ECO 204
Chapter 8 
PERFECT COMPETITION

Armed with some basic information about both the demand and the supply sides of the market, we can now examine some of the specifics underlying firm decision-making with respect to output and price. How much output should the firm produce? What price should the firm charge?
It begins with an overview of the general question to be answered in Chapters 8-10: How does the structure of the output market affect decisions that a firm makes? Four basic characteristics--the number of sellers, the type of product produced, the ability of competing firms to enter or exit, and the ability of the firm to make price changes--define the type of market in which the firm sells its output. Perfect competition, the topic of Chapter 8 is the most competitive of all structures to be studied. This will be contrasted with monopoly, the least competitive of all structures, in Chapter 9. Although these two chapters detail the extremes, Chapter 10 presents models of firm and market organization that are more applicable to today's market. Government intervention in both perfectly competitive and monopolistic markets often disrupts the predictions made by our models.
Perfect competition is characterized by the existence of many sellers, a homogeneous product, free entry and exit, and perfect information for buyers and sellers. Thus, as far as the individual firm is concerned, the demand curve is perfectly elastic. Although the market demand is downward-sloping, the firm is powerless to affect market price and hence must take the price as given.
To find the profit-maximizing output level for the firm, two methods are used. First, the firm chooses the output level that maximizes the distance between total revenue and total cost. This is defined as optimal as long as revenues are high enough to cover the firm's variable costs of production. Second, the firm chooses the output level where marginal revenue is equal to marginal cost. To determine firm profitability, compare price to average total cost of production. Given this MR = MC decision rule, price = MR and it is obvious that the MC curve (above minimum AVC) represents the firm's supply curve. Industry supply can be found in a manner similar to industry demand, by horizontal summation of the individual firms' supply curves.
OK for the short run, but how about the long run? In a perfectly competitive industry, long-run equilibrium is characterized by the existence of normal profits. If the firm earns just enough to cover its opportunity costs, there is no further incentive for rivals to enter or to exit. In some cases, input prices change in response to entry and exit, so perfectly competitive industries can be classified as constant-cost, increasing-cost, or decreasing-cost industries.
The concluding section of the chapter contains an evaluation of perfect competition. Although it results in efficiency aspects not found with any other market structure, homogeneity of product and the possibility of heavy external costs help to offset its positive aspects. 
Outline
I.      The Structure of Markets

        A.      Various levels of market competition exist
        B.      The four basic characteristics used to define the level of competition in 
                an industry are number of sellers, type of product, ease of entry into the 
                industry, and the firm's influence over price

II.     Perfect Competition

        A.      Characteristics of perfect competition
                1.      There is a large number of buyers and sellers--so many that no single firm can, by itself, affect market supply or demand
                2.      All firms produce a identical product
                3.      There is free entry into and exit out of the industry
                4.      Buyers and sellers have perfect information about market conditions

        B.      These characteristics imply that a firm is a price taker--it has no control over output price
                1.      If the firm raises its price above the market price, it will sell no output, losing all of its customers to competitors                    perfect substitutes
                2.      If the firm lowers its price below the market price, it will sell all of its output at the lower price and reduce its revenue
                3.      Given these conditions, it appears to the individual perfectly competitive firm that the demand curve is perfectly elastic
                        a.      The market demand curve is downward-sloping; that is, the law of demand holds
                        b.      Make a distinction between the market demand curve and the perfectly elastic demand curve used by individual firms 
                                only because it represents the behavior of the buyers

III.    Production in the Short Run

        A.      There are two ways to find the profit-maximizing output level
                1.      Choose the output level that maximizes the difference between total revenue and total cost
                2.      Choose the output level where marginal revenue equals marginal cost (note that MR must cut MC from above for profit to be maximized)
                3.      If TR is less than total variable cost, or if p is less than AVC at the optimal level of output, then the firm should shut down
                B.      To determine firm profitability, compare price with average total cost at the optimal level of output
                1.      If P > ATC, the firm is earning economic profit
                2.      If P = ATC, the firm is earning normal profit
                3.      If P < ATC, the firm is making a loss
                4.      If P < AVC, the firm can minimize its losses by shutting down
        C.      The short-run supply curve of a perfectly competitive firm is the marginal cost curve above minimum AVC
        D.      The industry's short-run supply curve is the horizontal summation of the short-run supply curves for all the firms in the industry

IV.     Long-Run Equilibrium in Perfect Competition

        A.      Long-run equilibrium is a state of balance; that is, firms in an industry have no incentive to change their level of operation, and 
                rivals have no incentive to enter or exit the industry
        
	B.      When the industry is in long-run equilibrium, the following condition holds: P = MR = MC = LRAC min = SRAC min
       
V.      An Evaluation of Perfect Competition

        A.      Some positive aspects of perfect competition
                1.      Firms must produce with maximum efficiency or they will be forced out of the industry
                2.      Resources are allocated to their most productive use as industry profitability causes firms to enter and exit
                3.      Government regulation is not necessary; individuals acting in their own self-interest promote the public interest
        B.      Some negative aspects of perfect competition
                1.      Economies of scale never fully develop because firms remain very small
                2.      Externalities may develop, since firms must keep costs at a minimum
                3.      Innovation is stifled, since firms have no hope of earning long-run economic profits
                4.      Homogeneity of product yields little consumer choice