Perfect Competition - Essay - Managerial Economics

Perfect Competition - Essay - Managerial Economics

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Four possible markets: Perfect Competition (price-takers), Monopolistic Competition (price-searchers), Oligopoly (a few firms dominate) and Monopoly (single seller)
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ECN 469: Managerial Economics Professor Mark J. Perry

- 1 -


In previous chapters, we have examined managerial decisions within (inside) the firm without regard to

the firm's external environment or "market structure." For the next 5 chapters, we look at the market

structure (industry) in which the firm competes. This area of economics is sometimes called "Industrial


Four possible markets: Perfect Competition (price-takers), Monopolistic Competition (price-

searchers), Oligopoly (a few firms dominate) and Monopoly (single seller), which vary according to:

a. Number of firms in the industry

b. Barriers to entry (exit) for new firms

c. Degree to which firms can control price

Government regulation of industry is determined partly by market structure. Regulation is supposed to

guarantee maximum competition to protect consumers against anti-competitive practices like: restraint

of trade, collusion, price-fixing, attempts to limit/eliminate competition, attempts to monopolize an

industry, etc. For example: Sherman Antitrust Act, mergers have to be approved by FTC, government

regulation of "natural monopolies" like utilities, cable TV, etc.


We start with Perfect Competition (PC), sometimes considered an ideal model of "friction-free

capitalism." See Table 10.1 on p. 398, Perfect Competition: Many firms in the industry and no

barriers to entry (exit). Extreme opposite of PC is Monopoly: 1 firm and high barriers to entry.

Sound managerial decisions depend on thorough knowledge of market forces of Supply and Demand,

because most firms are buying inputs in competitive markets and selling its output in competitive

markets. Example: GM buys materials (steel, rubber, parts, etc.), labor, capital equipment in

competitive markets, borrows money (bonds, bank loans) in competitive credit markets, raises equity

capital in competitive capital markets, and sells its output in competitive retail markets for new


See graph p. 400, Figure 10.1, for market conditions for shoes in a local market.

QD = 13 - .2P

QS = -2 + .4P

We can set QD = QS and solve for P*: 13 - .2P = -2 + .4P

P* = $25 per pair of shoes

Q* = 13 - .2 (25) = 8 thousand shoes

$25 is the "market clearing" price, i.e. the price that clears the market. Market clearing = equilibrium =

(QD = QS) = no shortages = no surpluses.

What if the price is P = $20 instead of P = $25?

ECN 469: Managerial Economics Professor Mark J. Perry

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QD = 9 thousand

QS = 6 thousand

Therefore, QD > QS, the market does not clear, there is a ____________ of 3 thousand shoes.

What if P = $30?

QS = 10 thousand

QD = 7 thousand

QS > QD, and there is a ______________ of 3 thousand shoes.

In the absence of artificial price controls, an unregulated market will move in the direction of market

clearing, market equilibrium conditions.


Changing market conditions will result in shifts in the S and D curves. For example, suppose there is

an economic expansion in the local community, the D curve will INCREASE as in Figure 10.2 (p.

402), shift to the right. And any given price, D will be higher. The increase in D will bid up the Price,

and firms will increase output and increase QS (remember that S does NOT increase).

Factors that affect the cost of production will shift the S curve. Anything that LOWERS the cost of

production (lower inputs prices, advances in technology) will INCREASE the Supply curve, as on p.

402, Figure 10.2. Result: Prices fall, QD goes UP (Demand stays the same).

Remember: parallel shifts in the S or D curve result in a new INTERCEPT (constant). D goes UP,

intercept goes UP, S goes up, intercept goes DOWN.


Conditions of markets with Perfect Competition (PC), think of farming as an example:

1. Large market with thousands of small firms and thousands of consumers.

2. No barriers to entry (exit), easy to go into business (or exit), e.g. taxis in Wash. DC. The easy entry

and exit results in Zero Economic Profit (P = ATC) in LR.

3. All firms produce an identical, homogenous, standardized product, e.g. oil, wheat, corn, beef. No

brand names or differentiated products. A single market price prevails.

4. Firms are "price takers," i.e. they take the market price as given because the output decisions of

one firm do NOT affect the market price. Consumers are also price takers, i.e. their buying behavior

has no effect on P.

ECN 469: Managerial Economics Professor Mark J. Perry

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Decisions of the Competitive Firm

The market price (P*) is determined by S and D for the entire market, and then the individual firm just

"takes" that market price as given, e.g. $8 per unit. This means that the firm faces a horizontal demand

curve at the market P* of $8, see p. 406, Figure 10.3. In a PC market, the product is homogenous, a

firm's output is a perfect substitute for the other firm's output, and the Law of One Price prevails (P*).

