More on Perfect Competition
|Course:||ECON101: Principles of Microeconomics|
|Book:||More on Perfect Competition|
|Printed by:||Guest user|
|Date:||Wednesday, October 27, 2021, 3:13 PM|
Read Chapter 8, which provides an overview of the Perfect Competition model and a guide to the elements you need to know in order to understand the model. Be sure to read the sections following the introduction.
1. Introduction to Perfect Competition
Bring It Home
A Dime a DozenWhen you were younger did you babysit, deliver papers, or mow the lawn for money? If so, you faced stiff competition from a lot of other competitors who offered identical services. There was nothing to stop others from offering their services too.
All of you charged the "going rate". If you tried to charge more, your customers would simply buy from someone else. These conditions are very similar to the conditions agricultural growers face.
Growing a crop may be more difficult to start than a babysitting or lawn mowing service, but growers face the same fierce competition. In the grand scale of world agriculture, farmers face competition from thousands of others because they sell an identical product. After all, winter wheat is winter wheat. But it is relatively easy for farmers to leave the marketplace for another crop. In this case, they do not sell the family farm, they switch crops.
Take the case of the upper Midwest region of the United States - for many generations the area was called "King Wheat". According to the United States Department of Agriculture National Agricultural Statistics Service, statistics by state, in 1997, 11.6 million acres of wheat and 780,000 acres of corn were planted in North Dakota. In the intervening 15 or so years has the mix of crops changed? Since it is relatively easy to switch crops, did farmers change what was planted as the relative crop prices changed? We will find out at chapter’s end.
Introduction to Perfect CompetitionIn this chapter, you will learn about:
- Perfect Competition and Why It Matters
- How Perfectly Competitive Firms Make Output Decisions
- Entry and Exit Decisions in the Long RunEfficiency in Perfectly Competitive Markets
Source: Rice University, https://openstax.org/books/principles-microeconomics/pages/8-introduction-to-perfect-competition
This work is licensed under a Creative Commons Attribution 4.0 License.
2. Perfect Competition and Why It Matters
By the end of this section, you will be able to:
- Explain the characteristics of a perfectly competitive market
- Discuss how perfectly competitive firms react in the short run and in the long run
Firms are said to be in perfect competition when the following conditions occur: (1) many firms produce identical products; (2) many buyers are available to buy the product, and many sellers are available to sell the product; (3) sellers and buyers have all relevant information to make rational decisions about the product being bought and sold; and (4) firms can enter and leave the market without any restrictions - in other words, there is free entry and exit into and out of the market.
A perfectly competitive firm is known as a price taker, because the pressure of competing firms forces them to accept the prevailing equilibrium price in the market. If a firm in a perfectly competitive market raises the price of its product by so much as a penny, it will lose all of its sales to competitors. When a wheat grower, as discussed in the Bring it Home feature, wants to know what the going price of wheat is, he or she has to go to the computer or listen to the radio to check. The market price is determined solely by supply and demand in the entire market and not the individual farmer. Also, a perfectly competitive firm must be a very small player in the overall market, so that it can increase or decrease output without noticeably affecting the overall quantity supplied and price in the market.
A perfectly competitive market is a hypothetical extreme; however, producers in a number of industries do face many competitor firms selling highly similar goods, in which case they must often act as price takers. Agricultural markets are often used as an example. The same crops grown by different farmers are largely interchangeable. According to the United States Department of Agriculture monthly reports, in 2015, U.S. corn farmers received an average price of $6.00 per bushel and wheat farmers received an average price of $6.00 per bushel. A corn farmer who attempted to sell at $7.00 per bushel, or a wheat grower who attempted to sell for $8.00 per bushel, would not have found any buyers. A perfectly competitive firm will not sell below the equilibrium price either. Why should they when they can sell all they want at the higher price? Other examples of agricultural markets that operate in close to perfectly competitive markets are small roadside produce markets and small organic farmers.
This chapter examines how profit-seeking firms decide how much to produce in perfectly competitive markets. Such firms will analyze their costs as discussed in the chapter on Cost and Industry Structure. In the short run, the perfectly competitive firm will seek the quantity of output where profits are highest or, if profits are not possible, where losses are lowest. In this example, the "short run" refers to a situation in which firms are producing with one fixed input and incur fixed costs of production. (In the real world, firms can have many fixed inputs).
