Perfect Competition: Role of Prices

For a market to be perfectly competitive, one of the main criteria is that all firms (and consumers) are price takers.

The following conditions are also necessary:

1. There must be many buyers and sellers in the market for an identical product. 2. Firms' products are identical. 3. Buyers and sellers must be fully informed about prices, products, and technology. 4. There are no barriers to entry (or exit). 5. Selling firms are profit-maximizing entrepreneurial firms.

The scenario about the ice cream industry depicts a perfectly competitive market.

Buyers view vanilla ice cream from different stores as identical products, new stores can enter the industry, and each store has no influence on the going market price.

In perfect competition, many firms sell identical products to many buyers. Therefore, if Falero charges even slightly more for a box than other firms charge, it will lose all its customers because every other firm in the industry is offering a lower price. In other words, one of Falero's boxes is a perfect substitute for boxes from the factory next door or from any other factory.

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So, a perfectly competitive firm faces a perfectly elastic demand for its output at the current market price.

In this case, the equilibrium market price is $5 per box, so Falero faces a perfectly elastic demand curve for its boxes at $5.

Since a perfectly competitive firm faces a perfectly elastic demand curve at the market price, it can sell any quantity it chooses at this price. Therefore, the change in total revenue that results from a one-unit increase in the quantity sold is equal to the market price, so the marginal revenue curve is a horizontal line at the market price of per box.

Since the demand curve is also a horizontal line at the market price, the demand curve and the marginal revenue curve are the same.

Economic profit equals total revenue minus total cost, so profit is at its maximum when the difference between total revenue and total cost is at its greatest

Economic profit is defined as the difference between total cost and total revenue. At a price of $12,000, a profit-maximizing firm in a perfectly competitive market will produce 4,000 hybrid vehicles per year, since this is the quantity where marginal cost equals the market price (which equals a competitive firm's marginal revenue).

Since profit is the difference between total revenue (TR) and total cost (TC), we can rewrite this expression as:

Profit = TR - TC

Profit = (P x Q) - (ATC x Q)

Profit = (P - ATC) x Q

In this case, profit = ($12,000 per vehicle - $16,000 per vehicle) x 4,000 per vehicle= -$4,000 x 4,000 = -$16,000,000, which is an economic loss. This is the blue shaded area (labeled A) in the graph above.

The firm will produce as long as the market price is above the shutdown price of 10 cents, so the firm's supply curve corresponds to the portion of the marginal cost curve for prices above 10 cents. For example, at 10 cents, the firm will produce 150,000 pairs of socks, so (150, 10) is a point on the firm's supply curve; at 15 cents, the firm will produce 200,000 pairs of socks, so (200, 15) is another point.

For prices below 10 cents, the firm will not produce at all.

The shutdown price of $2 marks the point at which average variable cost is at its minimum. In the short run, when price is below $2, a firm's variable costs exceed its total revenue, so the firm would maximize profits (minimize losses) by shutting down. The break-even price of $4 marks the point at which average total cost is at its minimum. In the long run, when price is below $4, a firm's total costs exceed its total revenue, so the firm would maximize profits (minimize losses) by exiting the market.

In the short run, the individual supply curve for a firm is the portion of the marginal cost curve that corresponds to prices greater than and equal to the shutdown price of $2. In perfect competition, the market supply curve is just the horizontal sum of all the firms' marginal cost curves. At prices below $2, firms will not produce in the short run. At $2, firms will produce a total of 3 yo-yos per firm x 100 firms = 300 yo-yos. Therefore, (300, 2) is a point on the short-run industry supply curve. Similarly, at $3, firms will produce a total of 4 yo-yos per firm x 100 firms = 400 yo-yos. Therefore, (400, 3) is another point on the short-run industry supply curve. Use similar calculations to plot the rest of the market supply curve.

The market price of $3 corresponds to a point on the MC curve that is between the firm's ATC and AVC. Therefore, in the short run, although the firm cannot cover all its fixed costs, it will generate enough revenue to cover all its variable costs. The firm will ignore the fixed costs and produce in the short run. In the long run, the firm will shut down and exit the industry, since $3 is below the break-even (long-run exit) price. Because the firm can never cover its fixed costs, and the business runs at a loss, it is profit maximizing to exit the market.| |

A firm's short-run decision is not solely based on whether or not it incurs profits or losses. It depends on whether the market price is below or above its shutdown price, or minimum average variable cost. As long as the market price is above average variable cost, a firm will produce in the short run since it is covering its variable cost. In cases where there are fixed costs and price is equal to or just above the shutdown price, this will mean that the average total cost is higher than the market price, which leads to losses. However, in the short run, a firm's decision to produce is independent of any fixed costs, so even if it cannot cover fixed costs and earn profits, it will produce nonetheless.

If the price exceeds the marginal cost of increasing output by one unit, the firm will produce another unit. It keeps increasing its output until it reaches a point where increasing output by one more unit has a marginal cost that is greater than marginal revenue (in this case, the going market price).

In this example, the marginal cost of increasing output from five to six units is less than the market price. The marginal cost of increasing output from six to seven units is greater than the market price. So, the firm stops at six units. This is its profit-maximizing quantity.

The table below summarizes the firm's marginal cost.

The firm considers its minimum variable cost in its short-run production decisions. It will produce in the short run if the market price is equal to or greater than its minimum average variable cost. That is, as long as it can cover its variable costs, it will produce in the short run.

The firm considers its minimum average total cost in its long-run production decisions. It will produce in the long run if the market price is equal to or greater than its minimum average total cost; that is, as long as the firm at least breaks even in its economic profits.

The table below summarizes the firm's average variable cost, which equals average total cost since there is no fixed cost

The initial long-run equilibrium was at the intersection of the initial industry short-run supply and demand curves (S100 and D1) at coordinates (4,000, 65). After the change in consumer preferences, the long-run equilibrium is at the intersection of the new industry short-run supply and demand curves (S70 and D2) at coordinates (2,000, 60). The long-run industry supply curve will pass through these long-run equilibrium points, so you should have placed each of the black points (X symbols) at these coordinates.

Notice that this industry is an increasing-cost industry. That is, an increase in demand increases factor prices. Firms stop entering the market and expanding production at a higher equilibrium market price because the price at which zero profit is made has risen. Therefore, the long-run supply curve is upward sloping.

In the long run, firms in a perfectly competitive market enter and exit the market without barriers, and they make zero economic profit. The reasoning goes as follows: if firms make economic profits, new firms will enter the market, shifting the market supply curve to the right until the market price has fallen enough such that no firm is earning economic profit and there is no longer incentive to enter. If firms are incurring economic losses, firms will exit the market, the market supply curve will shift to the left, and the market price will rise until firms make zero economic profit. So, in the long run, firms are operating at the "break-even" point, or the minimum of the short-run average total cost curve AND the long-run average total cost curve.