At P*, the firm can sell its entire output, but if it tries to raise P to $8.05, it will sell 0. The PC firm is a

price taker.

OUTPUT RULE: A firm in a PC market will increase output until MR = MC to MAX profits (or MIN


For a price taker: D = MR = P (= $8 in this case). For the firm on p. 406, Figure 10.3, its profit

maximizing output Q* = 6 thousand (MR = MC). Notice that at Q*, P > ATC, ($8 > $6.50) so the firm

is making a POS SR economic profit of $1.50 per unit ($1.50 x 6000 = $9000).

The existence of POSITIVE Economic Profits will attract entry in the LR (there are NO barriers to

entry). As firms enter the industry, competition increases, total output increases, P* falls (to $6 in this

case), and the output for a typical firm declines (from 6 to 5 in this case).

In a PC market, the following LR conditions will prevail:

D = P = MC = MR = min ATC, see page 406, Figure 10.3, panel b.

Paradox of PC market:

The simultaneous pursuit of Profit Max by firms in a PC market will result in Zero Econ Profits for

all firms in the LR. Also, the minimum cost production (min ATC) will prevail for all firms.

Remember that Zero Econ Profit = Pos Acctg. Profit = Normal, risk-adjusted normal rate-of-return.

Also, the PC market represents the "ideal" market outcome for consumers and society because P = MC

and P = min ATC, and Econ Profits are 0.

Market Equilibrium

See p. 408, Figure 10.4, we now look at the conditions for the entire market or industry. We start at

Point E with a P* of $6, corresponding to the firm's demand curve on p. 406, Figure 10.3. The market

demand of 200 thousand units is supplied by 40 PC firms each supplying 5,000 units, at the min ATC

of $6. Market is in equilibrium, Econ Profits are 0, there is no tendency for firms to enter or exit the


Now suppose there is a permanent increase in D from D to D', due an increase in consumer income, or

an increase in the number of consumers in the market, a change of tastes/preferences, etc. What


ECN 469: Managerial Economics Professor Mark J. Perry

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1. SR - The increased D raises P* to $8, and Q* goes to 240 thousand at Point E'. Each firm now

increases output and supplies 6000 units. However, all firms now make Pos Econ Profits, since P >

ATC, $8 > $6.00.

2. LR - The Pos Econ Profits will attract entry, new firms will enter the industry. Eventually the

market will be at E*, P* = $6, and Q* = 280 thousand. P* = $6 = min ATC for the original firms, so

the original firms will reduce output and once again produce 5000 each. The market demand of

280,000 will now be supplied by (280,000 / 5000) 56 equal-size firms, each producing 5000 units.

That is, 16 new firms will enter the industry.

The market grew by 40% from 200,000 to 280,000, and number of firms grew by 40% from 40 to 56.

LR Market Supply

Notice that in this case the market grew by 40%, and the market price ($6) and min ATC ($6) stayed

the same in LR, indicating that this is a constant cost industry. Output increased without putting

upward (or downward) pressure on input costs. In the case of a constant cost industry, the LRAC curve

is flat at P*, and the LR Market Supply Curve is horizontal at P*. Example: Housing market in U.S has

a horizontal LR Supply Curve because the main inputs (building materials and construction workers)

are relatively abundant.

Example of Increasing Cost Industry: Oil Drilling uses inputs that are limited in supply: skilled labor,

sophisticated capital equipment, and a limited supply of land where oil is present. If oil drilling activity

increased by 30%, it is likely that the industry would face increasing costs of production (rising ATC)

due to: the increased competition and demand for: a) specialized equipment and b) skilled labor would

bid up prices for those inputs. Also, oil companies would start oil exploration and drilling on marginal

sites, resulting in rising ATC per barrel. Result: Rising ATC and an upward industry supply curve, due

to increasing costs of production.


Paradox: Narrow self-interest (profit maximizing behavior in a competitive market economy) results

in socially efficient outcomes. See Adam Smith quote, p. 410.

Almost a miracle that individual selfish decisions must lead to a collectively efficient outcome.

Individual wheat farmers are NOT trying to minimize the total cost of society's wheat, they are just

selfishly trying to maximize profits, but the net result of pursuing Profit Max in a PC market: MIN

ATC per bushel of wheat. In other words, there is NO OTHER ARRANGEMENT OR

ALTERNATIVE that would result in a lower overall cost to the society than a perfectly competitive

market. Explains why GDP per capita in Cuba is $1700 vs. $34,000 in U.S.

