ECON 356 - Outline Twelve
The Model of Perfect Competition
This model was first introduced in the 1930s -- and although has been heavily criticized, remains in the mainstream textbooks. There are parts of the model that simply carry the theory we have been discussing forward to derive the short run supply curve for a firm - which we will do. But the theory in general came to be known as "the theory of competition" (and also monopoly) that supported and lead to the creation of government policy. We will discuss and understand the model -- and then critique it.
The Model
The model first assumes that firms are seeking monetary profit.
The Four Conditions for Perfect Competition
1. Firms sell a standardized (or homogeneous) product:
2. Firms are "price takers" - the market price is given to every individual firm. Therefore, the idea is that there are many small firms, none of which have any influence on price because they are all so small. Any firm that changes its price and has an effect on the market is considered to have "monopoly power" and we are no longer in the situation of "perfect competition":
3. Factors of production are perfectly mobile in the long run (free or costless exit and entry in all industries):
4. Firms and consumers have perfect information:
As you can see -- none of the conditions of perfect competition are ever met in the real world. They are all unrealistic assumptions about a supposed "ideal" situation. More on this later.
The Short Run Condition for Profit Maximization
Profit = Total Revenue - Total Costs (where costs include opportunity costs)
Therefore, a firm wants to maximize the difference between total revenue and total costs (when total revenue is higher) -- or if it is losing money, to minimize these losses.
Total Revenue (remember, all firms are price takers -- selling at the exact same price -- and all products are sold for that price)
So total revenue = Price x Quantity (price is constant)
Total Cost (remember the total cost curve takes on the shape of the VC curve -- it is VC plus FC)
Therefore GRAPH
Profit is maximized at the point of output where the distance between the two curves is maximized.
So how do we find that point? The short run profit maximization (or loss minimization) rule (providing price is greater than AVC - more on this later) is that we will produce at the output level where Marginal Revenue = Marginal Cost when marginal cost is rising. This will give us the point relating to the one above (TR - TC is max).
Marginal Revenue: Change in total revenue due to a change in output sold.
Remember -- if every good is sold for the same price, then the marginal revenue = P and it is also = Average Revenue
Example: If Q = 100, P = $10
Total Revenue = P x Q = $1,000
Average Revenue = TR/Q = $1,000/100 = $10
Marginal Revenue = Change in TR/Change in Q = $10/1 = $10
So let's graph the marginal revenue and marginal cost curves and find our profit maximizing level of output:
GRAPH
Note that the profit is maximized only if the price (MR) equals MC on the rising portion of the marginal cost curve. Why?
The Short Run Shut Down Condition
Although our rule above applies to a firm losing money (loss minimization) -- there is a point where the firm will shut down even in the short run (and simply let the capital assets sit idle until they can be sold off in the long run).
When will the firm shut down in the short run? When its price will not even cover average variable costs (or total revenue does not cover total variable costs). Why?
Example:
If the price = $10 (which is also AR) and the firms ATC (per unit cost) = $12, the firm is losing money. Assuming Q = 100, then
TR = $1,000, TC = $1,200, loss = $200.
But the firm might keep operating even in this situation. Why? Because it is losing less than if it shut down. Let's break up our ATC into average variable and average fixed costs.
If AFC = $4 and AVC = $8 then the firm would still operate in the short run. It is earning $10 per unit -- enough to cover the $8 AVC, which it would not have if it didn't operate, and have $2 to put towards its AFC -- so it is only losing $2 per unit, or $200. If it shuts down, it will lose $400.
If the price in our example fell to $7, however, then the firm would shut down. Why? Because the $7 does not even cover the AVC that it has when operating -- so the firm is losing $1 on the AVC and still has its $4 AFC -- so it is losing a total of $500.
If it shut down -- it would not have any revenue, but only its Fixed Costs to cover -- so it would be losing $400. It should shut down.
The Short Run Firm Supply Curve
So now we can derive the firm's short run supply curve. Since the firm will operate (if it operates) where MR = MC, then as the price (MR) changes, it will operate along the MC curve:
GRAPH
But remember, the firm must cover its AVC, or it might as well shut down -- since it will lose more money if it operates.
So the short run supply curve for a firm is the MC curve everywhere above the AVC curve - since it will stop operating once the price (MR) falls below AVC.
GRAPH
The Short Run Industry Supply Curve
As with demand, to get the industry supply curve we simply add up the firm's supply curves horizontally.
GRAPH
Short Run Competitive Equilibrium
So we have seen that in this model the firm chooses the most profitable output level given a certain market price. So where does the price come from exactly? The market -- the intersection of the the market supply and demand curves.
So the firm takes that price as given and then chooses where to operate. Let's first assume that the firm is making a zero economic profit:
ZERO ECONOMIC PROFIT at a price of $10 and output level = 100, :
GRAPHS (both the market and firm)
Note that the ATC curve is tangent at the level of output where MR = MC.
Now let's assume that the price goes up to $12 -- because of changes in market supply and/or demand:
POSITIVE ECONOMIC PROFIT at a price of $12:
GRAPHS (both the market and firm)
Where is the positive economic profit (above normal rate of return) on the graph? How much is it? Can you put this in total revenue - total cost terms?
Now let's assume that the price drops to $8 -- again because of changes in market supply and/or demand:
ECONOMIC LOSS at a price of $8:
GRAPH (both the market and the firm)
Where is the economic loss on the graph? How much is it? Can you put this in total revenue - total cost terms?
Adjustments in the Long Run
By definition, an equilibrium is a place where if we are there, there is no reason to move from there, if we are not there, we will try to get there.
Hence -- once there, there is no reason for action (it is a place of perfect information and no action).
So as the market moves from one equilibrium to the next (and price changes) -- individual firms either lose or gain. When this happens -- due to our assumptions of perfect information and costless exit and entry of resources -- firms will move in and out of markets in response to changes in market prices and the profits and losses that come from those price changes. Everything else, of course, is held constant.
CASE ONE - ECONOMIC PROFIT - Assume the firms in the industry are making an economic profit. What will happen in this market? Remember the assumption in the model -- free exit and entry of resources and perfect information.
ENTRY - GRAPH (both the market and the firm)
So firms will enter the industry until firms in this industry (all the same remember) are making a normal rate of return (zero economic profit).
CASE TWO - ECONOMIC LOSS - Assume the firms in the industry are making an economic loss. What will happen in this market? Remember the assumption in the model -- free exit and entry of resources and perfect information.
EXIT - GRAPH (both the market and the firm)
So firms will exit the industry until firms in this industry (all the same remember) are making a normal rate of return (zero economic profit).
Efficiency in the Model of Perfect Competition
Why is this considered "perfect" competition? Why is this an "ideal" situation theoretically? Because the long run equilibrium situation is considered to be "efficient" in this model. Why - and how is efficiency defined?
Allocative efficiency:
No reason for the resources to move from long run equilibrium. Remember - zero economic profit - just making the firm's opportunity cost (can't do better).
Productive efficiency:
Producing at the minimum point on the ATC curve.