quantity/
Time Period

0

D2
Quantity/
Time Period

An increase in market demand causes the equilibrium price to rise. The demand curve the firm faces
adjusts by the amount of the increase in price, and the firm increases its output to equate MC and MR.
The adjustment process is such that the firms marginal cost curve is its short-run curve.

ama80571_09_c09_249-276.indd 254

1/28/13 9:49 AM

Section 9.2

Competitive Adjustment in the Short Run

CHAPTER 9

Economics in Action: Plotting Profits and Perfect Competition
Free Econ Help uses graphs to explain perfect competition (where marginal cost equals marginal revenue) and how one can identify profit maximization. Follow the link to see at http://www.youtube
.com/watch?v5eh1cc6P-eeI.

The Supply Curve
Changes in market price cause the firm to increase or decrease production along its marginal cost curve until MR 5 MC. The profit maximizing priceoutput combinations generate a supply curve, which, as we have just seen, is also the marginal cost curve. In Figure
9.2, the firms short-run marginal cost curve is the same as its short-run supply curve. A
short-run supply curve is a supply curve for the period in which the size of the plant cannot be varied (the short run). In perfect competition, the short-run marginal cost curve is
the short-run supply curve. As the market price rose, the firm in Figure 9.2 increased its
output. The quantity which will be produced at each price is identified by the marginal
cost curve. Of course, no firm that seeks to maximize profit would choose to produce output at any price; there is a price below which the firm would lose money if it continued to
participate. As we shall see, we can identify the point on the marginal cost curve at which
the firm should cease production. The marginal cost curve (above the so-called shutdown
point) is also the supply curve for a competitive firm.
We can now look at the relationship between the firms supply (marginal cost) curve
and the market supply curve. The firms supply curve represents its output response to
increased market prices. Just as an industry is made up of all the firms that produce and
sell homogenous goods, the short-run supply curve of an industry is the sum of supply
curves for all firms in the industry. If we were to add the output (horizontally) across the
short-run supply curves for all firms, we would construct the short-run market (or industry) supply curve. The market supply curve is simply the aggregate of all the firms supply curves. The short-run market supply curve, then, is the aggregate of the portions of all
firms marginal cost curves that lie above their average variable cost curves. In the long
run, more firms can enter an industry as a response to economic profits. The market supply curve will shift to the right because it is made up of more individual supply curves.
On the other hand, as firms leave an industry due to losses, the market supply curve will
shift to the left, representing a decrease in supply. This decrease is due to the fact that there
are fewer individual supply curves to be summed.

Profits and Losses
We have just seen how a representative firm adjusts in the short run to changes in market
demand. We dont yet know whether the firm has a profit or a loss, or how large this profit
or loss is. To find out, we need to add the average cost curve to the graph. Also, in order
to decide if the firm should continue to produce if losses are encountered, we need to add
the average variable cost curve.

ama80571_09_c09_249-276.indd 255

1/28/13 9:49 AM

Section 9.2

CHAPTER 9

Competitive Adjustment in the Short Run

In Figure 9.3, the firm is maximizing profit by producing output x1 at price P1, where
P 5 MR 5 MC. The average cost of producing x1 is measured by distance x1C in
Figure 9.3. The total cost of producing x1 is represented by the area of the rectangle
0P1Cx1. Total revenue in Figure 9.3 is also the area of 0P1Cx1, so TR 5 TC. This firm is
therefore making zero economic profit, although it is meeting its opportunity costs.
Remember that total cost includes normal profit, which is the return on capital and enterprise necessary to keep firms in an industry.
The point at which the firm is making only a normal rate of return, or zero economic
profit, is the breakeven point. If there is zero economic profit then P 5 AC and so AC 5 P
5 MR 5 MC. The breakeven point occurs at the intersection of the average cost (AC) curve
and the marginal cost (MC) curve. If price rises above the breakeven point, the firm will
make an economic profit; if the price falls below breakeven, the result will be a negative
economic profit.