In the long run, perfectly competitive firms will react to profits by increasing production. They will respond to losses by reducing production or exiting the market. Ultimately, a long-run equilibrium will be attained when no new firms want to enter the market and existing firms do not want to leave the market, as economic profits have been driven down to zero.
3. How Perfectly Competitive Firms Make Output Decisions
By the end of this section, you will be able to:
- Calculate profits by comparing total revenue and total cost
- Identify profits and losses with the average cost curve
- Explain the shutdown point
- Determine the price at which a firm should continue producing in the short run
A perfectly competitive firm has only one major decision to make - namely, what quantity to produce. To understand why this is so, consider a different way of writing out the basic definition of profit:
Profit = Total revenue − Total cost
= (Price)(Quantity produced) − (Average cost)(Quantity produced)
Since a perfectly competitive firm must accept the price for its output as determined by the product's market demand and supply, it cannot choose the price it charges. This is already determined in the profit equation, and so the perfectly competitive firm can sell any number of units at exactly the same price. It implies that the firm faces a perfectly elastic demand curve for its product: buyers are willing to buy any number of units of output from the firm at the market price. When the perfectly competitive firm chooses what quantity to produce, then this quantity - along with the prices prevailing in the market for output and inputs - will determine the firm's total revenue, total costs, and ultimately, level of profits.
Determining the Highest Profit by Comparing Total Revenue and Total Cost
A perfectly competitive firm can sell as large a quantity as it wishes, as long as it accepts the prevailing market price. Total revenue is going to increase as the firm sells more, depending on the price of the product and the number of units sold. If
you increase the number of units sold at a given price, then total revenue will increase. If the price of the product increases for every unit sold, then total revenue also increases. As an example of how a perfectly competitive firm decides what
quantity to produce, consider the case of a small farmer who produces raspberries and sells them frozen for $4 per pack. Sales of one pack of raspberries will bring in $4, two packs will be $8, three packs will be $12, and so on. If, for example,
the price of frozen raspberries doubles to $8 per pack, then sales of one pack of raspberries will be $8, two packs will be $16, three packs will be $24, and so on.
Total revenue and total costs for the raspberry farm, broken down into fixed and variable costs, are shown in Table 8.1 and also appear in Figure 8.2. The horizontal axis shows the quantity of frozen raspberries produced in packs; the vertical axis shows both total revenue and total costs, measured in dollars. The total cost curve intersects with the vertical axis at a value that shows the level of fixed costs, and then slopes upward. All these cost curves follow the same characteristics as the curves covered in the Cost and Industry Structure chapter.
Figure 8.2 Total Cost and Total Revenue at the Raspberry Farm Total revenue for a perfectly competitive firm is a straight line sloping up. The slope is equal to the price of the good. Total cost also slopes up, but with some curvature.
At higher levels of output, total cost begins to slope upward more steeply because of diminishing marginal returns. The maximum profit will occur at the quantity where the gap of total revenue over total cost is largest.
||Total Cost (TC)
||Fixed Cost (FC)
||Variable Cost (VC)
||Total Revenue (TR)
Table 8.1 Total Cost and Total Revenue at the Raspberry Farm
Based on its total revenue and total cost curves, a perfectly competitive firm like the raspberry farm can calculate the quantity of output that will provide the highest level of profit. At any given quantity, total revenue minus total cost will equal profit. One way to determine the most profitable quantity to produce is to see at what quantity total revenue exceeds total cost by the largest amount. On Figure 8.2, the vertical gap between total revenue and total cost represents either profit (if total revenues are greater that total costs at a certain quantity) or losses (if total costs are greater that total revenues at a certain quantity). In this example, total costs will exceed total revenues at output levels from 0 to 40, and so over this range of output, the firm will be making losses. At output levels from 50 to 80, total revenues exceed total costs, so the firm is earning profits. But then at an output of 90 or 100, total costs again exceed total revenues and the firm is making losses. Total profits appear in the final column of Table 8.1. The highest total profits in the table, as in the figure that is based on the table values, occur at an output of 70–80, when profits will be $56.
