Unit 9 - The Perfectly Competitive Market


In this topic we explore the market structure facing a typical firm. We will analyze the competitive situation of the industry and how the presence or absence of competition affects the individual firm's behavior. It should be emphasized, that we are creating models of each industrial structure. We are not trying to replicate complete reality. However, as you will see, we can draw a fairly accurate picture of the different types of industries and the interaction of firms with one another.

We first ask why it is important to study the nature of the industry in which a typical firm in that industry operates. First, it is important for the firm to understand the competitive environment. As competition in a given industry increases, the firm will have less ability to control the price it charges customers, especially to raise prices. At one extreme is a perfectly competitive industry where the typical firm has no discretion over price. To gain greater control over prices and profits firms may undertake expensive advertisement campaigns so that customers perceive differences between the products of that firm and its competitors. Alternatively, a firm may collude with its competitors to reduce or eliminate price competition. Finally, a firm may try to be the sole provider of the product and become a monopolist. However, such a firm will come under the scrutiny of regulators.

By understanding the presence or potential for competition, a firm has a greater opportunity for profits and long-run success. A failure to understand such basics can ensure a firm's eventual bankruptcy.

Most of us will strive to achieve a financially comfortable life. Typically, we will earn the majority of our income during our lives by working. However, it is certainly possible to supplement wage income with non-wage sources such as the capital gains earned from investing in stocks (equities). Astute investors will have a good comprehension of the competitive environment of the firms in which they choose to buy shares.

For example, in an industry where many firms produce similar products, investors will understand that the typical firm will not have much ability to raise the prices of its products in order to increase profits and share value. Firms that thrive in this type of environment will constantly innovate, offer new services and lower production costs in order to gain market share and to increase profits. The models developed in this topic will give the student a fundamental understanding of the circumstances facing firms and the prices of their stock shares.

We begin our analysis of market structure by looking at the perfectly competitive industry. Although the typical firm will not operate in a perfectly competitive environment, perfect competition provides a benchmark to compare other industrial structures. Other types of market structures we will examine are:

The following table lists some basic relations between each type of market structure that we will study in this topic.

Industry Type

Number of Firms in the Industry

Degree of Competition

Product Differences Between Firms

Perfect Competition many firms very competitive identical or homogenous
Monopolistic Competition many firms or many products very competitive small, differences emphasized by advertising
Oligopoly few firms collusion restricts competition very similar
Monopoly one firm entry of new firms restricted -

Perfect Competition

We begin our analysis with a look at the firm in a perfectly competitive market structure. Remember that we are creating a model of this market structure based on some simple assumptions. Given our assumptions, we can analyze the behavior of a typical firm in this industry. Before going through the tradition assumptions about the perfectly competitive industry let us discuss how we should look at the firm. For simplicity, think of the perfectly competitive firm as exhibiting the behavior of a shark; a single-minded eating machine. The firm we will look at has one simple objective: to maximize profits. Thus, for the purposes of our analysis we can ignore issues related to social justice and externalities of production such as pollution. If pollution is consistent with profit maximization, then the firm has no hesitation to pollute. In other words, we can leave moral values out of our discussion and keep our model as simple as possible. Later in this course, we will include issues related to production, but for now, our goal is to keep the model as simple as possible.

Assumptions of the perfectly competitive industry:

In the real world, what types of firms fit these assumptions? Not many. It is best to think of a farmer growing a certain type of wheat or corn. For a given strain of wheat, one farmer's wheat is identical to the wheat grown by another farmer (as long as they are of the same variety). The grain buyer will offer the same price to each of the farmers selling his wheat. No farmer will be able to command a higher price than the other producing an identical type. Of course, if a farmer is growing organic wheat, this can be considered a different type or market than wheat that is considered non-organic.

Typically, the price a farmer will receive for his wheat is set in the futures markets in Chicago. The Chicago Board of Trade and the Chicago Mercantile Exchange trade futures contracts specifying the price of wheat at any given time. The price a farmer receives for his wheat is set in the futures market and he will sell his wheat at the price set in the contract. We assume the individual farmer is too small to influence the price of futures contract for his wheat. For a given variety of wheat, the futures market considers one farmer's output to be identical to another's and all farmers selling their wheat at a given time will receive the same price.

