Unit 10

June 11, 2020 Mr Maurice Ntemo 2014 1

After studying this chapter, you will be able to:
Define perfect competition
Explain how firms make their supply decisions and why they
sometimes shut down temporarily and lay off workers
Explain how price and output in an industry are determined
and why firms enter and leave the industry
Predict the effects of a change in demand and of a
technological advance
Explain why perfect competition is efficient

June 11, 2020 Mr Maurice Ntemo 2014 2

Themes of this chapter:
1.What is Perfect Competition?
2.The Firm’s Decisions in Perfect Competition
3.Output, Price and Profit in Perfect Competition
4.Changing Tastes and Advancing Technology
5.Competition and Efficiency

June 11, 2020 Mr Maurice Ntemo 2014 3

What is perfect competition?
Perfect competition is an industry in which competition is
as fierce (very strong) and extreme as possible ;
Many firms sell identical products to many buyers.
There are no restrictions to entry into the industry.
Established firms have no advantages over new ones.
Sellers and buyers are well informed about prices.
Sellers are price takers.
Taxi industry is one of so many examples.

June 11, 2020 Mr Maurice Ntemo 2014 4

How Perfect Competition Arises
Perfect competition arises:
When firm’s minimum efficient scale is small relative to market
demand so there is room for many firms in the industry. A firm’s
minimum efficient scale is the smallest quantity of output at
which long-run average cost reaches its lowest level.
And when each firm is perceived to produce a good or
service that has no unique characteristics, so consumers
don’t care which firm they buy from.

June 11, 2020 Mr Maurice Ntemo 2014 5

Price Takers
A price taker is a firm that cannot influence the market price and that sets its own
price at the market price.
The key reason why a perfectly competitive firm is a price taker is that it produces a
tiny proportion of the total output of a particular good and buyers are well informed
about the prices of other firms.
Imagine that you are a farmer in Kwazulu Natal. You have a thousand hectares to
cultivate on – which sounds like a lot. But compared to the thousands of hectares in the
rest of the country, as well as the millions more in Botswana, Mozambique and
Lesotho, your thousand acres is a drop in the ocean. Nothing makes your wheat any
better than any other farmer’s, and all the buyers of wheat know the price at which they
can do business.
If the market price of wheat is R2 400 a ton and you ask for R2 500, no one will buy
from you.
People can go to the next farmer and the next and the one after that and buy all they
need for R2 400 a ton. If you set your price at R2 300, you’ll have lots of buyers. But
you can sell all your output for R2 400 a ton, so you’re just giving away R100 a ton.
You can do no better than sell for the market price – you are a price taker. For that
reason, each firm’s demand curve is completely elastic and horizontal. But the
demand curve for the industry is still a bit downward sloping.
June 11, 2020 Mr Maurice Ntemo 2014 6
Economic Profit and Revenue
A firm’s goal is to maximise economic profit, which is equal to total revenue minus
total cost.
Total cost is the opportunity cost of production, which includes normal profit, the
return that the entrepreneur can expect to receive on the average in an alternative
business.
Total Revenue
A firm’s total revenue equals the price of its output multiplied by the number of units
of output sold (price times quantity).
Marginal Revenue
Marginal revenue is the change in total revenue that results from a one-unit increase
in the quantity sold. Marginal revenue is calculated by dividing the change in total
revenue by the change in the quantity sold.
Figure 10.1 illustrates a firm’s revenue concepts.
Part (a) shows that market demand and market supply determine the
market price that the firm must take.

June 11, 2020 Mr Maurice Ntemo 2014 7

Demand for Firm’s Product and Market Demand

June 11, 2020 Mr Maurice Ntemo 2014 8

 FIGUre 10.1 Demand, Price, and Revenue in Perfect Competition
A horizontal demand curve is perfectly elastic. So the firm faces a perfectly elastic demand for
its output. One of Sifiso’s sweaters is a perfect substitute for sweaters from the factory next door
or from any other factory. Notice, though, that the market demand for sweaters in Figure 10.1(a)
is not perfectly elastic. The market demand curve is downward-sloping, and its elasticity depends
June 11, 2020 Mr Maurice Ntemo 2014 9
on the substitutability of sweaters for other goods and services.
 A perfectly competitive firm faces two constraints:
1. A market constraint summarized by the market price and
the firm’s revenue curves.
2. A technology constraint summarized by the firm’s
product curves and cost curves (like those in Unit 9).
The goal of the firm is to make maximum economic profit,
given the constraints it faces.
So the firm must make four decisions: Two in the short run and
two in the long run.