A higher price would mean that total revenue would be higher for every quantity sold. A lower price would mean that total revenue would be lower for every quantity sold. What happens if the price drops low enough so that the total revenue line is completely below the total cost curve; that is, at every level of output, total costs are higher than total revenues? In this instance, the best the firm can do is to suffer losses. But a profit-maximizing firm will prefer the quantity of output where total revenues come closest to total costs and thus where the losses are smallest.
Comparing Marginal Revenue and Marginal Costs
Notice that marginal revenue does not change as the firm produces more output. That is because the price is determined by supply and demand and does not change as the farmer produces more (keeping in mind that, due to the relative small size of each firm, increasing their supply has no impact on the total market supply where price is determined).
Ordinarily, marginal cost changes as the firm produces a greater quantity.
Table 8.3 Marginal Revenues and Marginal Costs at the Raspberry Farm
In this example, the marginal revenue and marginal cost curves cross at a price of $4 and a quantity of 80 produced. If the farmer started out producing at a level of 60, and then experimented with increasing production to 70, marginal revenues from the increase in production would exceed marginal costs - and so profits would rise. The farmer has an incentive to keep producing. From a level of 70 to 80, marginal cost and marginal revenue are equal so profit doesn't change. If the farmer then experimented further with increasing production from 80 to 90, he would find that marginal costs from the increase in production are greater than marginal revenues, and so profits would decline.
The profit-maximizing choice for a perfectly competitive firm will occur where marginal revenue is equal to marginal cost - that is, where MR = MC. A profit-seeking firm should keep expanding production as long as MR > MC. But at the level of output where MR = MC, the firm should recognize that it has achieved the highest possible level of economic profits. (In the example above, the profit maximizing output level is between 70 and 80 units of output, but the firm will not know they've maximized profit until they reach 80, where MR = MC). Expanding production into the zone where MR < MC will only reduce economic profits. Because the marginal revenue received by a perfectly competitive firm is equal to the price P, so that P = MR, the profit-maximizing rule for a perfectly competitive firm can also be written as a recommendation to produce at the quantity where P = MC.
Profits and Losses with the Average Cost Curve
First consider a situation where the price is equal to $5 for a pack of frozen raspberries. The rule for a profit-maximizing perfectly competitive firm is to produce the level of output where Price= MR = MC, so the raspberry farmer will produce a quantity of 90, which is labeled as e in Figure 8.5 (a). Remember that the area of a rectangle is equal to its base multiplied by its height. The farm's total revenue at this price will be shown by the large shaded rectangle from the origin over to a quantity of 90 packs (the base) up to point E' (the height), over to the price of $5, and back to the origin. The average cost of producing 80 packs is shown by point C or about $3.50. Total costs will be the quantity of 80 times the average cost of $3.50, which is shown by the area of the rectangle from the origin to a quantity of 90, up to point C, over to the vertical axis and down to the origin. It should be clear from examining the two rectangles that total revenue is greater than total cost. Thus, profits will be the blue shaded rectangle on top.
It can be calculated as:
Or, it can be calculated as:
Now consider Figure 8.5 (b), where the price has fallen to $3.00 for a pack of frozen raspberries. Again, the perfectly competitive firm will choose the level of output where Price = MR = MC, but in this case, the quantity produced will be 70. At this price and output level, where the marginal cost curve is crossing the average cost curve, the price received by the firm is exactly equal to its average cost of production.
The farm's total revenue at this price will be shown by the large shaded rectangle from the origin over to a quantity of 70 packs (the base) up to point E (the height), over to the price of $3, and back to the origin. The average cost of producing 70 packs is shown by point C'. Total costs will be the quantity of 70 times the average cost of $3.00, which is shown by the area of the rectangle from the origin to a quantity of 70, up to point E, over to the vertical axis and down to the origin. It should be clear from that the rectangles for total revenue and total cost are the same. Thus, the firm is making zero profit. The calculations are as follows:
Or, it can be calculated as:
In Figure 8.5 (c), the market price has fallen still further to $2.00 for a pack of frozen raspberries. At this price, marginal revenue intersects marginal cost at a quantity of 50. The farm's total revenue at this price will be shown by the large shaded rectangle from the origin over to a quantity of 50 packs (the base) up to point E” (the height), over to the price of $2, and back to the origin. The average cost of producing 50 packs is shown by point C” or about $3.30. Total costs will be the quantity of 50 times the average cost of $3.30, which is shown by the area of the rectangle from the origin to a quantity of 50, up to point C”, over to the vertical axis and down to the origin. It should be clear from examining the two rectangles that total revenue is less than total cost. Thus, the firm is losing money and the loss (or negative profit) will be the rose-shaded rectangle.