We have a model where the wheat farmer is a price taker. The price at which he can sell his wheat is determined by the supply and demand for wheat in the market (or the supply and demand for futures contracts to be more exact). Given the market price of wheat, the farmer can sell as much wheat as he desires or as little. The two graphs below illustrate the concept of a price-taking firm.

Figure 9-1 on the left shows the supply of the good (wheat) and demand for that good (wheat) for the industry. The equilibrium of supply and demand in the market determines the equilibrium price or PM(arket). In the graph to the right, Figure 9-2, we show the situation facing the perfectly competitive firm (wheat farmer) given the price set in the market. The firm is a price taker and must accept the market price, PM. At PM, the firm's demand curve is a horizontal line, meaning that the demand for the firm's output is infinite. Our wheat farmer can sell as much as he likes or as little at the market price.

If the farmer tries to sell at a price above PM, nobody will buy from him since they can buy the good at the lower market price from another seller, thus demand will fall to zero. Conversely, our wheat farmer will never sell at a price below PM since he can always receive the higher market price, PM.

In Figure 9-2 the marginal revenue (MR) is constant and equals to demand. Marginal revenue is equal to the change in total revenue (TR) as output increases by another unit. Total revenue is equal to the price of the good times the level of output of the good or:

TR = P x Q

For a perfectly competitive firm that is a price taker, the price the firm receives remains constant. As a result, the total revenue curve is linear and revenues change positively with output. Since the TR curve has a constant slope, marginal revenue equals the slope of the TR curve and is also constant. Total revenue increases by a constant amount with each additional unit of output produced. Thus marginal revenue does not change as output increases. For the perfectly competitive firm, MR remains constant and is equal to the demand curve.

Profit Maximization and the Perfectly Competitive Firm

Now that we have determined the situation facing a perfectly competitive firm - it can sell as much as it wants at the market price - we now determine how much the firm will produce. As we noted earlier, the firm has a single goal and that is to maximize profits. The firm will produce an output level that allows it to maximize profits, no more, no less. We will assume that the firm sells all it produces.

Profit equals the difference between the firm's revenues received from selling the good and the cost of production.

profit = total revenue (TR) - total cost (TC)

The firm's profit maximizing level of output is that level of production, q*, that maximizes the difference between total revenue and total cost as shown in Figure 9-3. This output level coincides with a point where the slope of the total revenue and total cost curves are equal as shown by the dashed line. Just as the slope of the total revenue curve at any point is equal to marginal revenue, the slope of the total cost curve at any point is equal to the firm's marginal cost.

Marginal revenue equals the additional revenue received by producing another unit of the good (e.g. another bushel of wheat). Likewise, marginal cost (MC) is the addition to total cost of producing that incremental unit. This gives us another, more convenient, method of determining the firm's profit maximizing level of output:

A firm maximizes profits at the output level where marginal revenue (MR) equals marginal cost (MC).

 We can interpret the MR = MC rule logically. As long as the additional revenue earned from producing another unit of the good exceeds the incremental cost, then profits increase as output expands. As long as MR > MC, the firm should expand output. Just the opposite reasoning holds when MR < MC as output increases by another unit. Under these circumstances, the additional cost of producing another unit is greater than the associated revenue and profits will drop as production rises. As long as MR < MC, the firm should decrease output.

Figure 9-4 Illustrates the concept discussed here. In the range of production where MR > MC, the firm will increase total profits by expanding output. Conversely, when MR < MC, additional output only reduces total profits as the cost of production exceeds the related revenues from selling that good. Only when MR = MC, will the firm reach maximum profits.

 

 

 

Now we use Figure 9-5 to show the relationship between demand, marginal revenue and marginal cost for the firm. We have determined that the perfectly competitive firm is a price taker and accepts the market price PM. Although the firm can sell as much as it desires at PM, it produces the amount of the good consistent with its objective of maximizing profits. The profit maximizing output level is shown as q*.

 


 


Important note: Throughout the remainder of this topic and later in this course, we will be analyzing different types of market structures. One important rule consistent with all firms that we will look at regardless of the industry type is the firm will seek to maximize profits and will do so where MR = MC.


