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chapter

eleven

Firms in Perfectly Competitive Markets

Prepared by: Fernando & Yvonn Quijano

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed.
Perfect Competition in the Market for Organic Apples
After studying this chapter, you
should be able to:
Competitive Markets

1 Define a perfectly competitive


market, and explain why a

LEARNING OBJECTIVES
perfect competitor faces a
CHAPTER 11: Firms in Perfectly

horizontal demand curve.


2 Explain how a perfect
competitor decides how much
to produce.
3 Use graphs to show a firm’s
profit or loss.
4 Explain why firms may shut
down temporarily.
5 Explain how entry and exit
ensure that firms earn zero
economic profit in the long run.
The process of 6 Explain how perfect competition
competition is at the leads to economic efficiency.
heart of the market
system and is the
focus of this chapter.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 2 of 35
Firms in Perfectly Competitive Markets

11 – 1
The Four Market Structures
Competitive Markets

MARKET STRUCTURE
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PERFECT MONOPOLISTIC
CHARACTERISTIC COMPETITION COMPETITION OLIGOPOLY MONOPOLY
Number of firms Many Many Few One

Type of product Identical Differentiated Identical or Unique


differentiated
Ease of entry High High Low Entry blocked

Examples of • Wheat • Selling DVDs • Manufacturing • First-class


industries • Apples • Restaurants computers mail delivery
• Manufacturing • Tap water
automobiles

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 3 of 35
1 LEARNING OBJECTIVE

Competitive Markets
Perfectly Competitive Markets

Perfectly competitive market


A market that meets the
CHAPTER 11: Firms in Perfectly

conditions of (1) many buyers


and sellers, (2) all firms selling
identical products, (3) no
barriers to new firms entering
the market.(4) free flow of
information.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 4 of 35
Perfectly Competitive Markets

A Perfectly Competitive Firm Cannot Affect the Market Price


Price taker A buyer or seller that is
Competitive Markets

unable to affect the market price.


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11 - 1
A Perfectly Competitive Firm
Faces a Horizontal Demand
Curve

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 5 of 35
2 LEARNING OBJECTIVE
How a Firm Maximizes Profit in a
Perfectly Competitive Market
Profit Total revenue minus total cost.
Profit = TR - TC
Competitive Markets

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The Market Demand for Wheat
versus the Demand or One
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Farmer’s Wheat

Don’t Confuse the Demand Curve for Farmer Douglas’s Wheat with the Market Demand Curve for Wheat
© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 6 of 35
How a Firm Maximizes Profit in a
Perfectly Competitive Market

Revenue for a Firm in a Perfectly Competitive Market


Competitive Markets

Average revenue (AR) Total revenue divided by the


number of units sold.
CHAPTER 11: Firms in Perfectly

TR TR P  Q
AR  so, AR   P
Q Q Q

Marginal revenue (MR) Change in total revenue from


selling one more unit.

Change in total revenue TR


Marginal Revenue  , or MR 
Change in quantity Q

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 7 of 35
Equilibrium condition

𝜋 =𝑅−𝐶
Competitive Markets
CHAPTER 11: Firms in Perfectly

𝜕𝜋
To maximise π , =0
𝜕𝑄

𝜕𝑅 𝜕𝐶
= − =0
𝜕𝑄 𝜕𝑄

i.e., MR –MC = 0

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 8 of 35
Contd..
The first order condition for profit maximization = P = MR = AR = MC

The second order condition requires


Competitive Markets

𝜕2 𝜋
=<0
CHAPTER 11: Firms in Perfectly

𝜕𝑄2

𝜕2𝑅 𝜕2𝐶
= 𝜕𝑄 2 − 𝜕𝑄 2
<0

𝜕2𝑅 𝜕2𝐶
Since 𝜕𝑄 2 =0 𝑠ℎ𝑜𝑢𝑙𝑑 𝑏𝑒 𝑝𝑜𝑠𝑖𝑡𝑖𝑣𝑒
𝜕𝑄 2

Which means the slope of the MC curve should be greater than the slope of the MR curve

The MC curve should cut the MR curve from below.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 9 of 35
3 LEARNING OBJECTIVE
Illustrating Profit or Loss
on the Cost Curve Graph