The calculations are:
|Price > ATC||Firm earns an economic profit|
|Price = ATC||Firm earns zero economic profit|
|Price < ATC||Firm earns a loss|
The Shutdown Point
As an example, consider the situation of the Yoga Center, which has signed a contract to rent space that costs $10,000 per month. If the firm decides to operate, its marginal costs for hiring yoga teachers is $15,000 for the month. If the firm shuts down, it must still pay the rent, but it would not need to hire labor. Table 8.5 shows three possible scenarios. In the first scenario, the Yoga Center does not have any clients, and therefore does not make any revenues, in which case it faces losses of $10,000 equal to the fixed costs. In the second scenario, the Yoga Center has clients that earn the center revenues of $10,000 for the month, but ultimately experiences losses of $15,000 due to having to hire yoga instructors to cover the classes. In the third scenario, the Yoga Center earns revenues of $20,000 for the month, but experiences losses of $5,000.
|If the center shuts down now, revenues are zero but it will not incur any variable costs and would only need to pay fixed costs of $10,000.|
|profit = total revenue – (fixed costs + variable cost)
= 0 –$10,000
|The center earns revenues of $10,000, and variable costs are $15,000. The center should shut down now.|
|profit = total revenue – (fixed costs + variable cost)
= $10,000 – ($10,000 + $15,000)
|The center earns revenues of $20,000, and variable costs are $15,000. The center should continue in business.|
|profit = total revenue – (fixed costs + variable cost)
= $20,000 – ($10,000 + $15,000)
This example suggests that the key factor is whether a firm can earn enough revenues to cover at least its variable costs by remaining open. Let's return now to our raspberry farm. Figure 8.6 illustrates this lesson by adding the average variable cost curve to the marginal cost and average cost curves. At a price of $2.20 per pack, as shown in Figure 8.6 (a), the farm produces at a level of 50. It is making losses of $56 (as explained earlier), but price is above average variable cost and so the firm continues to operate. However, if the price declined to $1.80 per pack, as shown in Figure 8.6 (b), and if the firm applied its rule of producing where P = MR = MC, it would produce a quantity of 40. This price is below average variable cost for this level of output. If the farmer cannot pay workers (the variable costs), then it has to shut down. At this price and output, total revenues would be $72 (quantity of 40 times price of $1.80) and total cost would be $144, for overall losses of $72. If the farm shuts down, it must pay only its fixed costs of $62, so shutting down is preferable to selling at a price of $1.80 per pack.
|| Average Variable Cost
Table 8.6 Cost of Production for the Raspberry Farm
The intersection of the average variable cost curve and the marginal cost curve, which shows the price where the firm would lack enough revenue to cover its variable costs, is called the shutdown point. If the perfectly competitive firm can charge a price above the shutdown point, then the firm is at least covering its average variable costs. It is also making enough revenue to cover at least a portion of fixed costs, so it should limp ahead even if it is making losses in the short run, since at least those losses will be smaller than if the firm shuts down immediately and incurs a loss equal to total fixed costs. However, if the firm is receiving a price below the price at the shutdown point, then the firm is not even covering its variable costs. In this case, staying open is making the firm's losses larger, and it should shut down immediately. To summarize, if:
- price < minimum average variable cost, then firm shuts down
- price = minimum average variable cost, then firm stays in business
Short-Run Outcomes for Perfectly Competitive FirmsThe average cost and average variable cost curves divide the marginal cost curve into three segments, as shown in Figure 8.7. At the market price, which the perfectly competitive firm accepts as given, the profit-maximizing firm chooses the output level where price or marginal revenue, which are the same thing for a perfectly competitive firm, is equal to marginal cost: P = MR = MC.
