Economics Chapter 8 Summary

Chapter 8: Analysis of Perfectly Competitive Markets
A. Supply Behavior of The Competitive Firm

Behavior of a Competitive
First, we will assume that our competitive firm maximizes profits. Second, we
reiterate that perfect competition is a world of atomistic firms who are price-takers.
Profit Maximization
Profits are like the net earnings or take-home pay of a business. They represent
the amount a firm can pay in dividends to the owners, reinvest in new plant and
equipment, or employ to make financial investments. All these activities increase
the value of the fi rm to its owners.
Firms maximize profits because that maximizes the economic benefit to the owners
of the firm. Allowing lower-than-maximum profits is like asking for a pay cut, which
few business owners will voluntarily undertake.
Profit maximization requires the firm to manage its internal operations efficiently
(prevent waste, encourage worker morale, choose efficient production processes,
and so forth) and to make sound decisions in the marketplace (buy the correct
quantity of inputs at least cost and choose the optimal level of output).
Perfect Competition
Perfect competition is the world of price-takers. A perfectly competitive firm sells a
homogeneous product (one identical to the product sold by others in the industry).
Here are the major points to remember:
1. Under perfect competition, there are many small firms, each producing an
identical product and each too small to affect the market price.
2. The perfect competitor faces a completely horizontal demand (or dd) curve.
3. The extra revenue gained from each extra unit sold is therefore the market price.
Competitive Supply Where Marginal Cost Equals Price

Rule for a firm’s supply under perfect competition: A firm will maximize profits when
it produces at that level where marginal cost equals price:
Marginal cost = price or MC = P
A profit-maximizing firm will set its output at that level where marginal cost equals
price. Diagrammatically, this means that a firm’s marginal cost curve is also its
supply curve.
Total Cost and the Shutdown Condition
Shutdown rule: The shutdown point comes where revenues just cover variable
costs or where losses are equal to fixed costs. When the price falls below average
variable costs, the fi rm will maximize profits (minimize its losses) by shutting down.
The analysis of shutdown conditions leads to the surprising conclusion that profit-
maximizing fi rms may in the short run continue to operate even though they are
losing money. This condition will hold particularly for firms that are heavily indebted
and therefore have high fixed costs (the airlines being a good example). For these
firms, if losses are less than fixed costs, profits are maximized, and losses are
minimized when they pay the fixed costs and continue to operate.
B. Supply Behavior in Competitive Industries

Summing All Firms’ Supply Curves to Get Market Supply
The total quantity brought to market at a given price will be the sum of the
individual quantities that all firms supply at that price. This reasoning leads to the
following relationship between individual and market supplies for a perfectly
competitive industry:
The market supply curve for a good in a perfectly competitive market is obtained by
adding horizontally the supply curves of all the individual producers of that good.
Short-Run and Long-Run Equilibrium

Economists have observed that demand shifts produce greater price adjustments
and smaller quantity adjustments in the short run than they do in the long run. We
can understand this observation by distinguishing two time periods for market
equilibrium that correspond to different cost categories: (
(1) short-run equilibrium, when output changes must use the same fixed amount of
capital, and (2) long-run equilibrium, when capital and all other factors are variable
and there is free entry and exit of fi rms into and from the industry. The long-run
supply curve of industries using scarce factors rises because of diminishing
returns.
The Long Run for a Competitive Industry

Zero-profit long-run equilibrium: In a competitive industry populated by identical fi
rms with free entry and exit, the long-run equilibrium condition is that price equals
marginal cost equals the minimum long-run average cost for each identical firm:
P = MC = minimum long-run AC = zero-profit price
This is the long-run zero-economic-profit condition.
By contrast, firms in unprofitable industries leave to seek better profit opportunities;
prices and profits then tend to rise. The long-run equilibrium in a perfectly
competitive industry is therefore one with no economic profits.
C. Special Cases of Competitive Markets

General Rules
Demand rule: (a) Generally, an increase in demand for a commodity (the supply
curve being unchanged) will raise the price of the commodity. (b) For most
commodities, an increase in demand will also increase the quantity demanded. A
decrease in demand will have the opposite effects.
Supply rule: (c) An increase in supply of a commodity (the demand curve being
constant) will generally lower the price and increase the quantity bought and sold.
(d) A decrease in supply has the opposite effects.
These two rules of supply and demand summarize the qualitative effects of shifts in
supply and demand. But the quantitative effects on price and quantity depend upon
the exact shapes of the supply and demand curves. In the cases that follow, we will
see the response for a few important cost and supply situations.
Constant Cost
Production of many manufacturing items, such as textiles, can be expanded by
merely duplicating factories, machinery, and labor. Producing 200,000 shirts per
day simply requires that we do the same thing as we did when we were
manufacturing 100,000 per day but on a doubled scale. In addition, assume that
the textile industry uses land, labor, and other inputs in the same proportions as
the rest of the economy.
Increasing Costs and Diminishing Returns

Production of many manufacturing items, such as textiles, can be expanded by
merely duplicating factories, machinery, and labor. Producing 200,000 shirts per
day simply requires that we do the same thing as we did when we were
manufacturing 100,000 per day but on a doubled scale. In addition, assume that
the textile industry uses land, labor, and other inputs in the same proportions as
the rest of the economy.
Fixed Supply and Economic Rent