Figure 9.3: Firm earning zero economic profit
Price,
Cost
MC

P1

0

AC

C

D=AR=MR

x1

Quantity/Time Period

The average cost (AC) curve is used to determine if a firm is making an economic profit. If average
revenue (price) is equal to average cost, the firm is making zero economic profit.

ama80571_09_c09_249-276.indd 256

1/28/13 9:49 AM

Section 9.2

CHAPTER 9

Competitive Adjustment in the Short Run

If the firms average cost (AC) curve is the one drawn in Figure 9.4, the average cost of
producing x1 is the distance x1A. Total revenue (TR) is still P1 3 x1, or the area of 0P1Bx1
Total cost is now the area of 0CAx1. Since TR . TC, there is an economic profit equal to the
area of CP1BA in Figure 9.4. On the other hand, if the firms average cost curve is the one
drawn in Figure 9.5, the average cost of producing x1 is the distance x1 A. Total revenue is
the area of 0P1Bx1 and total cost is the area of 0CAx1. In this case, TC . TR, so economic
losses are being incurred. The economic loss is equal to the area of P1CAB in Figure 9.5.

Figure 9.4: Firm earning an economic profit
Price,
Cost

MC
AC

P1
C

0

B

D=AR=MR

Profit
A

x1

Quantity/Time Period

If the firms average revenue is greater than its average cost at the level of output being produced, the
firm is making an economic profit.

ama80571_09_c09_249-276.indd 257

1/28/13 9:49 AM

Section 9.3

CHAPTER 9

The Shutdown Decision

Figure 9.5: Firm suffering a loss
Price,
Cost
MC
AC

C
P1

0

A
Loss

D=AR=MR
B

x1

Quantity/Time Period

If the firms average cost is greater than its average revenue at the level of output being produced, the
firm is incurring a loss.

Should the firm of Figure 9.5 continue to produce, and, if so, for how long? It is suffering
a loss, which means the productive resources employed by this firm could earn more in
some other use. Revenues are less than opportunity costs. But keep in mind that this diagram shows the short run, which means that some input is fixed. This fixed input means
that there are fixed costs that cannot be eliminated. Fixed costs must be paid in the short
run even if production ceases. Because variable costs are the only ones under the firms
control in the short run, we need to include the average variable cost (AVC) curve to determine the conditions under which the firm should cease production.

9.3

The Shutdown Decision

T

he short-run cost curves of a firm are depicted with several equilibrium points in
Figure 9.6. At a price of P1, which represents a marginal revenue of MR1, the firm
maximizes profits by producing x1. At P1, the firm is making an economic profit
because total revenue (area of 0P1Ax1) is greater than total cost (area of 0C1Dx1). At price P2
5 MR2, the firm would produce x2 and make zero economic profit because total revenue

ama80571_09_c09_249-276.indd 258

1/28/13 9:49 AM

Section 9.3

CHAPTER 9

The Shutdown Decision

(area of 0P2Bx2) is equal to total cost (area of 0C2Bx2). Notice that this Point B lies at the
intersection of the average cost and marginal cost curves. This, then, is the breakeven
point, and the firm makes zero economic profit.

Figure 9.6: The shutdown point
Price,
Cost
C4

MC
AC

G
A

P1

D
B

H

P3

0

MR 1

E

C3
C1
C 2 ,P 2

P4

AVC

MR 3

S

MR 4

F

x4

MR 2

x3

x2

x1

Output/Time Period

If a firms average revenue is greater than its average variable cost, the firm will be able to cover total
variable costs and make a payment toward total fixed costs. If price falls below average variable costs,
the firm will lose less money if it shuts down than if it continues to produce. The shutdown point in this
case is Point S at a price of P3.

Examine carefully what happens when price falls to P3 and marginal revenue falls to MR3.
The profit-maximizing or loss-minimizing output is now x3. At output level x3, economic
losses are incurred because total revenue is the area of 0P3Sx3, and total cost is the area of
0C3Ex3. Economic losses are thus represented by the rectangle P3C3ES. The firm needs to
answer this question: Should it produce and incur this loss or should it cease production?
Remember, if production is halted, fixed costs must still be paid. In Figure 9.6, if the market price is P3, the firm is earning a total revenue equal to the area of 0P3Sx3, and its total
variable costs (TVC 5 AVC 3 Q) are 0P3Sx3. At this priceoutput combination, marginal
revenue is equal to average variable cost. In other words, the firm is covering (exactly)
its total variable costs and losing an amount equal to its total fixed costs. It must pay the
fixed costs even if it shuts down, so at price P3 the firm is indifferent about shutting down
or continuing to produce. If the price falls below P3, the firm should shut down in order

