Perfect Competition: Structure, Profit Maximization, and Efficiency

Perfect Competition

Introduction to Perfect Competition

Perfect competition is a foundational concept in microeconomics, describing a market structure where many buyers and sellers interact, none of whom can individually influence the market price. Adam Smith's philosophy of the "invisible hand" suggests that self-interested actions by individuals in such markets can lead to outcomes beneficial for society as a whole.

• Self-interest: Individuals are motivated by their own interests, which, in a perfectly competitive market, aligns with societal welfare.

• Invisible hand: Market forces guide resources to their most valued uses without central direction.

Market Structure Classification

Market structure refers to the key traits of a market, including the number of firms, product similarity, and ease of entry/exit. The main types are:

• Pure competition (Perfect competition)

• Monopoly

• Monopolistic competition

• Oligopoly

These structures differ in competitiveness, with perfect competition being the most competitive and monopoly the least.

Analyzing a Market: The 5-Step Procedure

1. Characterize the market.

2. Determine the demand facing the representative firm.

3. Find the profit-maximizing output.

4. Graphically determine short-run profit or loss.

5. Compare short-run and long-run outcomes; assess societal pros and cons.

Conditions for Perfect Competition

When Does Perfect Competition Arise?

• Minimum efficient scale: Each firm is small relative to total market demand, allowing many sellers.

• Homogeneous products: Goods are perfect substitutes; buyers do not differentiate between sellers.

• Example: Soybean markets, where one farmer's soybeans are indistinguishable from another's.

Characteristics of Perfect Competition

• Large number of buyers and sellers: No single participant can influence price.

• Homogeneous product: Buyers are indifferent to the source of the product.

• Price takers: Both buyers and sellers accept the market price.

• Free entry and exit: Resources can move freely in and out of the market.

• Perfect information: All market participants have costless access to information about prices and products.

Demand Curve in Perfect Competition

Firm vs. Market Demand

In a perfectly competitive market, the market demand curve is downward sloping, but the individual firm's demand curve is perfectly elastic (horizontal) at the market price.

• Market price: The price at which the firm can sell any quantity.

• Firm's demand: Horizontal line at the market price.

Profit Maximization in the Short Run

Methods for Finding Profit-Maximizing Output

• Total Revenue minus Total Cost (TR - TC) Method: Find the output level where the difference between total revenue and total cost is maximized.

• Marginal Revenue equals Marginal Cost (MR = MC) Method: Find the output level where marginal revenue equals marginal cost.

Key Terms and Formulas

• Economic profit: $\text{Economic Profit} = \text{Total Revenue} - \text{Total Cost}$

• Opportunity cost: The value of the next best alternative forgone.

• Total revenue: $\text{Total Revenue} = \text{Price} \times \text{Quantity}$

• Marginal revenue: $\text{Marginal Revenue} = \Delta \text{Total Revenue} / \Delta \text{Quantity}$

Example Table: Profit Maximization

Output Quantity	TR	TC	TR-TC	MC	MR
0	0	22	-22	-	-
1	25	45	-20	23	25
2	50	66	-16	21	25
3	75	85	-10	19	25
4	100	100	0	15	25
5	125	114	11	14	25
6	150	126	24	12	25
7	175	141	34	15	25
8	200	160	40	19	25
9	225	183	42	23	25
10	250	210	40	27	25
11	275	245	30	35	25
12	300	300	0	55	25

Graphical Analysis

• Profit is maximized where the vertical distance between TR and TC is greatest.

• Alternatively, profit is maximized where MR = MC.

Profits and Losses in the Short Run

Determining Profit, Normal Profit, and Loss

• Compare market price (P) to average total cost (ATC) at the profit-maximizing output.

• If $P > ATC$, the firm earns economic profit.

• If $P = ATC$, the firm earns normal profit (zero economic profit).

• If $AVC < P < ATC$, the firm incurs a loss but continues to produce.

• If $P < AVC$, the firm shuts down in the short run.

Example Table: Short-Run Profit and Loss

Quantity	MC	FC	TVC	TC	MR	TR	Total Profit
0	-	50	0	50	-	0	-50
1	7	50	12	62	20	20	-42
2	3	50	13	63	25	38	-25
3	5	50	18	68	35	55	-13
4	10	50	20	70	35	70	0
5	8	50	26	76	35	88	12
6	7	50	30	80	35	105	25
7	8	50	36	86	35	125	39

Profit Maximization Rule

MR = MC Rule

A firm maximizes profit by producing the output where marginal revenue equals marginal cost:

• Discrete case: If MR = MC at two quantities, both may maximize profit.

• If no exact equality, produce where MR > MC for the last unit.

Shutdown Decision in the Short Run

When Should a Firm Shut Down?

• Shutting down means producing zero output temporarily, not going out of business.

• If market price < minimum AVC, the firm shuts down and incurs a loss equal to total fixed cost.

• If producing at a price below AVC, the firm incurs additional avoidable losses.

Shutdown Point

• The output and price at which total revenue just covers total variable cost.

• Occurs where AVC is minimized and MC crosses AVC.

• At this point, the firm is indifferent between producing and shutting down.

Summary of Profit Maximization Outcomes

• (1) $P = MR = MC > ATC$: Economic profit.

• (2) $P = MR = MC = ATC$: Zero economic profit (normal profit).

• (3) $AVC < P = MR = MC < ATC$: Loss, but firm continues to produce.

• (4) $P = MR = MC < AVC$: Firm shuts down.

• (5) $P = MR = MC = AVC$: Indifferent between shutting down and producing at a loss equal to total fixed cost.

Short-Run Supply Curve

Firm's Short-Run Supply Curve

• The firm's marginal cost curve above the minimum AVC is its short-run supply curve.

Industry Short-Run Supply Curve

• Derived by horizontally summing all firms' MC curves above their minimum AVC.

• Short-run equilibrium occurs where industry quantity supplied equals quantity demanded.

Long-Run Equilibrium in Perfect Competition

Long-Run Adjustments

• All inputs are variable; no fixed costs.

• Entry and exit of firms drive the market to zero economic profit.

• Long-run equilibrium: $P = MR = MC = SRATC = LRAC$

Industry Cost Structures and Long-Run Supply Curve

• Constant-cost industry: Entry/exit does not affect individual firm costs; long-run supply curve is perfectly elastic (horizontal).

• Decreasing-cost industry: Entry lowers costs due to external economies; long-run supply curve is downward sloping.

• Increasing-cost industry: Entry raises costs due to external diseconomies; long-run supply curve is upward sloping.

Efficiency in Perfect Competition

Resource Allocation and Efficiency

• Resource allocation is efficient when marginal benefit equals marginal cost.

• In competitive equilibrium, if no externalities exist, demand equals marginal social benefit and supply equals marginal social cost.

• Externalities (external benefits or costs) cause market equilibrium to diverge from allocative efficiency.

Summary Table: Profit Maximization Outcomes

Condition	Firm's Outcome
$P = MR = MC > ATC$	Economic profit
$P = MR = MC = ATC$	Normal profit (zero economic profit)
$AVC < P = MR = MC < ATC$	Loss, but firm produces
$P = MR = MC < AVC$	Firm shuts down
$P = MR = MC = AVC$	Indifferent between shutting down and producing

Additional info: These notes expand on the provided slides by including definitions, formulas, and structured tables for clarity and completeness. All equations are presented in LaTeX format for academic rigor.