Marginal Cost and the Firm's Supply CurveFor a perfectly competitive firm, the marginal cost curve is identical to the firm's supply curve starting from the minimum point on the average variable cost curve. To understand why this perhaps surprising insight holds true, first think about what the supply curve means. A firm checks the market price and then looks at its supply curve to decide what quantity to produce. Now, think about what it means to say that a firm will maximize its profits by producing at the quantity where P = MC. This rule means that the firm checks the market price, and then looks at its marginal cost to determine the quantity to produce - and makes sure that the price is greater than the minimum average variable cost. In other words, the marginal cost curve above the minimum point on the average variable cost curve becomes the firm's supply curve.
Work It Out
At What Price Should the Firm Continue Producing in the Short Run?
(TFC + TVC)
|Quantity||Price||Total Revenue (P x Q)
|| Profits (TR-TC)
Step 5. Once you have determined the profit-maximizing output level (in this case, output quantity 5), you can look at the amount of profits made (in this case, $40).
Step 6. If the firm is making economic losses, the firm needs to determine whether it produces the output level where price equals marginal revenue and equals marginal cost or it shuts down and only incurs its fixed costs.
Step 7. For the output level where marginal revenue is equal to marginal cost, check if the market price is greater than the average variable cost of producing that output level.
- If P > AVC but P < ATC, then the firm continues to produce in the short-run, making economic losses.
- If P < AVC, then the firm stops producing and only incurs its fixed costs.
In this example, the price of $28 is greater than the AVC ($16.40) of producing 5 units of output, so the firm continues producing.
4. Entry and Exit Decisions in the Long Run
By the end of this section, you will be able to:
- Explain how entry and exit lead to zero profits in the long run
- Discuss the long-run adjustment process
The line between the short run and the long run cannot be defined precisely with a stopwatch, or even with a calendar. It varies according to the specific business. The distinction between the short run and the long run is therefore more technical: in the short run, firms cannot change the usage of fixed inputs, while in the long run, the firm can adjust all factors of production.
In a competitive market, profits are a red cape that incites businesses to charge. If a business is making a profit in the short run, it has an incentive to expand existing factories or to build new ones. New firms may start production, as well. When new firms enter the industry in response to increased industry profits it is called entry.
Losses are the black thundercloud that causes businesses to flee. If a business is making losses in the short run, it will either keep limping along or just shut down, depending on whether its revenues are covering its variable costs. But in the long run, firms that are facing losses will shut down at least some of their output, and some firms will cease production altogether. The long-run process of reducing production in response to a sustained pattern of losses is called exit. The following Clear It Up feature discusses where some of these losses might come from, and the reasons why some firms go out of business.
Clear It Up
Why do firms cease to exist?
Can we say anything about what causes a firm to exit an industry? Profits are the measurement that determines whether a business stays operating or not. Individuals start businesses with the purpose of making profits. They invest their money, time, effort, and many other resources to produce and sell something that they hope will give them something in return. Unfortunately, not all businesses are successful, and many new startups soon realize that their "business adventure" must eventually end.
In the model of perfectly competitive firms, those that consistently cannot make money will "exit," which is a nice, bloodless word for a more painful process. When a business fails, after all, workers lose their jobs, investors lose their money, and owners and managers can lose their dreams. Many businesses fail. The U.S. Small Business Administration indicates that in 2011, 409,040 new firms "entered," and 470,376 firms failed.
Sometimes a business fails because of poor management or workers who are not very productive, or because of tough domestic or foreign competition. Businesses also fail from a variety of causes that might best be summarized as bad luck. For example, conditions of demand and supply in the market shift in an unexpected way, so that the prices that can be charged for outputs fall or the prices that need to be paid for inputs rise. With millions of businesses in the U.S. economy, even a small fraction of them failing will affect many people - and business failures can be very hard on the workers and managers directly involved. But from the standpoint of the overall economic system, business exits are sometimes a necessary evil if a market-oriented system is going to offer a flexible mechanism for satisfying customers, keeping costs low, and inventing new products.
How Entry and Exit Lead to Zero Profits in the Long Run
No perfectly competitive firm acting alone can affect the market price. However, the combination of many firms entering or exiting the market will affect overall supply in the market. In turn, a shift in supply for the market as a whole will affect the market price. Entry and exit to and from the market are the driving forces behind a process that, in the long run, pushes the price down to minimum average total costs so that all firms are earning a zero profit.