Remember that in a PC market: P = MC = min ATC = Zero Econ Profits, which is socially efficient.

As a consumer you are able to buy products at: a) the MC of production and b) the min ATC. What

outcome could be better?

ECN 469: Managerial Economics Professor Mark J. Perry

- 5 -

Private Markets: Benefits and Costs

To better understand market efficiency, we use Cost-Benefit analysis, since Max Efficiency is the

outcome where Benefits are Maximized, Costs are Minimized. Goal: MAX NET BENEFITS (B - C).

Day Care Example: Assume a couple would like up to 10 hours of day care per week, and would be

willing to pay up to $8 per hour, i.e. at P > $8 hour they prefer NOT to get daycare at all, and P = $8

they would be exactly indifferent between getting daycare and not getting it. At any P < $8/hour they

would like up to 10 hours.

Assume that there is a retired grandmother in the neighborhood who is qualified and recommended and

she is willing to provide daycare at a minimum price of $4/hr. If P < $4, she is unwilling to work, at

any P > $4 she is willing to work, and when P=$4 she is indifferent between working and not working.

Can the couple and grandmother enter into a mutually beneficial arrangement, i.e. a transaction where

both parties benefit? YES. Assume that they settle on P = $6/hr. for 10 hours per week. The couple is

willing to pay up to $8/hr. but they end up paying only $6, generating $2/hr. in "consumer surplus,"

which measures the difference between what they would be willing to pay ($80 week) and what they

actually have to pay ($60 week). The couple gets $20 per week in consumer surplus (CS), representing

their "gains from trade." See graph on p. 412, Figure 10.5.

The profits (gains) to the grandmother (seller) are called "producer surplus" and represent the

difference between what she is willing to work for ($40 per week) and what she actually gets ($60 per

week). The $20 per week represents her "economic profits" or "gains from trade."

A market transaction for 10 hours per week is efficient because it generates $40 worth of net benefits

(gains) for the participants and there is no other arrangement that would result in net benefits > $40.

For example, taxes, regulations or restrictions that resulted in only 5 hours per week of day of daycare

would generate only $20 of total gains per week, and that outcome would be inefficient compared to

the 10 hour alternative. In other words, at 5 hours per week there are unexploited gains from trade,

trade that would benefit both parties. In contrast, at 10 hours per week there are NO unexploited gains

from additional trade.

The Total Gain from Trade (per week):

CS + PS = (8 - P) Q + (P - 4) Q = 8Q - PQ + PQ - 4Q = 4Q

For ten hours per week CS + PS = $4 (10) = $40.

Note: P = $6 is NOT the only outcome, and the Total Gain does NOT depend on the market P. If P =

$7/hr., there is still $40 of Total Gain, but now the sellers gets $30 and the buyer gets $10. The market

price and the resulting distribution of the gain might depend on negotiating ability, buyer's elasticity of

demand vs. seller's elasticity of supply, etc. Given the initial assumptions, there is $40 of Total Gains

from Trade, which will be allocated to CS and PS in some combination. The exact distribution is

independent of the fact that there is $40 of gain.

ECN 469: Managerial Economics Professor Mark J. Perry

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The Entire Day-Care Market

See p. 414, Figure 10.6, for a graph of the Regional Demand Curve for day-care services in a given

geographical region (Flint, Genesee County, Michigan, etc.). Note that:

1. The maximum price anyone is willing to pay is $12/hour.

2. The area above the market price and under the demand curve (triangle) represents the monetary

value of the Consumer Surplus (CS).

Example: If the market price is $4/hour, there are actually thousands of consumers who would be

willing to between $4.01 and $12 per hour, but they only HAVE to pay $4, which generates CS for

consumers in the day-care market. Only the consumer at the margin actually values the service at

exactly $4/hour, everyone else values it more than $4. In this case, CS = (8 x $8) / 2 = $32m.

3. We can think of the Demand Curve as a Marginal Benefit Curve. The price represents the

monetary value that consumers are willing to pay for each additional, or marginal, unit of service. The

marginal benefits decline as more of the product is consumed.

We now add the market supply curve for the day-care market in the graph on p. 416, Figure 10.7.

Efficient day-care providers are charging $2.50/hour, meaning that less-efficient grandmothers

charging $4/hour are priced out of the day-care market. The competitive market price is $2.50/hour

and Q = 9.5m hours per week at the market price. The competitive outcome of P* = $2.50 and

Q* = 9.5m is efficient, i.e. it maximizes the Total Gains from Trade. In this case, the market is PC and

$2.50 is the MC and the ATC, and since P = ATC, economics profits = 0. In other words, ALL Gains

from Trade go to the consumer in the form of consumer surplus (CS) in a PC market!! CS Triangle =

($12 - 2.50) x 9.5 x .5 = $45.125m.

