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:

• Homogeneous products
• Consumers have perfect information about prices
• All firms, incumbent and potential entrants alike, have equal access to resources

Implications of these characteristics:

• Price-taking firm
• Law of one price
• Free entry

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

must hold:

·        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