Costs and the Perfectly Competitive Firm

Just because the firm is producing at an output level that maximizes its profits, does not indicate that the firm is actually making money. Under certain circumstances, profit maximization is the same as loss minimization. A firm that is operating at a loss, will still find that its optimal output level is where MR = MC. By producing at this level, the firm will minimize its losses. But we are getting ahead of ourselves here. In order to determine if the firm is making a profit, breaking even or operating at a loss, we need to look at costs.

In an economics course, profits are defined as economic profits. Economic profits equal the difference between a firm's revenues and costs. If revenues exceed cost then the firm is making economic profits and conversely, if revenues are less than costs, the firm is losing money.

Costs are comprised of two parts:

Take for example our good friend, Electra Corvette. After graduating from medical school, Electra decides that she has two career options. First she can take a job working at a nearby Health Maintenance Organization (HMO) that is offering her an annual salary of $100,000 to start. Or Electra can follow her dream of being an independent businesswomen and start her own medical practice.

Recognizing that she is a pillar of the local community, Electra passes on working for the HMO and starts her own business as a doctor. The table below summarizes the basic finances of Dr. Corvette's business after her first year as an independent doctor.

Total revenues. $500,000
Explicit (accounting) costs (includes supplies, nurse salaries, insurance, lab tests and all other costs of doing business. - $440,000
Implicit costs (salary Electra would have earned working at the HMO. -$100,000
Explicit + Implicit Costs = Total Costs -$540,000
Accounting profit (revenues - explicit costs). $60,000
Economic profit (revenues - total costs) -$40,000

As you can see from the numbers, Electra covered her accounting expenses and even took home $60,000. However, if she had worked at the local HMO, she would have taken home $100,000 instead. When adding her implicit costs, or opportunity cost of not working elsewhere, Electra has total costs of $540,000 and an economic loss of $40,000. Of course you may argue, Electra also receives the joy of running her own business, something that cannot be measured in terms of money. However, remember the framework of our basic model; we exclude such matters as external benefits or costs.

Assuming that it is money that matters, what should Dr. Corvette do? Electra may reason that it takes several years to become established and build up a steady group of patients. Over time she believes, economic losses should fall and she will soon break even or make economic profits. Thus, she may decide to stay in business despite her economic losses. Or, Electra may decide that the economic losses may persist indefinitely. In this case, she will close down her business and accept the job at the HMO.

For another example, let us consider a wheat farmer who is making economic profits. This situation is shown in Figure 9-6. As before, the profit maximizing level of output is attained where MR = MC. To see if the firm is making economic profits, we need information from the average total cost curve (ATC). Note that MC always intersects ATC at the minimum point of the ATC curve. Since price is greater than average total costs at the profit maximizing output level, this firm is making a profit.

 

 

Figure 9-7 shows the area of economic profits that the firm is earning. Total profits are equal to total revenue minus total cost. Total revenue is equal to the price of the good (PM) times quantity (q*). In the graph, the area of total revenue is bounded by oPMaq*. Since average total cost (ATC) equals total cost divided by output (q*), total cost equals ATC times q*. In the graph, the area of total cost is bounded by ocbq*. Economic profits are positive since total revenues exceed total costs. The area of profit is the difference between the two and is bounded by PMabc, and is shown by the crosshatched area.

Consider the implications of economic profits for this wheat farmer and other farmers growing the same type of wheat with similar costs and reaping economic profits. The presence of economic profits implies that the business owner is earning more than he could earn working in another occupation or for someone else. The presence of economic profits in an industry sends out a signal to other farmers and entrepreneurs. Consider for example a corn farmer who is incurring economic losses while growing corn. The economic profits present in the wheat industry will give him a strong incentive to switch to wheat during the next planting season. Other individuals who are considering starting their own farm or working for an agricultural company will favor wheat farming since they can earn more than if they received a paycheck from a firm.

