8.1: Perfect Competition and Why It Matters
Firms in a perfectly competitive market are said to be “price takers”—that is, once the market determines an equilibrium price for the product, firms must accept this price. If you sell a product in a perfectly competitive market, but you are not happy with its price, would you raise the price, even by a cent?
Would independent trucking fit the characteristics of a perfectly competitive industry?
A single firm in a perfectly competitive market is relatively small compared to the rest of the market. What does this mean? How “small” is “small”?
What are the four basic assumptions of perfect competition? Explain in words what they imply for a perfectly competitive firm.
What is a “price taker” firm?
Critical Thinking Questions
Finding a life partner is a complicated process that may take many years. It is hard to think of this process as being part of a very complex market, with a demand and a supply for partners. Think about how this market works and some of its characteristics, such as search costs. Would you consider it a perfectly competitive market?
Can you name five examples of perfectly competitive markets? Why or why not?
No, you would not raise the price. Your product is exactly the same as the product of the many other firms in the market. If your price is greater than that of your competitors, then your customers would switch to them and stop buying from you. You would lose all your sales.
Possibly. Independent truckers are by definition small and numerous. All that is required to get into the business is a truck (not an inexpensive asset, though) and a commercial driver’s license. To exit, one need only sell the truck. All trucks are essentially the same, providing transportation from point A to point B. (We’re assuming we not talking about specialized trucks.) Independent truckers must take the going rate for their service, so independent trucking does seem to have most of the characteristics of perfect competition.
8.2: How Perfectly Competitive Firms Make Output Decisions
Look at Table below. What would happen to the firm’s profits if the market price increases to \($6\) per pack of raspberries?
|Quantity||Total Cost||Fixed Cost||Variable Cost||Total Revenue||Profit|
Suppose that the market price increases to \($6\), as shown in Table below. What would happen to the profit-maximizing output level?
|Quantity||Total Cost||Fixed Cost||Variable Cost||Marginal Cost||Total Revenue||Marginal Revenue|
Explain in words why a profit-maximizing firm will not choose to produce at a quantity where marginal cost exceeds marginal revenue.
A firm’s marginal cost curve above the average variable cost curve is equal to the firm’s individual supply curve. This means that every time a firm receives a price from the market it will be willing to supply the amount of output where the price equals marginal cost. What happens to the firm’s individual supply curve if marginal costs increase?
How does a perfectly competitive firm decide what price to charge?
What prevents a perfectly competitive firm from seeking higher profits by increasing the price that it charges?
How does a perfectly competitive firm calculate total revenue?
Briefly explain the reason for the shape of a marginal revenue curve for a perfectly competitive firm.
What two rules does a perfectly competitive firm apply to determine its profit-maximizing quantity of output?
How does the average cost curve help to show whether a firm is making profits or losses?
What two lines on a cost curve diagram intersect at the zero-profit point?
Should a firm shut down immediately if it is making losses?
How does the average variable cost curve help a firm know whether it should shut down immediately?
What two lines on a cost curve diagram intersect at the shutdown point?
Critical Thinking Questions
Your company operates in a perfectly competitive market. You have been told that advertising can help you increase your sales in the short run. Would you create an aggressive advertising campaign for your product?
Since a perfectly competitive firm can sell as much as it wishes at the market price, why can the firm not simply increase its profits by selling an extremely high quantity?
The AAA Aquarium Co. sells aquariums for \(\$20\) each. Fixed costs of production are \(\$20\). The total variable costs are \(\$20\) for one aquarium, \(\$25\) for two units, \(\$35\) for the three units, \(\$50\) for four units, and \(\$80\) for five units. In the form of a table, calculate total revenue, marginal revenue, total cost, and marginal cost for each output level (one to five units). What is the profit-maximizing quantity of output? On one diagram, sketch the total revenue and total cost curves. On another diagram, sketch the marginal revenue and marginal cost curves.
Perfectly competitive firm Doggies Paradise Inc. sells winter coats for dogs. Dog coats sell for \(\$72\) each. The fixed costs of production are \(\$100\). The total variable costs are \(\$64\) for one unit, \(\$84\) for two units, \(\$114\) for three units, \(\$184\) for four units, and \(\$270\) for five units. In the form of a table, calculate total revenue, marginal revenue, total cost and marginal cost for each output level (one to five units). On one diagram, sketch the total revenue and total cost curves. On another diagram, sketch the marginal revenue and marginal cost curves. What is the profit maximizing quantity?