Some goods or productive factors are completely fixed in amount, regardless of
price. There is only one Mona Lisa by da Vinci. Nature’s original endowment of
land can be taken as fixed in amount. Raising the price offered for land cannot
create an additional corner at 57th Street and Fifth Avenue in New York City.
Raising the pay of top managers is unlikely to change their effort. When the
quantity supplied is constant at every price, the payment for the use of such a
factor of production is called rent or pure economic rent.
Shifts in Supply
If the law of downward-sloping demand is valid, increased supply must decrease
price and increase quantity demanded. You should draw your own supply and
demand curves and verify the following quantitative corollaries of the supply rule:
(c) An increased supply will decrease P most when demand is inelastic.
(d) An increased supply will increase Q least when demand is inelastic.
D. Efficiency and Equity of Competitive Markets

Evaluating the Market Mechanism
The Concept of Efficiency
Pareto efficiency (or sometimes just efficiency) occurs when no possible
reorganization of production or distribution can make anyone better off without
making someone else worse off. Under conditions of allocative efficiency, one
person’s satisfaction or utility can be increased only by lowering someone else’s
utility.
Efficiency of Competitive Equilibrium

Another way of seeing the efficiency of the competitive equilibrium is by comparing
the economic effect of a small change from the equilibrium at E. As the following
three-step process shows, if MU = P = MC, then the allocation is efficient.
1. P = MU. Consumers choose food purchases up to the amount where P = MU.
As a result, every person is gaining P utils of satisfaction from the last unit of food
consumed. (Utils of satisfaction are measured in terms of the constant marginal
utility of leisure)
2. P = MC. As producers, each person is supplying food up to the point where the
price of food exactly equals the MC of the last unit of food supplied (the MC here
being the cost in terms of the forgone leisure needed to produce the last unit of
food). The price then is the utils of leisure-time satisfaction lost because of working
to grow that last unit of food.
3. Putting these two equations together, we see that MU = MC. This means that
the utils gained from the last unit of food consumed exactly equal the leisure utils
lost from the time needed to produce that last unit of food. It is exactly this
condition— that the marginal gain to society from the last unit consumed equals
the marginal cost to society of that last unit produced—which guarantees that a
competitive equilibrium is efficient.
Equilibrium with Many Consumers and Markets
The perfectly competitive market is a device for synthesizing (a) the willingness of
consumers possessing dollar votes to pay for goods with (b) the marginal costs of
those goods as represented by fi rms’ supply. Under certain conditions,
competition guarantees efficiency, in which no consumer’s utility can be raised
without lowering another consumer’s utility. This is true even in a world of many
factors and products
Marginal Cost as a Benchmark for Efficiency

Marginal cost is a fundamental concept for efficiency. For any goal-oriented
organization, efficiency requires that the marginal cost of attaining the goal should
be equal in every activity. In a market, an industry will produce its output at
minimum total cost only when each firm’s MC is equal to a common price.
Qualifications
There are two important areas where markets fail to achieve a social optimum.
First, markets may be inefficient in situations where pollution or other externalities
are present or when there is imperfect competition or information. Second, the
distribution of incomes under competitive markets, even when it is efficient, may
not be socially desirable or acceptable.
Market Failures
Imperfect Competition. When a firm has market power in a particular market (say
it has a monopoly because of a patented drug or a local electricity franchise), the fi
rm can raise the price of its product above its marginal cost. Consumers buy less
of such goods than they would under perfect competition, and consumer
satisfaction is reduced. This kind of reduction of consumer satisfaction is typical of
the inefficiencies created by imperfect competition.
Externalities. Externalities are another important market failure. Recall that
externalities arise when some of the side effects of production or consumption are
not included in market prices. For example, a power company might pump
sulfurous fumes into the air, causing damage to neighboring homes and to
people’s health. If the power company does not pay for the harmful impacts,
pollution will be inefficiently high and consumer welfare will suffer. Not all
externalities are harmful. Some are beneficial, such as the externalities that come
from knowledge-generating activities.
Imperfect Information. A third important market failure is imperfect information.
The invisible-hand theory assumes that buyers and sellers have complete
information about the goods and services they buy and sell.
Firms are assumed to know about all the production functions for operating in their
industry. Consumers are presumed to know about the quality and prices of goods
—such as whether the financial statements of firms are accurate and whether the
drugs, they use are safe and efficacious.
There are no scientifically correct answers to these questions. Positive economics
cannot say how much governments should intervene to correct the inequalities and
inefficiencies of the marketplace. These normative questions are appropriately
answered through political debate and fair elections. But economics can offer
valuable insights into the merit of alternative interventions so that the goals of a
modern society can be achieved in the most effective manner.

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Chapter 8: Analysis of Perfectly Competitive Markets

A. Supply Behavior of The Competitive Firm

Competitive Supply Where Marginal Cost Equals Price

B. Supply Behavior in Competitive Industries

Short-Run and Long-Run Equilibrium

The Long Run for a Competitive Industry

C. Special Cases of Competitive Markets

Increasing Costs and Diminishing Returns

Fixed Supply and Economic Rent

D. Efficiency and Equity of Competitive Markets

Efficiency of Competitive Equilibrium

Marginal Cost as a Benchmark for Efficiency

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