June 11, 2020 Mr Maurice Ntemo 2014 10

 The Firm’s Decisions in Perfect Competition
Short-Run Decisions
In the short run, the firm must decide:
1. Whether to produce or to shut down temporarily.
2. If the decision is to produce, what quantity to produce.
The table below lists Sifiso’s total revenue, total cost, and economic profit. Part (a)
graphs the total revenue and total cost curves. Economic profit, in part (a), is the height
of the blue area between the total cost and total revenue curves. Sifiso’s makes
maximum economic profit, R420 a day (R2 250 – R1 830), when it produces 9
sweaters – the output at which the vertical distance between the total revenue and total
cost curves is at its largest. At outputs of 4 sweaters a day and 12 sweaters a day,
Sifiso’s makes zero economic profit – these are breakeven points. At outputs less than
4 and greater than 12 sweaters a day, Sifiso’s incurs an economic loss. Part (b) of the
figure shows Sifiso’s profit curve. The profit curve is at its highest when economic
profit is at a maximum and cuts the horizontal axis at the breakeven points.
June 11, 2020 Mr Maurice Ntemo 2014 11
June 11, 2020 Mr Maurice Ntemo 2014 12
Long-Run Decisions
In the long run, the firm must
decide:
1. Whether to increase or
decrease its plant size.
2. Whether to stay in the industry
or leave it.
Part (a) also shows the total cost
curve, TC, which is like the one in
Unit 9.
Total revenue minus total cost is
economic profit (or loss), shown by
the curve EP in part (b).
The Firm and the Industry in the
Short Run and the Long Run
June 11, 2020 Mr Maurice Ntemo 2014Figure 10.2 Total Revenue, Total13Cost,
and Economic Profit
Profit-Maximising Output
Marginal Analysis
• The firm can use marginal analysis to determine the profit-
maximizing output.
• Because marginal revenue is constant and marginal cost
eventually increases as output increases, profit is maximized by
producing the output at which marginal revenue, MR, equals
marginal cost, MC.
• Figure 10.3 on the next slide shows the marginal analysis that
determines the profit-maximizing output.
• If MR > MC, economic profit increases if output increases.
• If MR < MC, economic profit decreases if output increases.
• If MR = MC, economic profit decreases if output changes in
either direction, so economic profit is maximized.
June 11, 2020 Mr Maurice Ntemo 2014 14
June 11, 2020 Mr Maurice Ntemo 2014 15
June 11, 2020 Mr Maurice Ntemo 2014 16
Profits and Losses in the Short Run
In short-run equilibrium, although the firm produces the profit-maximising output, it
does not necessarily end up making an economic profit. It might do so, but it might
alternatively break even or incur an economic loss. Economic profit (or loss) per
sweater is price, P, minus average total cost, ATC. So economic profit (or loss) is
(P – ATC) X Q. If price equals average total cost, a firm breaks even – the entrepreneur
makes normal profit. If price exceeds average total cost, a firm makes an economic
profit. If price is less than average total cost, a firm incurs an economic loss.
Figure 10.4 shows these three possible short-run profit outcomes.
Three Possible Profit Outcomes
In Figure 10.4(a), the price of a sweater is R200. Sifiso’s produces 8 sweaters a day. Average total
cost is R200 a sweater. Price equals average total cost (ATC), so Sifiso’s Sweaters breaks even (zero
economic profit) and Sifiso’s makes normal profit.
In Figure 10.4(b), the price of a sweater is R250. Profit is maximised when output is 9 sweaters a
day. Here, price exceeds average total cost, so Sifiso’s makes an economic profit of R420 a day. It is
made up of R46,70 per sweater (R250 – R203,33) times the number of sweaters (R46,70 X 9 =
R420). The height of the blue rectangle is profit per sweater, R46,70, and the quantity of sweaters
produced, 9 a day, so the area of the rectangle is Sifiso’s economic profit of R420 a day.
In Figure 10.4(c), the price of a sweater is R170. It is less than average total cost resulting in an
economic loss. Price and marginal revenue are R170 a sweater, and the profitmaximising (in this
case, loss-minimising) output is 7 sweaters a day. Sifiso’s total revenue is R1190 a day. Average
total cost
Juneis
11,R201,40
2020 a sweater, so the economic
Mr Mauriceloss is R31,40per
Ntemo 2014 sweater (R201,40 – R170). 17 This
loss per sweater times the number of sweaters is R220 (R31,40 x7 = R220).
June 11, 2020 Mr Maurice Ntemo 2014 18
The Firm’s Short-Run Supply Curve
A perfectly competitive firm’s short run supply curve shows
how the firm’s profit-maximizing output varies as the market
price varies, other things remaining the same.
Because the firm produces the output at which marginal cost
equals marginal revenue, and because marginal revenue
equals price, the firm’s supply curve is linked to its marginal
cost curve.
But there is a price below which the firm produces nothing
and shuts down temporarily.
 Temporary Factory Shutdown
 The Short-Run Supply Curve