Profit = (P x Q)  TC
Competitive Markets

( P  Q ) TC
CHAPTER 11: Firms in Perfectly

Profit
 
Q Q Q

Or

Profit
 P  ATC,
Q

Profit = (P  ATC)Q

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 10 of 35
Illustrating Profit or Loss
on the Cost Curve Graph
Showing a Profit on the Graph
11 - 4
Competitive Markets

The Area of Maximum Profit


CHAPTER 11: Firms in Perfectly

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 11 of 35
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3 LEARNING OBJECTIVE
Determining Profit-Maximizing Price and Quantity
Competitive Markets
CHAPTER 11: Firms in Perfectly

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 12 of 35
Illustrating Profit or Loss
on the Cost Curve Graph
Illustrating When a Firm Is Breaking Even or Operating at a Loss
 P > ATC, which means the firm makes a profit
 P = ATC, which means the firm breaks even (its total cost equals it total revenue)
Competitive Markets

 P < ATC, which means the firm experiences losses


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A Firm Breaking Even and Experiencing Losses

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 13 of 35
Illustrating Profit or Loss
on the Cost Curve Graph

Remember that Firms Maximize Total Profit, Not Profit per Unit
Competitive Markets
CHAPTER 11: Firms in Perfectly

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 14 of 35
Firm making loss
Competitive Markets
CHAPTER 11: Firms in Perfectly

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4 LEARNING OBJECTIVE
Deciding Whether to Produce or
to Shut Down in the Short Run

In the short run a firm suffering losses has


Competitive Markets

two choices:
CHAPTER 11: Firms in Perfectly

 Continue to produce

 Stop production by shutting down


temporarily

Sunk cost A cost that has already been


paid and that cannot be recovered.

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When to Close a Laundry
Competitive Markets
CHAPTER 11: Firms in Perfectly

Keeping a business open even


when suffering losses can
sometimes be the best decision
in the short run.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 17 of 35
Deciding Whether to Produce
or to Shut Down in the Short Run
The Supply Curve of the Firm in the Short Run
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The Firm’s Short-Run Supply Curve
Competitive Markets
CHAPTER 11: Firms in Perfectly

Shutdown point The minimum point on a firm’s average variable cost


curve; if the price falls below this point, the firm shuts down production in
the short run.
© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 18 of 35
“If Everyone Can Do It, You Can’t Make Money At It” –
The Entry and Exit of Firms in the Long Run
Economic Profit and the Entry or Exit Decision
ECONOMIC PROFIT LEADS TO ENTRY OF NEW FIRMS
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The Effect of Entry on Economic Profits
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© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 19 of 35
“If Everyone Can Do It, You Can’t Make Money At It” –
The Entry and Exit of Firms in the Long Run
Economic Profit and the Entry or Exit Decision
ECONOMIC LOSSES LEAD TO EXIT OF FIRMS
Competitive Markets

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The Effect of Exit on Economic Losses
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© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 20 of 35
“If Everyone Can Do It, You Can’t Make Money At It” –
The Entry and Exit of Firms in the Long Run

Long-Run Equilibrium in a Perfectly Competitive Market


Competitive Markets

Long-run competitive equilibrium


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The situation in which the entry and


exit of firms have resulted in the typical
firm just breaking even.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 21 of 35
6 LEARNING OBJECTIVE

Competitive Markets
Perfect Competition and Efficiency

Productive Efficiency
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Productive efficiency The situation


in which a good or service is produced
at the lowest possible cost.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 22 of 35
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6 LEARNING OBJECTIVE

How Productive Efficiency Benefits Consumers


Competitive Markets
CHAPTER 11: Firms in Perfectly

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 23 of 35
Perfect Competition and Efficiency
Allocative Efficiency
Firms will supply all those goods that provide
Competitive Markets

consumers with a marginal benefit at least as great as


the marginal cost of producing them:
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 The price of a good represents the marginal benefit


consumers receive from consuming the last unit of the
good sold.

 Perfectly competitive firms produce up to the point where


the price of the good equals the marginal cost of
producing the last unit.

 Therefore, firms produce up to the point where the last


unit provides a marginal benefit to consumers equal to
the marginal cost of producing it.
© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 24 of 35
Perfect Competition and Efficiency

Allocative Efficiency
Competitive Markets

Allocative efficiency A state of the economy


CHAPTER 11: Firms in Perfectly

in which production reflects consumer


preferences; in particular, every good or service is
produced up to the point where the last unit
provides a marginal benefit to consumers equal to
the marginal cost of producing it.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 25 of 35

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