Perfect Competition in the Long Run

You got to know when to hold 'em, know when to fold 'em,Know when to walk away and know when to run.

-Kenny Rogers

Slide 1 of 19

Recall the characteristics of perfect competition

Perfect Competition Monopolistic Competition Oligopoly Duopoly Monopoly

At the absolute end of this spectrum, competition is fierce.

Characteristics of perfect competition:

Product is homogeneous

This means that each producer makes a very similar product. Examples include blue crab

fisherman and wheat farmers, whose good are similar.There are many, many buyers and sellers

and each firm constitutes a very small fraction of the market

Firms have no control over price

There are no barriers to entry

This means that producers have no impact on the market. If they decide not to produce, market

prices don’t change.

Examples include roadside farmers markets.

This means that producers take the market price for their goods. They do not have enough power

to influence it.

Examples include tomato farmers and fishermen.

This means that anyone can easily engage in this activity. You

could become a fisherman tomorrow if you wanted. It

doesn’t mean you’ll succeed, but you can do it.

Market Structure Overview

Slide 2 of 19

This module: We’ll analyze perfectly competitive firms in the long run

Perfect Competition Monopolistic Competition Oligopoly Duopoly Monopoly

PerfectCompetition

This is the topic of the

next module.

Then we’ll discuss all the firms in the middle in Module 11.

In this module, we’ll explore these firms in

the long run.

Slide 3 of 19

In the long run…things can change!

In the previous module, we learned how Joe, our perfectly competitive catfish farmer maximized his

profit in the short run.

Because he was a price taker, he took the price that the market gave him…that was $131 per unit in our

example.

Over time (in the long run) however, prices can change (as can many other things).

For example, what if a report came out stating that catfish was harmful to health? Price would fall.

Slide 4 of 19

Let’s look at two scenarios

In the first scenario, we’ll assume that catfish prices fall drastically…perhaps to $71 per unit.

We can use the MR=MC rule to determine Joe’s profit maximizing rate of output at that new price

and see what kind of profit Joe will earn.

We can then see if it is worthwhile for Joe to operate at this lower price. Perhaps he should

just go out of business.

We’ll call that analysis the “Shut Down Decision”.

MR=MC

Slide 5 of 19

Scenario #1: What if prices for catfish fell to $71?

Recall, Joe was selling catfish at $131 per bushel.

What if prices fell to $71. What is Joe’s profit maximizing output

PerfectCompetition

Slide 6 of 19

What if prices for catfish fell?Should Joe shut down?

Using MR>MC would dictate that Joe produce 5 units.

But if Joe produces his profit maximizing rate of output, which is 5 units, his profit is $-115.

It is cheaper to just shut down and lose the $100 in fixed costs!

Joe Should Shut Down!

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In the second scenario, well reduce catfish prices to $81 instead of $71 and repeat

the shut down decision analysis.

Joe definitely does not want to produce the 6th unit…it costs more (MC=$80) than it brings in (MR=$71).

Slide 7 of 19

Scenario 2: What if catfish prices fell instead to $81

Using MR>MC would dictate that Joe produce 6 units.

At that rate of output, profit is $-64.

That beats losing $100 in the short run! That is

called loss minimization!

What if prices fell to $81 instead of $71?

Joe Should not shut down in the short run!

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Slide 8 of 19

Do companies really operate in loss minimization?

Absolutely. They defer maintenance or other costs just trying to hang in there until things turn around.

Failure to upgradeUnsanitary Conditions

Willingness to let parts of facility

deteriorate

Just look for these signs:

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BSanitation

Grade

Slide 9 of 19

It is cheaper for Joe to shut down.

The shut down decision can be seen graphically, too

As long as price (which is MR) is above the AVC, the

perfectly competitive producer should stay open!

Note the new curve! To make a shut down

decision, we need to examine AVC also

Profit

We saw that at a price of $131, there is clearly profit for Joe to make!

LossLoss

At his profit maximizing rate of output (MR=MC at 9 units) MR is well above ATC and AVC!

We saw that at a price of $71,it is time for Joe

to shut down.

At the new profit maximizing rate of

output (MR=MC at 5 units) MR is below ATC

and AVC!

But at a price of $81, it was worthwhile for Joe

to stay open in the short run.

Note that MR>AVC!

At the new profit maximizing rate of

output (MR=MC at 6 units) MR is above

AVC, but below ATC.

At $81 per unit, Joe should not shut down in

the short run. He is engaged in loss minimization!

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Slide 10 of 19

0 Units

-$10Shutdown

No

Individual Exercise: Give the shut down decision a try!

Try filling out these blank cells and then answering the questions below..

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Slide 11 of 19

Perfect Competition from the industry perspective

So far, we have talked about an individual firm’s

perspective.

But remember that all firms collectively become

the supply side of the market.

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Slide 12 of 19

In perfect competition, there is a constant churn of firms entering and exiting the market

In cases where there are no profits to be made, firms go our of business.

In cases where there are profits being made, firms enter the industry to compete.

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Slide 13 of 19

Also recall that individual supply decisions collectively add up to the market supply

Each individual determines their own supply.

Those individual supply curves are added together to get a market supply curve

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Slide 14 of 19

Firm entry and exit affects the overall market

Imagine this represents a market where

perfectly competitive firms

are making profits.

As other business people see profits being

made in this industry, they

open a business and compete.

With more suppliers, the supply curve shifts right.

As more business people

enter the market, the

supply curve moves right even further.

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Slide 15 of 19

Where there are profits, firms enter and drive prices down

Imagine the graph on the left represents a perfectly competitive market and the graph on the right represents cost

and revenue curves for the typical firm in that industry.

Given that there are profits being made, new entrants in the market are lured in. They want to compete in this market to

earn some of the profits.

The entry of new business shifts the market supply curve right and drives prices down. However, there are still profits being

made, which will attract more entrants.

New firms will continue to enter this market until price reaches the lowest point on the Average Total Cost curve. With no profit to be made, no new firms enter and this industry is in

equilibrium.

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Market for Wheat Individual Wheat Producer

Slide 16 of 19

As consumers, we love perfect competition

We as consumers love perfect competition. It provides a mechanism that causes prices to find

the lowest point on the ATC.

In other words, we get these goods for as low a price as they can possibly be produced.

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Slide 17 of 19

A summary of perfect competition in the long run

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The existence of economic profits lures firms to enter.

The existence of economic losses induces firms to exit.

This churning process of firms constantly entering and exiting the market, like the tide of an ocean, is a characteristic of perfect competition

Slide 18 of 19

Churn in perfectly a competitive industry

Here’s a headline and excerpt from a recent article

Note the churning process and the constant drive to finds ways to produce at a lower price.

Keeping Dairy Cows on Pasture Lowers Cost of Milk

Small dairy farmers are going bankrupt by the thousands, largely due to declining milk prices. Keeping the cost of production low is one of the keys to staying solvent.

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Slide 19 of 19