There are many industries and firms in our economy earning tremendous profits. However, few operate in perfectly competitive industries. For economic profits to lead to a rapid expansion in the number of firms in an industry, there has to be easy and relatively inexpensive entry of new firms into the industry. It is much easier for an individual to set up his own farm and grow wheat on a few hundred acres than it is to compete with industrial giants such as General Motors and Intel. Perfect competition implies that startup costs are low and there are no other barriers to the entry of new firms (1). If this is the case:

the presence of economic profits in a perfectly competitive industry will lead to the entry of new firms.


(1) Examples of barriers to entry include:


The perfectly competitive firm should enjoy its economic profits, because they won't last long. With the entry of new firms, economic profits will soon be eliminated. The process is shown in the two graphs below.

The presence of economic profits where there is ease of entry for new firms quickly attracts competitors. In Figure 9-8 new firms entering the industry have the effect of shifting the industry supply curve to the right and market production increases. The increase in the industry supply curve lowers the market price for the good (wheat) from PMO to PM1 . Figure 9-9 on the right shows the outcome for the typical price-taking firm. The firm's demand and marginal revenue curves now reflect the new market price, PM1. At PM1, the firm has unlimited demand, but will produce at its the profit maximizing output level, q1, where MR = MC. As you can see in Figure 9-9, the firm's economic profits are eliminated.

As long as economic profits are present in a perfectly competitive industry, new firms will enter. As the number of firms continues to grow, the industry supply curve shifts outward, lowering the market price for the good. The price the typical firm receives for its output will continue to fall until all economic profits are eliminated. Finally, when economic profits fall to zero, the industry stabilizes and no more firms enter into the industry.

When Firms Disappear

As we mentioned in the beginning of this section, some firms operate at a loss, at least temporarily. As noted, all firms produce where MR = MC, even those producing at a loss. There is however, an exception to this rule; the firm may shut down and produce nothing. To determine if a firm that is not covering its cost should stay in operation, we need to split up average total cost into its variable and fixed components (2). The objective of the firm is to minimize its losses. A firm needs to decide if its revenues can cover all of its variable costs associated with production. If the firm can cover all of its variable costs then it should stay in operation in order to minimize its loses by paying off part of its fixed costs. Or if the firm's revenues are less than its total variable costs, then it will minimize it losses by shutting down.


(2) Fixed costs are those that do not change with the level of output. Fixed costs for a farmer would include land and machinery. The farmer must own these even before he decides to produce anything. Variable costs include the cost of labor, parts and all other inputs used in production that change with the level of output. For the farmer this would include labor he hires, seed, fertilizer, fuel and other expenses. As he increases his acreage under cultivation, his total variable costs will increase as well.


Figure 9-10 illustrates the situation for a loss minimizing firm that remains in operation, at least in the short-run. To facilitate our analysis, we include the firm's average variable cost (AVC) curve as well as the usual suspects. We begin by determining that the profit maximizing, or in this case, loss-minimizing firm still produces where MR = MC. As you can see, the market price, PM, lies below the firm's ATC curve at point y. Thus the firm does not fully cover total costs and is losing money. We now determine if the firm should stay in operation.

The rule to follow is: the perfectly competitive firm should continue to operate at a loss as long as the price it receives covers its variable costs (is equal to or above the minimum point on its AVC curve).

In Figure 9-10, the vertical distance from the horizontal axis at q* to point z on the AVC curve is the firm's variable costs of producing at point q*. The difference between point z and point y on the graph is the firm's fixed cost at output level q*. As you can see, the market price (PM) the firm receives is high enough to cover all of its variable costs. Additionally, by producing the firm covers part of its fixed production costs: the distance from z to a in the graph. The distance from a to y at q* is the remaining fixed cost that the firm does not cover and represents its losses.

To show that the firm will minimize its losses by producing when price is at PM, consider the alternative: to shut down and produce nothing. If the firm shuts down and reduces output to zero, it still incurs all of its fixed costs. However, as shown in Figure 9-10, by operating, the firm pays off at least part of its fixed costs. To minimize its losses, the firm would rather operate and at least cover a portion of its fixed costs rather than not produce and pay off none of its fixed costs.