June 11, 2020 Mr Maurice Ntemo 2014 19

June 11, 2020 Mr Maurice Ntemo 2014 20
Short-Run Industry Supply Curve
The short-run industry supply curve shows the quantity supplied by the industry at
each price when the factory size of each firm and the number of firms remain constant.
The quantity supplied by the industry at a given price is the sum of the quantities
supplied by all firms in the industry at that price.

Figure 10.6 shows the supply curve for an industry that has 1,000
firms like Lesedi’s.
At a price equal to minimum average variable cost—the shutdown
price—the industry supply curve is perfectly elastic because some firms
will produce the shutdown quantity and others will produce zero.

June 11, 2020 Mr Maurice Ntemo 2014 21

June 11, 2020 Mr Maurice Ntemo 2014 22
So far, we have studied a single firm in isolation. We have seen that the
firm’s profit-maximising actions depend on the market price, which the
firm takes
June 11, as
2020given. But how is the market
Mr Maurice price determined?
Ntemo 2014 23
Output, Price, and Profit in Perfect Competition
To determine the market price and the quantity bought and sold in a
perfectly competitive market, we need to study how market demand and
market supply interact. We begin this process by studying a perfectly
competitive market in the short run when the number of firms is fixed
and each firm has a given factory size.
Short-Run Equilibrium
Market demand and market supply determine the market price and
industry output. Figure 10.7 shows a short-run equilibrium. The supply
curve S is the same as S1 in Figure 10.6. If the market demand is shown
by the demand curve D1, the equilibrium price is R200 a sweater. Each
firm takes this price as given and produces its profit-maximising output,
which is 8 sweaters a day.
Because the industry has 1 000 firms, industry output is 8 000 sweaters a
day.

June 11, 2020 Mr Maurice Ntemo 2014 24

In part (a), the industry supply curve is S. Demand is D1, and the price is R200. At this
price, each firm produces 8 sweaters a day and the industry produces 8 000 sweaters a
day. In part (b), when demand increases to D2, the price rises to R250 and each firm
increases its output to 9 sweaters a day. Industry output is 9 000 sweaters a day. When
demand decreases to D3, the price falls to R170 and each firm decreases its output to 7
sweaters
Junea 11,
day.
2020Industry output is 7Mr
000 sweaters
Maurice a day.
Ntemo 2014 25
A Change in Demand
Changes in demand bring changes to short-run industry equilibrium.
An increase in demand bring a rightward shift of the industry demand
curve: the price rises and the quantity increases.
If demand increases, the demand curve shifts rightward to D2. The price rises to R250.
At this price, each firm maximises profit by increasing output. The new output is 9
sweaters a day for each firm and 9 000 sweaters a day for the industry. Figure 10.7
shows these changes.
A decrease in demand bring a leftward shift of the industry demand
curve: the price falls and the quantity decreases.
If demand decreases, the demand curve shifts leftward to D3. The price now falls to
R170. At this price, each firm maximises profit by decreasing its output. The new
output is 7 sweaters a day for each firm and 7 000 sweaters a day for the industry.
If the demand curve shifts farther leftward than D3, the price remains constant at R170
because the industry supply curve is horizontal at that price. Some firms continue to
produce 7 sweaters a day, and others temporarily shut down. Firms are indifferent
between these two activities, and whichever they choose, they incur an economic loss
equal to total fixed cost. The number of firms continuing to produce is just enough to
satisfy June
the 11, 2020
market demand at a priceMrofMaurice
R170Ntemo 2014
a sweater. 26
Long-Run Adjustments
In short-run equilibrium, a firm may make an economic profit,
break even, or incur an economic loss.
Which of these outcomes occurs determines how the industry
adjusts in the long run.
In the long run, the firm may:
Enter or exit an industry
Change its plant size

