Chapter 9: Perfectly Competitive Markets
In Chapters 7 and 8, we examined the cost minimization problem of a producer who wanted to reach a target output level. Now, we study how the producer chooses its target output to maximize the profits earned from production.
Chapter highlights include:
· Characteristics of a Perfectly Competitive Market
· The Law of One Price
· Price Taking Behavior
· Free Entry
· Accounting vs. Economic Profit
· Marginal Revenue
· The Firm's Short Run Supply Curve
· The Shut Down Price
· The Short Run Market Supply Curve
· Short Run Perfectly Competitive Equilibrium
· The Firm's Long Run Supply Curve
· Long Run Perfectly Competitive Equilibrium
· The Long Run Market Supply Curve
· Pecuniary Effects
· Economic Rent
· Producer's Surplus
After finishing this chapter, besides developing good understanding of the above key concepts, you should be able to:
· Solve the profit-maximization problem for a price-taking firm
· Derive the short-run supply curve of an individual firm
· Analyze long-run market equilibrium when there is free entry
1. Perfectly Competitive Market
Characteristics of a perfectly competitive market/industry:
Implications of these characteristics:
2. Profit-Maximization by a Price-taking firm
(1) Economic profit vs. accounting profit
Accounting profit = revenue – accounting cost
Economic profit = revenue – total opportunity cost
(2) The profit-maximization problem
Max Profit = TR(Q) – TC(Q)
Marginal revenue: MR =
For a price-taking firm, marginal revenue is equal to market price, MR = P.
For a price-taking firm, at a profit-maximizing quantity of output, two conditions
· P = MC
· MC is increasing
Logic: When P < MC, the firm can reduce its output by one unit and its profit will go up by MC – P; When P > MC, the firm can increase its output by one unit and its profit will go up by P – MC.
3. Short-run Market Supply
(1) Short-run costs
STC (Q) = TFC + TVC(Q)
(2) How does a change in output price affect the firm’s choice of its output?
· A profit-maximizing firm, if producing positive level of output, should choose Q where P = SMC and SMC is upward-sloping.
· A profit-maximizing firm should produce nothing if P < minimum AVC.
Thus the short-run supply curve of a firm consists of two parts: the portion of the SMC curve that lies above the AVC curve when P > minimum AVC, plus the part of the vertical axis between the origin and the minimum AVC. .
(3) Short-run market supply curve is the horizontal sum of the individual firm supply curves.
(4) Short-run market equilibrium: putting supply and demand together
4. Long-run Market Equilibrium
(1) Adjusting (short-run) fixed inputs: change plant size
(2) The Firm’s long-run supply curve
(3) Long-run perfectly competitive equilibrium satisfies three conditions:
· profit is maximized, so both plant size and output level are optimal
· economic profit is zero
· Quantity demanded equals quantity supplied at the market price
(4) The long-run market supply curve
(5) Industry cost structure and long-run market supply
· Constant cost industry: changes in industry output do not affect input prices
· Increasing cost industry: expansions of industry output cause increases in some input prices
· Decreasing cost industry: increases in industry output cause decreases in some input prices
5. Economic Rent
Economic rent of an input = A – B
Where A = maximum amount a firm in the industry is willing to pay for the input
B = opportunity cost of the input outside the industry, i.e., return the input owner
gets in the best alternative use outside the industry.
6. Producer Surplus of a price-taking firm
Producer surplus is the area between the supply curve and the market price
· Producer surplus for an individual firm
· Producer surplus for the market with fixed number of firms (short run)
· Producer surplus for the market with free entry (long run)
Economic Profit, Producer Surplus, and Economic Rent