Figure 9-11 shows the situation when a firm will minimize its losses by shutting down and reducing output to zero. In this case, the market price is not high enough to even cover the firm's variable costs. When price is below a firm's minimum point on its variable cost curve, the firm will minimize losses by producing nothing. In the graph, as long as price remains below point v, the firm should not operate. It will minimize losses by only having to pay its fixed costs.

As the graph shows, if the firm did choose to operate at PM, where MR=MC, then losses would include fixed costs plus some of its variable costs.

When Demand Changes

Let us now consider a firm's long-run equilibrium. In the long run, a firm's economic profits equal zero as shown in Figure 9-12. The long-run equilibrium for the perfectly competitive firm is at a point of zero economic profits, where:

MR = MC = min(ATC)

Figure 9-12 shows the long-run outcome for the perfectly competitive firm at point a in the graph. If economic profits had existed, the entry of new firms and the reduction in the market price has eliminated them in the long run. Or if there where economic losses present in the industry, some firms have exited in search of better opportunities elsewhere. As the industry supply curve shifts to the left with the departure of some firms, the market price rises to a level where the remaining firms break even with zero economic profits.


But things do change. Many industries see growth in demand for their products over time. Given an increase in demand for the product in the market, let us examine how this affects a perfectly competitive firm.

Figure 9-13 shows the impact of an increase in demand for the good in the marketplace. Figure 9-14 shows the delightful outcome for the typical firm in the perfectly competitive industry. With an increase in demand, the market price that the price-taking firm receives for its product rises from PM0 to PM1. As you can see, the firm is ecstatic. The growth in demand has allowed it to sell its output for a higher price and economic profits are realized. But happiness is fleeting as the economic profit enjoyed by the typical firm in the industry attracts opportunistic competitors. As new firms enter into the industry (as shown previously in Figure 9-8), the existing firm's see their economic profits slip away as the market price falls (see Figure 9-9). Once again, the story is the same: economic profits fall to zero and a new long-run equilibrium is reached.

Although we will not show it graphically, you can imagine the carnage that occurs when industry demand falls and the market demand curve shifts inward. As the market price erodes, firms experience economic losses, resulting the exit of some firms. With relief, the outcome for the remaining firms is the same in the long run as in our prior analysis: zero economic profits.

Decreasing Cost Industries and the Long Run Supply Curve

As we can see from our discussion above, changes in demand disrupt an industry's long-run equilibrium. An increase in demand eventually leads to an increase in the number of firms and an outward shift in the industry supply curve until a new equilibrium is reached where firms receive zero economic profits. As simple as this sounds, we must allow for some behind the scenes action.

In the short-run, technology is a given and considered to be static. The current state of technology determines what capital the firm can purchase to complement the labor it uses in production. If we assume that the industry and firm produce efficiently, then the firm utilizes the best technology available at that time. If technology is fixed in the short-run, the implication is that the firm can do nothing to change production costs in the short-run except change output levels and labor inputs. As a result, the marginal cost and average total cost curves are fixed in one place and as output changes we move along the curves.

However, in the long-run, the firm has unlimited options. First, it can add to its capital stock, thereby making the labor it uses more efficient and increase worker productivity. Secondly, the firm can take advantage of technological advances and improvements in the capital it uses. By replacing its outdated capital with better machinery, computers and other capital, the firm also improves worker productivity. Gains in worker productivity, or output per worker, reflects on marginal, variable and average production costs. As worker productivity increases, the marginal cost per unit of output for the firm declines. In addition, average cost per unit of output to the firm also decreases.

 

The effects of increasing worker productivity are shown graphically in Figure 9-15. Over time, as the firm adds additional and improved capital, output per worker increases. As worker productivity rises, the marginal cost of producing another unit of the good falls. This is shown graphically by a shift in the marginal cost curve from MC0 to MC1. Gains in worker productivity that lower marginal cost will also reduce the average cost per unit of output as shown by the drop in average cost from ATC0 to ATC1.


If a firm lowers its costs, and market prices remain constant, then the firm is earning economic profits when costs fall to MC1 and ATC1. This leads to an important conclusion that we will emphasize later - firms in a competitive environment where there are little differences between the product of one firm to that of another firm's need to constantly increase worker productivity in order to sustain economic profits.