June 11, 2020 Mr Maurice Ntemo 2014 27

Entry and Exit
Entry and exit influence price, the quantity produced, and economic profit. The
immediate effect of these decisions is to shift the industry supply curve. If more firms
enter an industry, supply increases and the industry supply curve shifts rightward. If
firms exit an industry, supply decreases and the industry supply curve shifts leftward.
The Effects of Entry
As new firms enter an industry, industry supply increases.
The industry supply curve shifts rightward.
The price falls, the quantity increases and the economic profit of each firm
decreases.
The Effects of Exit
As firms leave an industry, the price rises and the economic loss of each remaining firm
decreases. The same PC industry that saw a large amount of entry during the 1980s and
1990s has seen some exit. For example, in 2001, IBM, the firm that first launched the
PC, announced that it would no longer produce PCs. The intense competition from
Compaq, HP, Dell, and others that entered the industry following IBM’s lead has
lowered the price and eliminated the economic profit. So IBM now concentrates on
servers and other parts of the computer market. IBM exited the PC market because it
was incurring economic losses. Its exit decreased supply and made it possible for the
June 11, 2020 Mr Maurice Ntemo 2014 28
remaining firms in the industry to make zero economic profit.
June 11, 2020 Mr Maurice Ntemo 2014 29
Changes in Factory Size
A firm changes its factory size if, by doing so,
it can lower its costs and increase its
economic profit. You can probably think of
lots of examples of firms that have changed
their factory size.
Initially, Sifiso’s factory has marginal cost
curve MC0 and short-run average total cost
curve SRAC0. The market price is R250 a
sweater, and Sifiso’s marginal revenue is
MR0. The short-run profit-maximising FIGURE 10.9 Factory Size and Long-Run
Equilibrium
quantity is 6 sweaters a day. Sifiso’s Sweaters
can increase profit by increasing the factory
size.
If all firms in the sweater industry increase their factory sizes, the short-run
industry supply increases and the market price falls. In long-run equilibrium, a firm
operates with the factory size that minimises its average total cost. Here, Sifiso’s
Sweaters operates the factory with short-run marginal cost MC1 and short-run average
cost SRAC1.
June 11, 2020 Mr Maurice Ntemo 2014 30
Sifiso’s Sweaters is also on its long-run average cost curve LRAC and produces at point M. Its
output is 8 sweaters a day, and its average total cost equals the price of a sweater: R200.

Changing Tastes and Advancing Technology

Increased awareness of the health hazards of smoking has caused a decrease in the
demand for tobacco and cigarettes. The development of inexpensive car and air
transportation has caused a huge decrease in the demand for long-distance trains and
buses. Solid-state electronics have caused a large decrease in the demand for TV and
radio repair. The development of good quality inexpensive clothing has decreased the
demand for sewing machines. What happens in a competitive industry when there is a
permanent decrease in the demand for its product?
The widespread use of the personal computer has brought a huge increase in the
demand for CDs. What happens in a competitive industry when the demand for its
output increases?
Advances in technology are constantly lowering the costs of production. New
biotechnologies have dramatically lowered the costs of producing many food and
pharmaceutical products. New electronic technologies have lowered the cost of
producing just about every good and service. What happens in a competitive industry
when technological change lowers its production costs?
Let’s use the theory of perfect competition to answer these questions.
June 11, 2020 Mr Maurice Ntemo 2014 31
 A Permanent Change in Demand
A decrease in demand shifts the market demand curve leftward. The price
falls and the quantity decreases.
Figure 10.10 illustrates the effects of a permanent decrease in demand
when the industry is in long-run equilibrium.
A decrease in demand shifts the industry demand curve leftward. The
market price falls, and each firm decreases the quantity it produces.
An industry starts out in long-run competitive equilibrium. Part (a) shows the industry
demand curve D0, the industry supply curve S0, the equilibrium quantity Q0, and the
market price P0. Each firm sells its output at price P0, so its marginal revenue curve is
MR0 in part (b). Each firm produces q0 and makes zero economic profit.
Demand decreases permanently from D0 to D1 (part a). The market price falls to P1,
each firm decreases its output to q1 (part b), and industry output decreases to Q1 (part
a). In this new situation, firms incur economic losses and some firms leave the
industry.
As they do so, the industry supply curve gradually shifts leftward, from S0 to S1. This
shift gradually raises the market price from P1 back to P0. While the price is below P0,
firms incur economic losses and some
June 11, 2020
firms leave the industry. Once the price has
Mr Maurice Ntemo 2014 32
returned to P0, each firm makes zero economic profit. Firms have no further incentive
June 11, 2020 Mr Maurice Ntemo 2014 33
External Economics and Diseconomies
The change in the long-run equilibrium price following a
permanent change in demand depends on external economies and
external diseconomies.
External economies are factors beyond the control of an
individual firm that lower the firm’s costs as the industry output
increases.
External diseconomies are factors beyond the control of a firm
that raise the firm’s costs as industry output increases.
Figure 10.11(a) shows that in the absence of external economies
or external diseconomies, an increase in demand does not change
the price in the long run.