To understand how short-run profits for a perfectly competitive firm will evaporate in the long run, imagine the following situation. The market is in long-run equilibrium, where all firms earn zero economic profits producing the output level where P = MR = MC and P = AC. No firm has the incentive to enter or leave the market. Let's say that the product's demand increases, and with that, the market price goes up. The existing firms in the industry are now facing a higher price than before, so they will increase production to the new output level where P = MR = MC.
This will temporarily make the market price rise above the average cost curve, and therefore, the existing firms in the market will now be earning economic profits. However, these economic profits attract other firms to enter the market. Entry of many new firms causes the market supply curve to shift to the right. As the supply curve shifts to the right, the market price starts decreasing, and with that, economic profits fall for new and existing firms. As long as there are still profits in the market, entry will continue to shift supply to the right. This will stop whenever the market price is driven down to the zero-profit level, where no firm is earning economic profits.
Short-run losses will fade away by reversing this process. Say that the market is in long-run equilibrium. This time, instead, demand decreases, and with that, the market price starts falling. The existing firms in the industry are now facing a lower price than before, and as it will be below the average cost curve, they will now be making economic losses. Some firms will continue producing where the new P = MR = MC, as long as they are able to cover their average variable costs. Some firms will have to shut down immediately as they will not be able to cover their average variable costs, and will then only incur their fixed costs, minimizing their losses. Exit of many firms causes the market supply curve to shift to the left. As the supply curve shifts to the left, the market price starts rising, and economic losses start to be lower. This process ends whenever the market price rises to the zero-profit level, where the existing firms are no longer losing money and are at zero profits again. Thus, while a perfectly competitive firm can earn profits in the short run, in the long run the process of entry will push down prices until they reach the zero-profit level. Conversely, while a perfectly competitive firm may earn losses in the short run, firms will not continually lose money. In the long run, firms making losses are able to escape from their fixed costs, and their exit from the market will push the price back up to the zero-profit level. In the long run, this process of entry and exit will drive the price in perfectly competitive markets to the zero-profit point at the bottom of the AC curve, where marginal cost crosses average cost.
The Long-Run Adjustment and Industry Types
Whenever there are expansions in an industry, costs of production for the existing and new firms could either stay the same, increase, or even decrease. Therefore, we can categorize an industry as being (1) a constant cost industry (as demand increases, the cost of production for firms stays the same), (2) an increasing cost industry (as demand increases, the cost of production for firms increases), or (3) a decreasing cost industry (as demand increases the costs of production for the firms decreases).
For a constant cost industry, whenever there is an increase in market demand and price, then the supply curve shifts to the right with new firms' entry and stops at the point where the new long-run equilibrium intersects at the same market price as before. But why will costs remain the same? In this type of industry, the supply curve is very elastic. Firms can easily supply any quantity that consumers demand. In addition, there is a perfectly elastic supply of inputs - firms can easily increase their demand for employees, for example, with no increase to wages. Tying in to our Bring it Home discussion, an increased demand for ethanol in recent years has caused the demand for corn to increase. Consequently, many farmers switched from growing wheat to growing corn. Agricultural markets are generally good examples of constant cost industries.
For an increasing cost industry, as the market expands, the old and new firms experience increases in their costs of production, which makes the new zero-profit level intersect at a higher price than before. Here companies may have to deal with limited inputs, such as skilled labor. As the demand for these workers rise, wages rise and this increases the cost of production for all firms. The industry supply curve in this type of industry is more inelastic.
For a decreasing cost industry, as the market expands, the old and new firms experience lower costs of production, which makes the new zero-profit level intersect at a lower price than before. In this case, the industry and all the firms in it are experiencing falling average total costs. This can be due to an improvement in technology in the entire industry or an increase in the education of employees. High tech industries may be a good example of a decreasing cost market.
Figure 8.8 (a) presents the case of an adjustment process in a constant cost industry. Whenever there are output expansions in this type of industry, the long-run outcome implies more output produced at exactly the same original price. Note that supply was able to increase to meet the increased demand. When we join the before and after long-run equilibriums, the resulting line is the long run supply (LRS) curve in perfectly competitive markets. In this case, it is a flat curve. Figure 8.8 (b) and Figure 8.8 (c) present the cases for an increasing cost and decreasing cost industry, respectively. For an increasing cost industry, the LRS is upward sloping, while for a decreasing cost industry, the LRS is downward sloping.