Now that we see how a firm can lower its costs over time, let us look at the industry as a whole and derive the long-run industry supply curve. The long-run industry supply curve is obtained by taking a sequence of long-run equilibrium points in the industry. From our presentation above, we know that an increase in demand allows firms in that industry to earn economic profits. Economic profits attract new entrants into the industry and the industry supply curve shifts outward as well.

Figure 9-16 shows the dynamics for an industry after the initial increase in demand from D0 to D1. As firms earn economic profits, the entry of new firms leads to an outward shift in the industry supply curve from S0 to S1. However, in the case of a decreasing cost industry, supply shifts out further than demand. This is a result of the falling costs of production due to higher worker productivity. As firms lower there production costs, they earn additional economic profits. Profits that open the door even wider to new competitors.


For a decreasing cost industry, supply shifts outward in the long run due to two reasons:

  1. An increase in demand results in economic profits that attract new firms into the industry.
  2. Technological improvements lead to better capital and higher worker productivity. As worker productivity increases, production costs fall, causing the supply curve to shift rightward. Lower production costs also results in economic profits for existing firms and over time, new firms enter in search of these profits.

In the decreasing cost industry, the supply curve shifts outward for the two reasons listed above. Over time we can look at the long-run equilibrium of the supply and demand curves in order to derive the industry's long-run supply curve. The industry long-run supply curve is derived from the new equilibrium of supply and demand after one or both have changed.

Figure 9-17 shows three equilibrium points of supply and demand:

Connecting these equilibrium points gives us the long run supply curve (LRS).

In a decreasing cost industry, the long-run supply curve for that industry is downward sloping. The implication of this is that over time, the price of the good to the consumer is decreasing. There are numerous examples of goods produced in a decreasing cost industry. Over time, the price of personal computers has fallen like a rock when accounting for quality and features. Televisions, VCRs, compact disk players, computer software and the prices of many other goods exhibit behavior consistent with that of a firm in a decreasing cost industry. A consistent characteristic of all of these industries is the role of technology. Each of these industries is undergoing a rapid technological evolution. The impact of advances in technology has been to lower production costs, improve worker productivity and lead to substantial gains in product quality.


Applying theory to personal investment.

Micro theory can provide a useful background that stock pickers can utilize in choosing among companies. From the model of perfect competition, we can see that as present competition or the potential for competition increases, the likelihood for sustained profits falls. And the catalyst for stock price appreciation is often increases in profitability for a firm.

So, should the wise stock picker avoid firms in highly competitive industry since profits are quickly whittled down in growing industries? Not at all. When looking at an industry apply some fundamentals learned here:

How competitive is the industry. Holding everything else constant, a very competitive industry where firms produce relatively homogenous goods, probably will not provide opportunities for sustained growth in earnings and stock price appreciation. Except when:

An example of a very competitive industry is in the area of network communications. There are many firms producing relatively homogenous goods. Yet many firms thrive in this environment and have enjoyed a rapid (although bumpy) appreciation in their stock price. Due to exploding growth in demand and constant innovation, firms such as Cisco Systems and Cabletron have thrived in this very competitive industry.


As we have seen, the long-run industry supply curve for a decreasing cost industry is downward sloping. Therefore, the price of the good in the market in a decreasing cost industry falls over time (especially when we allow for improvements in quality). There are two other variants for the possible shape of an industry's long-run supply curve:

Figure 9-18 shows the long-run supply curve for an increasing cost industry. As demand grows over time, higher production costs result in a positively sloped industry supply curve and higher prices for the good or service.

Increasing cost industries tend to be labor intensive. An example is higher education. Since the development of the textbook, little has changed in the delivery of a classroom college course over time. Today, the majority of classes are still taken in the classroom that features the "sage on the stage" method of teaching. These courses are labor intensive and education costs have increased steadily to account for higher salaries. In the United States, the cost of a college education is typically increasing at a rate of three to four times the average inflation rate for all goods and services. Contrast education to a decreasing cost industry where technology has steadily displaced labor and made workers more efficient. In the typical classroom, technology has yet to make significant inroads into the learning process.

  
Copyright 1999, Jay Kaplan
All rights reserved
Last updated July 1999