CH11 MARKET POWER: PERFECT COMPETITION AND MONOPOLISTIC COMPETITION

Pages 178-182

Outline 11.2
I. How do firms in perfect competition maximize profits in the short run?
A. Firms maximize profits when they produce at the level of output where
MC=MR.
1. For perfect competition, we now have to add the marginal cost
curve, shown in Figure 11.2

2. We can see that the firm takes the price P from the industry and,
because the demand is perfectly elastic, P=D=AR=MR.
3. Profit is maximized where MC=MR, which is at the level of output
q.
a) We must remember that although the scale of the price
axis is the same for the firm and the industry, this is not the
case for output.
(1) The quantity q is very small in relation to the total
industry output, Q, and it would not even register on
the output axis for the industry.
(a) If it could, then it would be large enough to
shift the supply curve, and thus after the
industry price.
(i) In that case, the firms would have
some degree of market power.
B. In the short run in perfect competition, there are two possible profits/loss
situations:
1. Short-run abnormal profits:

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 a) In this case, which is shown in Figure 11.3, the firms in the
industry are making abnormal profits in the short run.
(1) This means that they are more than covering their
total costs, including the opportunity costs.

(2) As we can see in Figure 11.3, the firm is selling at

the industry price, P, and is maximizing profits by
producing at quantity q, where MC=MR.
(a) At q, the cost per unit, average cost, is C,
and the revenue per unit, average revenue,
is P, so average cost is less than average
revenue and the firm is making an abnormal
profit of P-C on each unit.
(i) The shaded area shows the total
abnormal profit.
2. Short-run losses
a) In this case, shown in Figure 11.5, the firms in the industry
are making losses in the short run.
(1) This means that they are not covering their total
costs.

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 b) In Figure 11.4, the firm is selling at the industry price, P,
and is maximizing profits by producing at the quantity q,
where MC=MR.
(1) However, at output q, the cost per unit is C, which
is greater than the price and so the firm is making a
loss of C-P on each unit.
(2) The shaded area shows the total loss.
(a) Although making a loss, the firm is still
producing at the "profit-maximizing" level of
output, because any other output would
create a greater loss.
(i) In effect, they are loss minimizing.
II. What happens to short-run profits or losses in the long run in perfect
competition?
A. If firms are making either short-run abnormal profits or short-run losses,
other firms begin to react and the situation starts to change until an
equilibrium point is reached in the long run.
1. Short-run abnormal profits to long-term normal profits.
a) Let us look at the situation of short-run abnormal profits.
(1) The process is shown in Figure 11.5.
(a) The firm is making abnormal profits shown
by the shaded area, but this situation will
not continue for long.

b) Since there is perfect knowledge and no barriers to entry,

firms outside the industry that could also produce the good
will start to enter the industry, attracted by the chance to
make abnormal profits.
(1) At first, this will have no real effect, because the
firms are relatively small.

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 (a) However, as more and more firms enter the
industry, attracted by the abnormal profits,
the industry supply curve will start to shift to
the right.
c) As the industry supply curve starts to shift from S towards
S1, the industry price begins to fall from P towards P1.
(1) Because the firms in the industry are price-takers,
the price that they can charge will start to fall and
their demand curves will start to shift downwards.
(a) This means that the abnormal profits that
they had been making will start to be
"competed away".
d) This process will continue as long as there are abnormal
profits in the industry.
(1) Eventually, the industry supply curve reaches S,
where the price is P1.
(a) At this point, the firms are "taking" the price
of P1 and the demand curve is
D1=AR1=MR1.
(i) We now find that the firms are
making normal profits with the price
per unit equal to the cost per unit, ie
P1=C.
(ii) The entrepreneurs of the firm in the
industry are satisfied because they
are exactly covering their opportunity
costs.
(a) However, there is now no
abnormal profit to attract
more firms into the industry
and so the industry is in a
long-run equilibrium situation.
(b) No one will now enter and no
one will leave.
(c) The outcome is a much
bigger industry producing Q1
units, with more, smaller
firms each producing q1
units.
2. Short-run losses to long-run normal profits
a) This process is shown in Figure 11.6
b) As we can see, the firm is making losses shown by the
shaded area, but this situation will not remain the same.

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c) Some firms in the industry will, after a time, start to leave
the industry.
(1) At first, this will have no real effect, because the
firms are relatively small.
(a) However, as more and more firms leave the
industry, unable to achieve normal profit, the
industry supply curve will start to shift to the
left.
d) As the industry supply curve starts to shift from S towards
S1, the industry price will begin to rise from P towards P1.
(1) As the firms in the industry are price-takers, the
price that they can charge will start to rise and their
demand curves will start to shift upwards.
(a) This means that the losses that they had
been making begin to get smaller.

e) This process will continue as long as there are losses

being made in the industry.
(1) Eventually, the industry supply curve reaches S1,
where the price is P1.
(a) At this point, the firms are "taking" the price
of P1 and the demand curve is
D1=AR=MR1.
(i) We now find that the firms are
making normal profits, with the price
per unit equal to the cost per unit, ie
P1=C1.
(a) Now the entrepreneurs of the
firms in the industry are
satisfied, because they are
exactly covering all of their

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 costs, includin their
opportunity costs.
(i) There are also no
abnormal profits to
attract new firms into
the industry, so the
industry is in a
long-run equilibrium
situation.
(ii) No one will now enter
and no one will now
leave.
(iii) The outcome will be a
smaller industry
producing only Q1
units, with slightly
larger firms, each
producing q1 units.
III. What is long-run equilibrium in perfect competition?
A. We can conclude that, in the long run, firms in perfect competition will
make normal profits.
1. This is because, even if they are making short-run abnormal
profits or short-run losses, the industry will adjust with firms
entering or leaving the industry until a normal profit situation is
reached.
a) In Figure 11.7, the firms are making normal profits in the
long run.
(1) They are selling at the price of P, which they are
taking from the industry.
(a) MC is equal to MR so they are maximizing
profits by producing q, and at that output P
is equal to AC so they are making normal
profits.

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2. In this situation, there is no incentive for firms to enter or leave the
industry and so the equilibrium will persist until there is a change
in either the industry demand curve or in the costs that the firms
face.
a) If this does happen, then firms will be making either
short-run abnormal profits or short-run losses and the
industry will once again adjust, with firms entering or
leaving until long-run equilibrium is restored.

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