Chapter 7: Perfect Competition 1 of 2

Ch. 7 Perfect Competition

Introduction and Review

What determines the equilibrium price and quantity for a good in a free market system?
Demand and supply.
Are the quantities of goods and services produced allocatively efficient?
Demand for a good comes from consumers. Consumer’s max sat. is met when
MC($)=MB. The result is a consumer demand function for each good. The market
demand curve is sum of all consumers’ demand functions at given prices. It tells us how
much consumers as a whole are willing and able to buy of that good. Similarly, at any
given quantity the market price is the willingness to pay of some people for that marginal
unit. CS=measure of gains from trade for the consumers. It is excess of what they are
willing to pay to buy a particular quantity over and above what they actually pay to get it.
Total expenditures by consumers on good= TR received by producers.

Supply comes from business firms, whose objective is to max profits by producing output
up to point where MB from that unit=its MC. MB= revenue firm receives from
consumers for sale of a unit. MC= payments to providers of production inputs for
producing that unit. Total MCP( marg. Cost of production)= price of variable input times
amt of variable input it takes to produce one unit of output. Cost of production depends
on input prices and internal organization of the firm. MR(marg. Revenue) depends on
structure of output market.

Market Sturctures
a. perfect competition- very large number of small firms producing identical
product. The product of a firm is perfect substitute for other firms.
b. Monopoly- one firm produces a product for which there’re no close
substitutes.
c. Monopolistic competition- case in b/w; combo of the above cases; a large
number of firms produce products that are similar. Each good is a
substitute for the other, but not a perfect substitute.
d. Oligopoly- handful of firms produce products either identical or similar or
somewhat different.

What is PERFECT COMPETITION?

Defined by 5 characteristics assumptions:

1. Large # of firms. In industry. Each firm is therefore very small, b/c lots of firms
2. Identical products. Therefore product is substitute for another one produced by
all firms.
3. price-taking firms. B/c each firm is small and products are identical, no firm can
have an effect on market price of product. The firms are price takers. They take
market prices as given. They have to follow market prices.
4. Perfect info. Those firms who’ve just entered have same knowledge as
incumbants.
Chapter 7: Perfect Competition 2 of 2

5. Free entry and exit. Both entry and exit is free. No sunk costs are incurred when
quit.

Why Study Perfect Competition?

Two Reasons:
1. Some industries closely fit its description, even if not perfectly. Ex) ag products
produced in such markets. Large number of wheat and rice farmers in US and
world. The rice and wheat is relatively the same for each farm. Relatively easy to
enter and exit and tech is relatively known to all. Even though there may be large
farmers, they still don’t control market prices. Ex) financial markets: large
number of people who sell stocks. No control over prices of assets. Ex) natural
gas. Many producers, etc

2. Results in economically desirable outcomes. Therefore it is used as a norm or

benchmark in cases:
a. policy maker and economist analyze performance of firms by comparing their
performance to perfect compe. Markets.
b. policy makinger compare one industry to perfect competition when
contemplating regulation of the industry.
c. Once ind. Is regulated, force firms in ind. To behave perfectly competitively,
such as electric companies
d . After firms are no longer regulated, monitor to make sure they are acting
perfectly competitive.

Demand Faced by Individual Firm

Demand faced by a firm. The function says how much the firm can sell or much
consumers will demand form it if charge different prices. Although firms can’t change
price, they can change quantity to produce. Demand is hor. Line at level of market price.