Lecture 13: More Perfect Competition

Outline:

1. Short run equilibria for the PC firm

i. Positive economic profits

ii. Normal economic profits

iii. Losses - keep producing

iv. Losses - shut down

2. Supply curve for the PC firm

3. Supply curve for the PC industry

4. Long run equilibrium for the PC firm

i. Importance of freedom of entry and exit

ii. PC firm will earn only normal profits in the LR

5. The appeal of Perfect Competition

1. Short Run equilibria for the PC firm:

GRAPHS - SR profits of the PC firm:

i. Positive Economic Profits:

Step 1: Find q* - the quantity where MR = MC

Step 2: At q* is P > AC?

if YES then the firm is earning positive economic profits

if NO move on

ii. Normal Economic profits:

Step 1: Find q* - the quantity where MR=MC

Step 2: At q* is P=AC?

if YES then the firm is earning zero (normal) economic profits

if NO then move on

iii. Losses - but the firm should keep producing

Step 1: Find q* - the quantity where MR=MC

Step 2: At q* is AVC P < AC?

If YES then the firm is earning losses but should continue to produce in the SR

If NO then move on

iv. Losses - and the firm should shut down

Step 1: Find q* - the quantity where MR=MC

Step 2: At q* P < AVC

Then the firm should shut down immediately

2. Short Run supply curve of the PC firm:

Definition:

The PC firm's supply curve is its MC curve above the AVC

curve.

Question: Why?

At any price: P = MC for the profit maximizing PC firm and since P=MR this also gives the profit maximizing level of output q* - which the firm will produce as long as P>AVC.

Remember: a supply curve is just the amount of output the firm wants to produce at every price.

3. Short Run supply curve of the PC industry:

The SR supply curve for the industry is obtained by summing horizontally over all the supply curves of the individual firms.

Example to illustrate this.

4. Long Run equilibrium for the PC firm:

*Importance of the assumption of freedom of entry and exit:

Q. If PC firms are making positive economic profits in the SR what happens to the industry in the LR?

A. New Firms ENTER the industry - this increases industry SUPPLY and decreases the good's PRICE.

Firms in the industry facing a lower price choose a new q* where:

P=MR=MC=min ATC= min LRAC

Note: Since P=ATC in the LR, PC FIRMS EARN NORMAL (ZERO) ECONOMIC PROFITS IN THE LR

Q. If PC firms are making losses but continuing to produce in the SR what happens to the industry in the LR?

A. Firms EXIT the industry - this decreases industry SUPPLY and increases the good's PRICE.

Firms in the industry facing a higher price choose a new q* where:

P=MR=MC=min ATC=min LRAC

Note: Since P=ATC in the LR, PC FIRMS EARN NORMAL (ZERO) ECONOMIC PROFITS IN THE LR

Question: What is the importance of the assumption of freedom of entry and exit in the LR, for the profits a PC firm can earn in the LR?

6. The appeal of Perfect Competition:

* Think of an economy where all markets are perfectly competitive

* There are thousands of small firms without any power to affect the market - firms simply respond to market signals - they are impersonal in their relationships to one another and to consumers.

* The market works like an "invisible hand" - as consumer tastes change for example - industry demand increases - the price of the good increases - firms respond to the higher price and produce more output and earn positive economic profits in the SR - in the LR new firms are encouraged to enter this market - as they enter industry supply shifts - the price of the good falls - firms respond to the lower price and produce and earn normal economic profits in the LR

* Consumers send a signal that they want more of a good - the firms respond - and because of freedom of entry and exit the price of the good is always as low as possible in the LR - as new firms enter such an industry.

Question: Does the term "perfectly competitive" make more sense now?

* This kind of market is called perfectly competitive because the PRICE of the good is always kept as low as possible in the LR because of the entry and exit of firms into the market.

Question: Why is PC so appealing ?

* Because of the absence of POWER - on the part of firms and on the part of consumers.

Question: Why are people concerned about concentration of economic power?

* The old saying goes - "power corrupts" -- and people are concerned that economic power translates into political power.