The assumptions of the model of perfect competition ensure that every decision maker is a price taker—the interaction of demand and supply in the market determines price. Although most firms in real markets have some control over their prices, the model of perfect competition suggests how changes in demand or in production cost will affect price and output in a wide range of real-world cases.
A firm in perfect competition maximizes profit in the short run by producing an output level at which marginal revenue equals marginal cost, provided marginal revenue is at least as great as the minimum value of average variable cost. For a perfectly competitive firm, marginal revenue equals price and average revenue. This implies that the firm’s marginal cost curve is its short-run supply curve for values greater than average variable cost. If price drops below average variable cost, the firm shuts down.
If firms in an industry are earning economic profit, entry by new firms will drive price down until economic profit achieves its long-run equilibrium value of zero. If firms are suffering economic losses, exit by existing firms will continue until price rises to eliminate the losses and economic profits are zero. A long-run equilibrium may be changed by a change in demand or in production cost, which would affect supply. The adjustment to the change in the short run is likely to result in economic profits or losses; these will be eliminated in the long run by entry or by exit.
- Explain how each of the assumptions of perfect competition contributes to the fact that all decision makers in perfect competition are price takers.
- If the assumptions of perfect competition are not likely to be met in the real world, how can the model be of any use?
- Explain the difference between marginal revenue, average revenue, and price in perfect competition.
- Suppose the only way a firm can increase its sales is to lower its price. Is this a perfectly competitive firm? Why or why not?
Consider the following goods and services. Which are the most likely to be produced in a perfectly competitive industry? Which are not? Explain why you made the choices you did, relating your answer to the assumptions of the model of perfect competition.
- Coca-Cola and Pepsi
- Private physicians in your local community
- Government bonds and corporate stocks
- Taxicabs in Lima, Peru—a city that does not restrict entry or the prices drivers can charge
- Explain why an economic profit of zero is acceptable to a firm.
- Explain why a perfectly competitive firm whose average total cost exceeds the market price may continue to operate in the short run. What about the long run?
- You have decided to major in biology rather than computer science. A news report suggests that the salaries of computer science majors are increasing. How does this affect the opportunity cost of your choice?
Explain how each of the following events would affect the marginal cost curves of firms and thus the supply curve in a perfectly competitive market in the short run.
- An increase in wages
- A tax of $1 per unit of output imposed on the seller
- The introduction of cost-cutting technology
- The imposition of an annual license fee of $1,000
- In a perfectly competitive market, who benefits from an event that lowers production costs for firms?
- Dry-cleaning establishments generate a considerable amount of air pollution in producing cleaning services. Suppose these firms are allowed to pollute without restriction and that reducing their pollution would add significantly to their production costs. Who benefits from the fact that they pollute the air? Now suppose the government requires them to reduce their pollution. Who will pay for the cleanup? (Assume dry cleaning is a perfectly competitive industry, and answer these questions from a long-run perspective.)
- The late columnist William F. Buckley, commenting on a strike by the Teamsters Union against UPS in 1997, offered this bit of economic analysis to explain how UPS had succeeded in reducing its average total cost: “UPS has done this by ‘economies of scale.’ Up to a point (where the marginal cost equals the price of the marginal unit), the larger the business, the less the per-unit cost.” Use the concept of economies of scale, together with the information presented in this chapter, to explain the error in Mr. Buckley’s statement (Buckley, W. F., 1997).
- Suppose that a perfectly competitive industry is in long-run equilibrium and experiences an increase in production cost. Who will bear the burden of the increase? Is this fair?
- Economists argue that the ultimate beneficiaries of the efforts of perfectly competitive firms are consumers. In what sense is this the case? Do the owners of perfectly competitive firms derive any long-run benefit from their efforts?
- Explain carefully why a fixed license fee does not shift a firm’s marginal cost curve in the short run. What about the long run?
The graph below provides revenue and cost information for a perfectly competitive firm producing paper clips.
Output Total Revenue Total Variable Cost Total Fixed Cost 1 $1,000 $1,500 $500 2 $2,000 $2,000 $500 3 $3,000 $2,600 $500 4 $4,000 $3,900 $500 5 $5,000 $5,000 $500
- How much are total fixed costs?
- About how much are total variable costs if 5,000 paper clips are produced?
- What is the price of a paper clip?
- What is the average revenue from producing paper clips?
- What is the marginal revenue of producing paper clips?
- Over what output range will this firm earn economic profits?
- Over what output range will this firm incur economic losses?
- What is the slope of the total revenue curve?
- What is the slope of the total cost curve at the profit-maximizing number of paper clips per hour?
- At about how many paper clips per hour do economic profits seem to be at a maximum?
Suppose rocking-chair manufacturing is a perfectly competitive industry in which there are 1,000 identical firms. Each firm’s total cost is related to output per day as follows:
Quantity Total cost Quantity Total cost 0 $500 5 $2,200 1 $1,000 6 $2,700 2 $1,300 7 $3,300 3 $1,500 8 $4,400 4 $1,800
- Prepare a table that shows total variable cost, average total cost, and marginal cost at each level of output.
- Plot the average total cost, average variable cost, and marginal cost curves for a single firm (remember that values for marginal cost are plotted at the midpoint of the respective intervals).
- What is the firm’s supply curve? How many chairs would the firm produce at prices of $350, $450, $550, and $650? (In computing quantities, assume that a firm produces a certain number of completed chairs each day; it does not produce fractions of a chair on any one day.)
Suppose the demand curve in the market for rocking chairs is given by the following table:
Price Quantity of chairs Demanded/day Price Quantity of chairs Demanded/day $650 5,000 $450 7,000 $550 6,000 $350 8,000
Plot the market demand curve for chairs. Compute and plot the market supply curve, using the information you obtained for a single firm in part (c). What is the equilibrium price? The equilibrium quantity?
- Given your solution in part (d), plot the total revenue and total cost curves for a single firm. Does your graph correspond to your solution in part (c)? Explain.
The following table shows the total output, total revenue, total variable cost, and total fixed cost of a firm. What level of output should the firm produce? Should it shut down? Should it exit the industry? Explain.
Output Total revenue Total variable cost Total fixed cost 1 $1,000 $1,500 $500 2 $2,000 $2,000 $500 3 $3,000 $2,600 $500 4 $4,000 $3,900 $500 5 $5,000 $5,000 $500
- Suppose a rise in fuel costs increases the cost of producing oats by $0.50 per bushel. Illustrate graphically how this change will affect the oat market and a single firm in the market in the short run and in the long run.
- Suppose the demand for car washes in Collegetown falls as a result of a cutback in college enrollment. Show graphically how the price and output for the market and for a single firm will be affected in the short run and in the long run. Assume the market is perfectly competitive and that it is initially in long-run equilibrium at a price of $12 per car wash. Assume also that input prices don’t change as the market responds to the change in demand.
Suppose that the market for dry-erase pens is perfectly competitive and that the pens cost $1 each. The industry is in long-run equilibrium. Now suppose that an increase in the cost of ink raises the production cost of the pens by $.25 per pen.
- Using a graph that shows the market as a whole and a typical firm in this market, illustrate the short run effects of the change.
- Is the price likely to rise by $.25? Why or why not?
- If it doesn’t, are firms likely to continue to operate in the short run? Why or why not?
- What is likely to happen in the long run? Illustrate your results with a large, clearly labeled graph.
Buckley, W. F., “Carey Took on ‘Greed’ as His Battle Cry,” The Gazette, 22 August 1997, News 7 (a Universal Press Syndicate column).