A computer company produces affordable, easy-to-use home computer systems and has fixed costs of \(\$250\). The marginal cost of producing computers is \(\$700\) for the first computer, \(\$250\) for the second, \(\$300\) for the third, \(\$350\) for the fourth, \(\$400\) for the fifth, \(\$450\) for the sixth, and \(\$500\) for the seventh.
- Create a table that shows the company’s output, total cost, marginal cost, average cost, variable cost, and average variable cost.
- At what price is the zero-profit point? At what price is the shutdown point?
- If the company sells the computers for \(\$500\), is it making a profit or a loss? How big is the profit or loss? Sketch a graph with \(AC\), \(MC\), and \(AVC\) curves to illustrate your answer and show the profit or loss.
- If the firm sells the computers for \(\$300\), is it making a profit or a loss? How big is the profit or loss? Sketch a graph with \(AC\), \(MC\), and \(AVC\) curves to illustrate your answer and show the profit or loss.
Holding total cost constant, profits at every output level would increase.
When the market price increases, marginal revenue increases. The firm would then increase production up to the point where the new price equals marginal cost, at a quantity of \(90\).
If marginal costs exceeds marginal revenue, then the firm will reduce its profits for every additional unit of output it produces. Profit would be greatest if it reduces output to where \(MR = MC\).
The firm will be willing to supply fewer units at every price level. In other words, the firm’s individual supply curve decreases and shifts to the left.
8.3: Entry and Exit Decisions in the Long Run
If new technology in a perfectly competitive market brings about a substantial reduction in costs of production, how will this affect the market?
A market in perfect competition is in long-run equilibrium. What happens to the market if labor unions are able to increase wages for workers?
Why does entry occur?
Why does exit occur?
Do entry and exit occur in the short run, the long run, both, or neither?
What price will a perfectly competitive firm end up charging in the long run? Why?
Critical Thinking Questions
Many firms in the United States file for bankruptcy every year, yet they still continue operating. Why would they do this instead of completely shutting down?
Why will profits for firms in a perfectly competitive industry tend to vanish in the long run?
Why will losses for firms in a perfectly competitive industry tend to vanish in the long run?
With a technological improvement that brings about a reduction in costs of production, an adjustment process will take place in the market. The technological improvement will result in an increase in supply curves, by individual firms and at the market level. The existing firms will experience higher profits for a while, which will attract other firms into the market. This entry process will stop whenever the market supply increases enough (both by existing and new firms) so profits are driven back to zero.
When wages increase, costs of production increase. Some firms would now be making economic losses and would shut down. The supply curve then starts shifting to the left, pushing the market price up. This process ends when all firms remaining in the market earn zero economic profits. The result is a contraction in the output produced in the market.
8.4: Efficiency in Perfectly Competitive Markets
Productive efficiency and allocative efficiency are two concepts achieved in the long run in a perfectly competitive market. These are the two reasons why we call them “perfect.” How would you use these two concepts to analyze other market structures and label them “imperfect?”
Explain how the profit-maximizing rule of setting \(P = MC\) leads a perfectly competitive market to be allocatively efficient.
Will a perfectly competitive market display productive efficiency? Why or why not?
Will a perfectly competitive market display allocative efficiency? Why or why not?
Critical Thinking Questions
Assuming that the market for cigarettes is in perfect competition, what does allocative and productive efficiency imply in this case? What does it not imply?
In the argument for why perfect competition is allocatively efficient, the price that people are willing to pay represents the gains to society and the marginal cost to the firm represents the costs to society. Can you think of some social costs or issues that are not included in the marginal cost to the firm? Or some social gains that are not included in what people pay for a good?
Perfect competition is considered to be “perfect” because both allocative and productive efficiency are met at the same time in a long-run equilibrium. If a market structure results in long-run equilibrium that does not minimize average total costs and/or does not charge a price equal to marginal cost, then either allocative or productive (or both) efficiencies are not met, and therefore the market cannot be labeled “perfect.”
Think of the market price as representing the gain to society from a purchase, since it represents what someone is willing to pay. Think of the marginal cost as representing the cost to society from making the last unit of a good. If \(P > MC\), then the benefits from producing more of a good exceed the costs, and society would gain from producing more of the good. If \(P < MC\), then the social costs of producing the marginal good exceed the social benefits, and society should produce less of the good. Only if \(P = MC\), the rule applied by a profit-maximizing perfectly competitive firm, will society’s costs and benefits be in balance. This choice will be the option that brings the greatest overall benefit to society.