Chapter 9: Perfect Competition

Key Point 5

At perfectly competitive equilibrium, P=AC=MC=MR=LR. This condition describes the ideal allocative efficiency of perfect competition, to which other market structures are compared. From a society's perspective, nothing can be done to improve the allocation of scarce resources.

Karl is a soybean farmer. If his firm is in perfect competition, he should be able to sell any amount of his soybeans at ...

At the market-clearing price If the perfectly competitive firm wants to sell any of its output, it must sell at the market-clearing price. If the firm sets a higher price, none of its output will be sold, because buyers can purchase an identical product at the lower market price elsewhere. Furthermore, it does not make sense to sell below the market price, because the firm can sell all it produces at the market price.

Key Point 2

A firm in a perfectly competitive market faces a perfectly elastic demand curve at the price determined by equilibrium in the market. The firm's short-run supply curve is the same as its short-run marginal cost curve.

Price Taker

A seller (or buyer) in perfect competition that has no influence on price and can sell (or buy) any amount at the market-clearing price.

Suppose that, in a perfectly competitive industry, demand increases, which attracts new firms into the industry. The original equilibrium price was $19.06; the new equilibrium price is $21.15. What type of industry is this now?

An increasing cost industry In the perfectly competitive model, it is logical to assume that as an industry's equilibrium price increases with the entry of new firms, the industry becomes an increasing cost industry.

True or False: A firm in perfect competition is referred to as a price maker because it can set the price for that product.

FALSE. A firm in perfect competition is referred to as a price taker because it must take, or accept, whatever the market price is. A perfectly competitive firm is small relative to the total market, and its product is the same as that of other firms, so it takes the market price.

True or False: A free market is an industry that is free of significant competition.

FALSE. A free market is a market that is free of government regulation. It is an economic system in which prices are determined by unrestricted competition among privately owned businesses.

What does P=AC=MC=MR=LR represent?

Ideal allocative efficiency Perfectly competitive equilibrium At perfectly competitive equilibrium, P=AC=MC=MR=LR. This condition describes the ideal allocative efficiency of perfect competition, to which other market structures are compared.

Key Point 4

Long-run adjustments to changes in market demand are dependent on the cost characteristics for the industry. Since entry is easy, additional firms will enter an industry as long as economic profits are present. Thus, economics profits, brought about by an increase in demand, will lead to new entry. An industry can be characterized by constant, increasing, or decreasing costs. The slope of the long-run market supply curve will depend on which of these cost situations prevails.

Key Point 1

Perfect competition is characterized by large numbers of buyers and sellers, homogeneous products, ease of entry into and exit out of the industry, perfect knowledge, and mobility of resources. Profits are the force that drives the perfectly competitive model to efficiency. The firm is seeking not efficiency, but profits. This search for profits produces the efficiency that characterizes the model of perfect competition. Large numbers of buyers in a perfectly competitive market ensure that no single buyer can influence price.

A firm in a perfectly competitive market faces a(n) ... demand curve at the price determined by equilibrium in the market.

Perfectly elastic A firm in a perfectly competitive market faces a perfectly elastic demand curve at the price determined by equilibrium in the market. Also, the firm's short-run supply curve is the same as its short-run marginal cost curve.

Which of the following scenarios BEST represents the concept of perfect knowledge?

Roger reads the Yelp comments about his competitor's artisan ice cream. One of the six basic assumptions of the perfect competition model is perfect knowledge. This means that knowledge - such as information about sellers, prices, and costs - is freely available to all individuals and firms. In this case, Roger monitoring his competition's online Yelp comments is an example of perfect (available) knowledge.

In a perfectly competitive firm, all else being equal, if price is $9.94 and average variable cost is $9.95, what should the firm do?

Shut down and pay the total fixed costs of production In a perfectly competitive firm if price is $9.94 and average variable cost is $9.95, the firm has reached its shutdown point. In the short run, when price falls below average variable cost, the firm should shut down in order to minimize losses, pay its total fixed costs (rent, insurance), and cease production.

What is the term for the minimum, or low point, on the AVC curve where it intersects the MC curve?

Shutdown point If price falls below that point, the firm should shut down and minimize its losses by producing zero output.

Key Point 3

Since the firm will shut down when price falls below average variable cost, the actual short-run supply curve is the marginal cost (MC) curve about the minimum point on the average variable cost (AVC) curve. This point of intersection is known as the shutdown point.

True or False: In the long run, when cost curves do not change as an industry expands or contracts, the industry is characterized by constant costs.

TRUE. An industry can be characterized by constant, increasing, or decreasing costs. In the long run, when cost curves do not change as an industry expands or contracts, the industry is characterized by constant costs. The slope of the long-run market supply curve will depend on which of these cost situations prevails.

True or False: If prices fall below a firm's shutdown point, the firm can stem its losses by ceasing production.

TRUE. If prices fall below a firm's shutdown point, the firm loses less by ceasing production - even temporarily, as in the case of seasonal businesses such as ski lodges. If a firm is not a seasonal business, then ceasing production and paying only necessary fixed costs (e.g., rent) is best until a long-run decision is made.

True or False: In the model of perfect competition, firms and their industry are driven to equilibrium at zero economic growth.

TRUE. The nature of perfect competition is such that firms and their industry are driven to equilibrium at zero economic growth. In other words, the industry is in long-run equilibrium when no economic forces are working to cause it to expand or contract (or to cause the price to change).

Market Power

The ability of buyers or sellers to affect price.

On what are long-run adjustments to changes in market demand dependent?

The cost characteristics for the industry Long-run adjustments to changes in market demand are dependent on the cost characteristics for the industry. An industry can be characterized by constant, increasing, or decreasing costs. The slope of the long-run market supply curve will depend on which of these cost situations prevails.

Perfect Competition

The market structure in which there are many sellers and buyers, firms produce a homogeneous product, and there is free entry into and exit out of the industry.

Shutdown Point

The minimum point on the average variable cost (AVC) curve, or the level of output at which a firm minimizes its losses by ceasing operation.

Breakeven Point

The point at which the firm is making only a normal rate of return.

Which of the following is NOT a basic assumption about the model of perfect competition?

There are a limited number of buyers. The six basic assumptions about the model of perfect competition are (1) there are many sellers; (2) there are many buyers; (3) there is a homogenous product; (4) there is perfect knowledge (transparency); (5) there is free entry into and free exit out of the industry; and (6) resources move freely.

Which of the following statements does NOT describe long-run equilibrium under perfect competition?

This is an ideal opportunity for equal growth and change among the perfect competitors. In long-run equilibrium, a firm has no further opportunities to improve or to enhance profitability; any larger or smaller physical operations or production levels would be non-optimal and would result in economic losses; and only the least cost, most efficient firms will survive in a perfect competition.