Figure 8.8 Adjustment Process in a Constant-Cost Industry In (a), demand increased and supply met it. Notice that the supply increase is equal to the demand increase. The result is that the equilibrium price stays the same as quantity sold increases. In (b), notice that sellers were not able to increase supply as much as demand. Some inputs were scarce, or wages were rising. The equilibrium price rises. In (c), sellers easily increased supply in response to the demand increase. Here, new technology or economies of scale caused the large increase in supply, resulting in declining equilibrium price.
5. Efficiency in Perfectly Competitive Markets
By the end of this section, you will be able to:
- Apply concepts of productive efficiency and allocative efficiency to perfectly competitive markets
- Compare the model of perfect competition to real-world
When profit-maximizing firms in perfectly competitive markets combine with utility-maximizing consumers, something remarkable happens: the resulting quantities of outputs of goods and services demonstrate both productive and allocative
efficiency (terms that were first introduced in (Choice in a World of Scarcity) .
Productive efficiency means producing without waste, so that the choice is on the production possibility frontier. In the long run in a perfectly competitive market, because of the process of entry and exit, the price in the market is equal to the minimum of the long-run average cost curve. In other words, goods are being produced and sold at the lowest possible average cost.
Allocative efficiency means that among the points on the production possibility frontier, the point that is chosen is socially preferred - at least in a particular and specific sense. In a perfectly competitive market, price will be equal to the marginal cost of production. Think about the price that is paid for a good as a measure of the social benefit received for that good; after all, willingness to pay conveys what the good is worth to a buyer. Then think about the marginal cost of producing the good as representing not just the cost for the firm, but more broadly as the social cost of producing that good. When perfectly competitive firms follow the rule that profits are maximized by producing at the quantity where price is equal to marginal cost, they are thus ensuring that the social benefits received from producing a good are in line with the social costs of production.
To explore what is meant by allocative efficiency, it is useful to walk through an example. Begin by assuming that the market for wholesale flowers is perfectly competitive, and so P = MC. Now, consider what it would mean if firms in that market produced a lesser quantity of flowers. At a lesser quantity, marginal costs will not yet have increased as much, so that price will exceed marginal cost; that is, P > MC. In that situation, the benefit to society as a whole of producing additional goods, as measured by the willingness of consumers to pay for marginal units of a good, would be higher than the cost of the inputs of labor and physical capital needed to produce the marginal good. In other words, the gains to society as a whole from producing additional marginal units will be greater than the costs.
Conversely, consider what it would mean if, compared to the level of output at the allocatively efficient choice when P = MC, firms produced a greater quantity of flowers. At a greater quantity, marginal costs of production will have increased so that P < MC. In that case, the marginal costs of producing additional flowers is greater than the benefit to society as measured by what people are willing to pay. For society as a whole, since the costs are outstripping the benefits, it will make sense to produce a lower quantity of such goods.
When perfectly competitive firms maximize their profits by producing the quantity where P = MC, they also assure that the benefits to consumers of what they are buying, as measured by the price they are willing to pay, is equal to the costs to society of producing the marginal units, as measured by the marginal costs the firm must pay - and thus that allocative efficiency holds.
The statements that a perfectly competitive market in the long run will feature both productive and allocative efficiency do need to be taken with a few grains of salt. Remember, economists are using the concept of "efficiency" in a particular and specific sense, not as a synonym for "desirable in every way". For one thing, consumers’ ability to pay reflects the income distribution in a particular society. Thus, a homeless person may have no ability to pay for housing because they have insufficient income.
Perfect competition, in the long run, is a hypothetical benchmark. For market structures such as monopoly, monopolistic competition, and oligopoly, which are more frequently observed in the real world than perfect competition, firms will not always produce at the minimum of average cost, nor will they always set price equal to marginal cost. Thus, these other competitive situations will not produce productive and allocative efficiency.
Moreover, real-world markets include many issues that are assumed away in the model of perfect competition, including pollution, inventions of new technology, poverty which may make some people unable to pay for basic necessities of life, government programs like national defense or education, discrimination in labor markets, and buyers and sellers who must deal with imperfect and unclear information. These issues are explored in other chapters. However, the theoretical efficiency of perfect competition does provide a useful benchmark for comparing the issues that arise from these real-world problems.