ama80571_09_c09_249-276.indd 259

1/28/13 9:49 AM

Section 9.3

The Shutdown Decision

CHAPTER 9

to minimize losses. By shutting down, it will lose only total fixed costs, instead of losing
total fixed costs plus some portion of variable costs (as it will if it continues to produce).
The minimum or low point on the AVC curve where it intersects the MC curve (Point S in
Figure 9.6) is called the shutdown point because if price falls below that point, the firm
loses less by ceasing production.
Consider price P4 (or MR4) in Figure 9.6. The MR 5 MC rule tells the firm that at P4 it
should produce output level x4. However, at x4 the firm is losing P4C4GF (0P4Fx4 2 0C4Gx4).
Total revenue of 0P4Fx4 does not cover the total variable costs of producing x4, which are
x4H times x4. In other words, the firm is losing more than its total fixed costs. It is making
variable cost outlays that it wouldnt have to make if it stopped production entirely. The
firm would be better off to shut down and only incur its fixed costs.
Because the firm shuts down, we need to modify the earlier statement that the firms marginal cost curve represents its short-run supply curve. That statement is not completely
correct. A firms short-run supply curve is represented by its marginal cost curve only
above the shutdown point (Point S in Figure 9.6). Below the shutdown point, the firm will
produce no output, so only the part of the marginal cost curve above the minimum point
on the average variable cost curve is the firms supply curve.
The model has just told us that in the short run, the firm will shut down when price falls
below average variable cost. It says nothing about the real-world timing of such a shutdown. The decision to shut down is more difficult in reality than in theory. It depends on
many factors, including time and anticipated changes. A few examples may illustrate such
problems.
First, imagine yourself the owner of a sporting goods store in a ski area or a beach resort.
Shutdown may be a seasonal decision. If revenues fall below average variable costs (clerks
wages, electricity, and so on) in the off-season, you may close up, bearing only your fixed
costs (such as rent on the store) until crowds return and your revenues increase. In this
case, shutdown does not mean you are moving your investments in plant and equipment
into other businesses. It simply means that you lose money in certain seasons and you lose
less money if you shut down. You fully intend to reopen for business when the snow flies
or the temperature sends people to the beaches. Past experience helps you to determine
when to shut down and when to reopen.
Second, imagine yourself the ownermanager of a steel mill. The price of steel has fallen
below your average variable costs of production. In the short run, you shut down (if laws
and union contracts allow you to do soa union contract might change labor from a variable to a fixed resource). The short run is too short a time period for you to vary your plant
size (which is one way of saying that you cant move your fixed resources in this time
period). If, however, you are convinced that this low price is permanent, you will begin
to liquidate. You will sell equipment and attempt to sell your buildings and other fixed
assets. As you do this, you are moving to the long run.
The short-run output decisions and profit determination for a perfectly competitive firm
can be illustrated with a simple example. Table 9.1 presents some production cost data for
a firm. Assuming that different market prices are the result of different market equilibrium situations, it is possible to determine the firms response to different prices. In Table
9....

This is the end of the preview. Download to see the full text
Sign up to view the entire interaction

Why Join Course Hero?

Course Hero has all the homework and study help you need to succeed! We’ve got course-specific notes, study guides, and practice tests along with expert tutors and customizable flashcards—available anywhere, anytime.

-

Educational Resources
  • -

    Study Documents

    Find the best study resources around, tagged to your specific courses. Share your own to gain free Course Hero access or to earn money with our Marketplace.

    Browse Documents
  • 890,990,898

    Question & Answers

    Get one-on-one homework help from our expert tutors—available online 24/7. Ask your own questions or browse existing Q&A threads. Satisfaction guaranteed!

    Ask a Question
  • 890,990,898

    Flashcards

    Browse existing sets or create your own using our digital flashcard system. A simple yet effective studying tool to help you earn the grade that you want!

    Browse Flashcards