What do you remember about perfect competition?
I mean, how would you recognize a perfectly competitive industry if you ran across one?
In perfect competition, 1) there are a large number of sellers (there are a large number
of buyers too, but we won't be worrying about that just now).
No individual is large enough to affect the market.
2) the product is homogeneous, or identical, or non-differentiated.
For example, milk.
When you go to buy 2% milk at the supermarket, what brand do you buy?
If you're like me, you buy whatever's on sale.
I have no brand loyalty whatsoever, because milk is milk.
3) There's perfect information.
It's actually not enough for products to be identical; everyone has to know that the products
are identical.
Otherwise, we can be fooled by things like pretty packaging, or celebrity endorsements.
In a perfectly competitive industry, firm versus firm advertising is useless.
All you'd be doing is driving up your own costs, and then customers would just buy from
a cheaper competitor.
However, you may see industry-wide advertising, like a “Got milk?”
campaign, “pork, the other white meat,” or “beef -- it's what's for dinner.”
These kinds of campaigns raise demand for each firm's product across the industry.
4) Easy entry and exit.
Because firms can enter and exit the industry at will, long-term profits would be affected,
but we'll get to that in just a bit.
For the individual firm owner, the combined effect of these characteristics is that he/she
has no power to control price, and will earn zero economic profit in the long run.
Let me ask you this: If the individual firm cannot set the price, then where does the
price come from?
Think back to our market activity earlier in the semester: in a market with lots of
buyers and sellers, the price is determined collectively by the market supply and market
demand.
This, then, is the prevailing price for each firm.
What happens if the firm doesn't like this price?
If it tries to charge more than P*, all of the customers will go someplace else.
So, the firm would be forced back down to P*.
If it tries to charge less than P*, then all customers in the industry will come to this
firm.
Sounds good, right?
Wrong.
This firm cannot accommodate the entire industry demand -- costs would skyrocket, and the firm
would be forced back up to P* to get rid of some of the customers.
All of this means that the firm is a price taker, forced to accept P*, the market-determined
equilibrium price.
Note that this also means, because the firm charges P* regardless of the quantity demanded,
that P* represents the firm's demand, as well.
Remember that perfectly elastic demand curve from earlier this semester, where consumers
are so hypersensitive to price that price is all that matters?
Well that's this market structure.
OK, so -- you’re producer in a perfectly competitive market, and you have no control
over the price that you can charge.
Is there anything you do have control over, that you can make decisions about?
A perfectly competitive firm may not be able to choose its price, but it can choose how
much output to produce.
The firm owner will choose the level of output that will maximize his/her profits (see episode
26B to see why marginal revenue equals marginal cost will always be the profit maximizing
rule).
So – you’re a firm owner in a perfectly competitive industry, you can’t choose the
price that you charge, but you can select the amount of output that you produce.
In order to maximize profit, you will always choose the level of output were marginal revenue
equals marginal cost.
Take a look at the perfectly competitive firm and see where this occurs.
Hmmm…
I need to choose output such that marginal revenue equals marginal cost, but right now
I don't see marginal revenue OR marginal cost!
Let’s start with marginal revenue.
Marginal revenue is the additional revenue that you earn when you sell an additional
unit of output.
For a perfectly competitive firm, since all units are sold for the same price, each unit
sold always adds the same amount of revenue, P*.
For example, if price is $5, then the total revenue for zero units is $0, for one unit
is $5, for two units is $10, and so on.
Selling one more unit generates five additional dollars of revenue each time.
Therefore marginal revenue is equal to the equilibrium price.
Note that this is only true for perfect competition.
What about marginal cost?
Well, marginal cost is actually pretty easy -- we constructed the cost curves, marginal
cost included, before knowing anything about market structures.
Those cost curves in the same regardless of the structure we’re operating in.
This means that the marginal cost for the perfectly competitive firm is just… marginal
cost (remember that J-shaped, Nike-swish thing), and now all we need to do is select the level
of output were marginal revenue equals marginal cost.
Now, because there are no average cost curves in this diagram yet, I can't actually show
you how large or small the profits are; only that q* will be the best level of output for
this particular producer, based on the profit-maximizing rule.
Let's look at just one example of how to find profit using this model, then we’ll do more
cases in class.
What if my perfectly competitive producer is operating in an industry where price is
greater than the cost per unit?
I can already tell that this producer will be making profits, since there's more coming
in for each unit than there is being paid out in cost, but let's see what it looks like.
Notice that I positioned the average cost curves below the price line.
Where is MR = MC?
This gives me q*.
At q*, what is the total revenue coming in?
Revenue is the price I can charge times the number of units that I sell.
In this case, the green area.
At q*, what's the total cost of producing this output?
It’s the cost per unit, ATC, times the number of units I sell -- in this case the red area.
The amount of revenue (in green) that doesn't get chewed up by the costs (in red) is profit.
In this case, I’ve indicated profit by the blue area.
In the short run, this producer earns positive profits.
Why do I say “in the short run”?
Because those short run profits attract the sharks -- other outside firms see the profits
and enter the industry to set up shop.
This causes industry supply increase, driving the price downward.
In the end, the entry only stops when there are no more profits to attract the sharks;
until price is equal to average total cost, and the firms just break even.
In the long run, a perfectly competitive firm's profits are always equal to zero.
NEXT TIME: Monopoly TRANSCRIPT00(MICRO) EPISODE 26: PERFECT COMPETITION