We also know that the height of the demand curve (which is the market price) measures the Marginal

Benefit (MB) of additional units at any given Q. Also, the height of the supply curve measures the MC

of producing the Qth unit. That is, the MB of day-care = $2.50 per hour and the MC of day-care =

$2.50 per hour, so Q* = 9.5m is optimal and socially efficient because MB = MC at that level of

output. Gains from exchange are MAXIMIZED by the market outcome.

Example: Suppose that a noncompetitive, artificial price was set at $4 per hour by a price control,

resulting in a reduction of Q to 8m. Who would advocate that price? The outcome is now inefficient

for the following reasons:

1. Now CS = $8 x 8 x .5 = $32m and NOT $45.125m, for a loss of CS = -$13.125m.

2. PS = ($4 - 2.50) x 8 = +$12m

3. Net Result: $12 of CS has been transferred to PS, resulting in a net loss (gain) of 0. However, there

is an overall net loss of CS of -$1.125m from the reduction in trade, which represents the "dead

weight loss (DWL)" or "dead weight cost" of restrictions on trade. See DWL triangle on board.

4. When P = $4, the MB > MC ($4 > 2.50), meaning that there is mutually advantageous (value

creating) trade from increasing output that is PREVENTED from taking place.

ECN 469: Managerial Economics Professor Mark J. Perry

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CONCLUSION: PC markets are socially efficient because they provide goods and services at the

minimum cost to the consumers who are most willing to pay for them for the following reasons:

1. Production is efficient, since only low-cost (min ATC) producers will survive in the LR. Intense

market competition will ensure that high-cost producers will either become low-cost producers in the

LR or get driven out of business. Profit-loss system provides intense discipline.

2. Consumption is efficient, in the sense that the "Law of One Price" prevails, and ONLY consumers

who are willing and able to pay the market price (those on the high end of the demand curve) will

actually end up with the goods. Also, efficiency in consumption means that you won't have an

outcome where consumers pay $4 for a good that they value at only $3. Only those consumers who

place a value of $4 or MORE will end up with the goods at the market price of $4, resulting in

efficiency in consumption.

3. The Level of Output is Efficient, i.e. the profit-maximizing level of output occurs where P = MB =

MC = min ATC, meaning that trade takes place between minimum-cost producers and maximum-

value consumers, ensuring that the level of output is efficient because it maximizes net benefits. In

other words, it is impossible to increase or decrease from Q* and increase net benefits.

Market-wide Efficiency

So far, we have discussed a single, competitive market. What about efficiency in thousands of

interdependent, multiple markets? Economic theory shows that if all individual markets are

perfectly competitive, the entire economy as a whole is efficient. A market economy composed of a

system of competitive markets where all inputs and outputs are bought and sold competitively will

provide the optimal solution to society's problem of resource allocation. Pure market economy

maximizes the net gains from trade, maximizes society's collective welfare, resulting in the highest

possible standard of living for the most amount of people.

In other words, 1) there is no alternative economic arrangement to a competitive market system that

will increase overall welfare, and 2) attempts to improve upon competitive markets (regardless of

intentions) will typically generate welfare losses for society. "Laissez-faire." Hayek: "The Fatal


Dynamic Efficiency Competitive markets are extremely dynamically efficient; a market economy is flexible, dynamic,

resilient and can easily adapt to changing market conditions, technology, demographics, etc. In fact,

the market is set to handle change with maximum efficiency, and is actually in a continual state of

adjustment, re-optimization, and resource reallocation with various self-adjustment and self-correcting

mechanisms. Market prices, the profit-and-loss system and entrepreneurs all contribute to the dynamic

adjustments in the economy. Markets are characterized by "Spontaneous Order." Examples:

1. When P = ATC and firms cannot control market price, they are in a constant search process to lower

ATC with new technology, new production methods, research and development, etc. Firms also have

an incentive to search globally for the lowest cost inputs.

ECN 469: Managerial Economics Professor Mark J. Perry

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2. Profits reward successful, efficient firms; and losses penalize inefficient, unsuccessful firms,

resulting in a continual re-allocation of scarce resources (inputs, labor, capital, land, etc.) AWAY from

firms that are losing money, TOWARD firms that are making money. In other words, successful firms

attract resources so that they can expand.