June 11, 2020 Mr Maurice Ntemo 2014 34

 The long-run industry supply curve LSA is horizontal.
Figure 10.11(b) shows that when external diseconomies are
present, an increase in demand brings a higher price in the long
run.
Figure 10.11(c) shows that when external economies are
present, an increase in demand brings a lower price in the long
run.
The long-run industry supply curve LSC is downward sloping.

June 11, 2020 Mr Maurice Ntemo 2014 35

Three possible changes in price and quantity occur in the long run. When demand
increases from D0 to D1, entry occurs and the industry supply curve shifts rightward
from S0 to S1.
In part (a), the long-run industry supply curve, LSa, is horizontal. The quantity
increases from Q0 to Q1, and the price remains constant at P0.
In part (b), the long-run industry supply curve is LSb; the price rises to P2, and the
quantity increases to Q2. This case occurs in industries with external diseconomies. In
part (c), the long-run industry supply curve is LSc; the price falls to P3, and the
quantity increases to Q3.
This case occurs in an industry with external economies.

June 11, 2020 Mr Maurice Ntemo 2014 36

Technological Change
New technologies are constantly discovered that lower costs.
A new technology enables firms to produce at a lower average cost
and a lower marginal cost—the firms’ cost curves shift downward.
Firms that adopt the new technology make an economic profit.
Competition and Efficiency
Efficient Use of Resources
Resource use is efficient when we produce the goods and services that people value
most highly. If someone can become better off without anyone else becoming worse
off, resources are not being used efficiently. For example, suppose we produce a
computer that no one wants and no one will ever use and, at the same time, some
people are clamouring for more video games. If we produce one less computer and
reallocate the unused resources to produce more video games, some people will
become better off and no one will be worse off. So the initial resource allocation was
inefficient.
In the more technical language that you have learned, resource use is efficient when
marginal social benefit equals marginal social cost. In the computer and video games
example, the marginal social benefit of a video game exceeds its marginal social cost.
June 11, 2020 Mr Maurice Ntemo 2014 37
And the marginal social cost of a computer exceeds its marginal social benefit.
So by producing fewer computers and more video games, we move resources toward a
higher-valued use.

Choices, Equilibrium, and Efficiency

 Choices
Consumers allocate their budgets to get the most value possible out of them. And
we derive a consumer’s demand curve by finding how the best budget allocation
changes as the price of a good changes. So consumers get the most value out of their
resources at all points along their demand curves. If the people who consume a good or
service are the only ones who benefit from it, there are no external benefits and the
market demand curve is the marginal social benefit curve.
Competitive firms produce the quantity that maximises profit. And we derive the firm’s
supply curve by finding the profit-maximising quantity at each price. So firms get the
most value out of their resources at all points along their supply curves. If the firms that
produce a good or service bear all the costs of producing it, there are no external costs
and the market supply curve is the marginal social cost curve.


June 11, 2020 Mr Maurice Ntemo 2014 38

 Equilibrium and Efficiency
Resources are used efficiently when marginal social benefit equals marginal social cost.
And competitive equilibrium achieves this efficient outcome because for consumers,
price equals marginal social benefit and for producers, price equals marginal social
cost.
The gains from trade are the consumer surplus plus the producer surplus. The gains
from trade for consumers are measured by consumer surplus, which is the area below
the demand curve and above the price paid. The gains from trade for producers are
measured by producer surplus, which is the area above the supply curve and below the
price received. The total gains from trade are the sum of consumer surplus
and producer surplus. When the market for a good or service is in equilibrium, the
gains from trade are maximised.
 Illustrating an Efficient Allocation
Figure 10.12 illustrates an efficient allocation of resources in a perfectly
competitive industry.
In part (a), each firm is producing at the lowest possible long-run average total
cost at the price P* and the quantity q*. (P=MC)
The quantity Q* and price P* are the competitive equilibrium values.
June 11, 2020 Mr Maurice Ntemo 2014 39
So competitive equilibrium is efficient.
In part (a), a firm in perfect competition produces at the lowest possible long-run
average total cost at q*. In part (b), consumers have made the best available choices
and are on the market demand curve and firms are producing at least cost and are on
the market supply curve. With no external benefits or external costs, resources are used
efficiently at the quantity Q* and the price P*. Perfect competition achieves an
efficient use
June 11,of resources.
2020 Mr Maurice Ntemo 2014 40