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Economics 2

Lecture 23 - Perfect Competition

characteristics of a perfectly competitive market
demand curve facing a perfect competitor
what does the MR curve look like for a perfect competitor?
profit maximization
the shutdown decision
firm's short-run supply curve
zero long run profits

Charcteristics of a Perfectly Competitive Market

1. many buyers and sellers
2. identical product
3. free entry and exit
4. perfect information

Demand Curve Facing a Perfect Competitor

The market price in a perfectly competitive market is determined by the market supply and demand curves. An individual firm in that market cannot charge more than the market price and will not charge less. So, the demand curve facing an individual firm is horizontal at the market price, that is, it is perfectly elastic.

What Does the MR Curve look like for a Perfect Competitor?

A firm maximizes profits by producing where MR=MC. For a perfectly competitive firm, the marginal revenue curve is the same as the demand curve.

 Q	P	TR	MR

 0           $1            $0
 1	1	 1	$1
 2	1	 2	 1
 3	1	 3	 1
 4	1	 4	 1

Profit Maximization

A perfect competitive firm faces a perfectly elastic demand curve at the market price.

A perfectly competitive firm can generate profits or losses in the short run.

The Shutdown Decision

In the short-run, certain costs, such as rent on land and equipment, must be paid whether or not any output is produced. These are the firm's fixed costs. When the firm is deciding whether or not to produce any output at all (the level of output is given by MR=MC), the firm looks only at its variable costs. The firm will produce if it can earn sufficient revenue to pay the variable costs.

• produce if TR > TVC (if P > AVC)
• shutdown if TR < TVC (if P < AVC)

Firm's Short-Run Supply Curve

The short-run supply curve of a perfectly competitive firm is the portion of its Marginal Cost curve above the Average Variable Cost curve.

Zero Long Run Profits

In the long-run, firms can enter and exit the industry. Economic profits will encourage firms to enter the industry. The increase in the number of sellers will increase supply and cause the market price to fall until the profits disappear. Firms will leave the industry when economic losses are being incurred. The decrease in the number of sellers decreases supply and causes the price to rise until the losses vanish. In the long run, firms in a perfectly competitive market earn zero economic profit. Also, in the long run, the price in a perfectly competitive market will equal the minimum of long-run average costs. Firms will be producing the good at the least cost. Therefore, perfect competition results in economic efficiency.

David A. Latzko Business and Economics Division Pennsylvania State University, York Campus office: 13 Main Classroom Building phone: (717) 771-4115 fax: (717) 771-4062 DXL31@psu.edu www.yk.psu.edu/~dxl31