3. The profit motive leads firms ensures a dynamic, continual ongoing search for new products, new

markets, etc. Firms that develop new products gain by: a) getting monopoly protection and b) the “first

mover advantage.”

4. Prices have an "economic content" and thereby continually direct and coordinate economic activity

in a very dynamic way. Example: Oil prices go to $100/bbl due to scarcity. The high prices

discourage oil consumption of a scarce resource and encourage oil exploration and discovery. Also,

high oil prices increase the incentive to develop alternative sources of energy (wind, solar, etc.) to

reduce dependence on oil.

5. Spontaneous order: The ability of markets to organize efficiently and respond to dynamic change,

efficiently coordinating the economic activity of 260m people, 67m household, 135m workers and 7m

companies in U.S. Examples: language, Internet. For example, if Demand for a product increases,

price goes up automatically, and the Quantity Supplied goes up automatically. If input prices fall, and

Supply increases, the price falls, and Quantity Demanded goes up automatically.

For example, how is the number of hotels, grocery stores, restaurants, movie theaters, car dealers, hair

salons, gas stations, etc. in Genesee County determined?

Alternative to Market? Central Planning, where the govt. set prices, determines output, determines

allocation, etc.

Possible sources of market failure that we look at in Ch 14:

1. Monopoly power.

2. Negative externalities like pollution.

3. Imperfect information.

Case Study: International Trade (p. 421)

1. Assume that the U.S. watch market is closed to foreign imports and that the relevant (domestic)

market is:

Qd = 50 - 2P

Qs = -10 + 2P

Set Qd = Qs and solve for P* = $15 and Q* = 20m, see graph on p. 425, Figure 10.8, Panel a, Point E.

2. Assume now that there is complete, unrestricted free trade globally for watches. The relevant market

is now the world market, and the Total world demand = Total world supply, and the price is determined

ECN 469: Managerial Economics Professor Mark J. Perry

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by market conditions in the global economy. Suppose that the world price for watches is $12.50, and

the U.S. market is still such that:

Qd = 50 - 2P

Qs = -10 + 2P

At the world price of $12.50:

Qd = 50 - 2 (12.50) = 25m

Qs = -10 + 2 (12.50) = 15m

In other words, the U.S. demand for watches (25m) exceeds the U.S. supply of watches (15m), and

therefore 10m watches are imported from foreign producers at the prevailing world price of $12.50.

See Figure 10.8, Panel a:

Point D = total U.S. demand = 25m watches

Point C = total U.S. supply = 15m watches

Line Segment CD = U.S. imports = 10m watches

60% of the U.S. market is supplied by domestic producers and 40% is supplied by foreign producers.

Given Situations 1 and 2 above, we can do an analysis of the Net Effects of going from open trade to a

complete ban on Imports:

1. U.S. price goes up to $15, and we move from Point D to Point E.

2. Domestic watch producers benefit, they now have 100% of the market at a higher price.

3. Domestic consumers are harmed, they now buy fewer watches at a higher price.

How do the Benefits to Producers compare to the Costs to Consumers? Costs > Benefits, resulting in a

loss of efficiency, a reduction in welfare, a lower standard of living for the country, reduction of

wealth, jobs, etc. Here is why:

Loss to Consumers in the form of lower CS is represented by the trapezoid area: ABDE. Remember

that CS is the area under the demand curve, and above the market price.

Gain to producers in the form of increased profits and increased Producer Surplus is represented by the

area ABCE. Increased PS equals the area between the old and new price, and above the U.S. supply


The net benefit (cost) to society is equal to the area: -ABDE (costs) + ABCE (benefits) = ECD (shaded


ECD = "Dead-weight loss" to the economy of the trade prohibition. Some of the loss to consumers

(ABCE) is just a transfer of money or income from consumers to producers, for a net gain/loss of 0.

The DWL is like a pure economic waste - costs that are incurred and NOT accompanied by any

benefits for anyone. The area ECD represents a DWL of $12.5m. The source of the DWL is that that

ECN 469: Managerial Economics Professor Mark J. Perry

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there are 5m consumers who have been priced out of the market, and now do not buy a watch. Also,

the remaining 20m consumers all pay a higher price, $15 instead of $12.50. The economy has also lost

productive efficiency. In fact, using our earlier criteria from p. 417, the trade barriers result in a)

inefficient production, b) inefficient consumption, and c) an inefficient level of output!!

This result is very typical, in that trade barriers always result in economically inefficient outcomes

where C > B, DWLs are significant, etc. If trade barriers lower prosperity and reduce our standard of

living, why do we have 8800 tariffs?

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