Bring It Home
A Dime a Dozen
glance at Table 8.12 reveals the dramatic increase in North Dakota corn production - more than double. Taking into consideration that corn typically yields two to three times as many bushels per acre as wheat, it is obvious there has been a significant
increase in bushels of corn. Why the increase in corn acreage? Converging prices.
||Corn (millions of acres)
|| Wheat (millions of acres)
Historically, wheat prices have been higher than corn prices, offsetting wheat’s lower yield per acre. However, in recent years wheat and corn prices have been converging. In April 2013, Agweek reported the gap was just 71 cents per bushel. As the difference in price narrowed, switching to the production of higher yield per acre of corn simply made good business sense. Erik Younggren, president of the National Association of Wheat Growers said in the Agweek article, "I don't think we're going to see mile after mile of waving amber fields [of wheat] anymore". (Until wheat prices rise, we will probably be seeing field after field of tasseled corn).
6. Key Terms
the long-run process of firms entering an industry in response to industry profits
the long-run process of firms reducing production and shutting down in response to industry losses
where all firms earn zero economic profits producing the output level where P = MR = MC and P = AC
the additional revenue gained from selling one more unit
the conditions in an industry, such as number of sellers, how easy or difficult it is for a new firm to enter, and the type of products that are sold
each firm faces many competitors that sell identical products
a firm in a perfectly competitive market that must take the prevailing market price as given
level of output where the marginal cost curve intersects the average variable cost curve at the minimum point of AVC; if the price is below this point, the firm should shut down immediately
7. Key Concept & Summary
Perfect Competition and Why It Matters
A perfectly competitive firm is a price taker, which means that it must accept the equilibrium price at which it sells goods. If a perfectly competitive firm attempts to charge even a tiny amount more than the market price, it will be unable to make any sales. In a perfectly competitive market there are thousands of sellers, easy entry, and identical products. A short-run production period is when firms are producing with some fixed inputs. Long-run equilibrium in a perfectly competitive industry occurs after all firms have entered and exited the industry and seller profits are driven to zero.
Perfect competition means that there are many sellers, there is easy entry and exiting of firms, products are identical from one seller to another, and sellers are price takers.
How Perfectly Competitive Firms Make Output Decisions
As a perfectly competitive firm produces a greater quantity of output, its total revenue steadily increases at a constant rate determined by the given market price. Profits will be highest (or losses will be smallest) at the quantity of output where total revenues exceed total costs by the greatest amount (or where total revenues fall short of total costs by the smallest amount). Alternatively, profits will be highest where marginal revenue, which is price for a perfectly competitive firm, is equal to marginal cost. If the market price faced by a perfectly competitive firm is above average cost at the profit-maximizing quantity of output, then the firm is making profits. If the market price is below average cost at the profit-maximizing quantity of output, then the firm is making losses.
If the market price is equal to average cost at the profit-maximizing level of output, then the firm is making zero profits. The point where the marginal cost curve crosses the average cost curve, at the minimum of the average cost curve, is called the “zero profit point". If the market price faced by a perfectly competitive firm is below average variable cost at the profit-maximizing quantity of output, then the firm should shut down operations immediately. If the market price faced by a perfectly competitive firm is above average variable cost, but below average cost, then the firm should continue producing in the short run, but exit in the long run. The point where the marginal cost curve crosses the average variable cost curve is called the shutdown point.
Entry and Exit Decisions in the Long Run
In the long run, firms will respond to profits through a process of entry, where existing firms expand output and new firms enter the market. Conversely, firms will react to losses in the long run through a process of exit, in which existing firms reduce output or cease production altogether. Through the process of entry in response to profits and exit in response to losses, the price level in a perfectly competitive market will move toward the zero-profit point, where the marginal cost curve crosses the AC curve, at the minimum of the average cost curve.
The long-run supply curve shows the long-run output supplied by firms in three different types of industries: constant cost, increasing cost, and decreasing cost.
Efficiency in Perfectly Competitive Markets
Long-run equilibrium in perfectly competitive markets meets two important conditions: allocative efficiency and productive efficiency. These two conditions have important implications. First, resources are allocated to their best alternative use. Second, they provide the maximum satisfaction attainable by society.