The assumptions of the model of perfect competition ensure that every decision maker is a price taker—the interaction of demand and supply in the market determines price. Although most firms in real markets have some control over their prices, the model of perfect competition suggests how changes in demand or in production cost will affect price and output in a wide range of real-world cases.
A firm in perfect competition maximizes profit in the short run by producing an output level at which marginal revenue equals marginal cost, provided marginal revenue is at least as great as the minimum value of average variable cost. For a perfectly competitive firm, marginal revenue equals price and average revenue. This implies that the firm’s marginal cost curve is its short-run supply curve for values greater than average variable cost. If price drops below average variable cost, the firm shuts down.
If firms in an industry are earning economic profit, entry by new firms will drive price down until economic profit achieves its long-run equilibrium value of zero. If firms are suffering economic losses, exit by existing firms will continue until price rises to eliminate the losses and economic profits are zero. A long-run equilibrium may be changed by a change in demand or in production cost, which would affect supply. The adjustment to the change in the short run is likely to result in economic profits or losses; these will be eliminated in the long run by entry or by exit.
Consider the following goods and services. Which are the most likely to be produced in a perfectly competitive industry? Which are not? Explain why you made the choices you did, relating your answer to the assumptions of the model of perfect competition.
Explain how each of the following events would affect the marginal cost curves of firms and thus the supply curve in a perfectly competitive market in the short run.
The graph below provides revenue and cost information for a perfectly competitive firm producing paper clips.
|Output||Total Revenue||Total Variable Cost||Total Fixed Cost|
Suppose rocking-chair manufacturing is a perfectly competitive industry in which there are 1,000 identical firms. Each firm’s total cost is related to output per day as follows:
|Quantity||Total cost||Quantity||Total cost|
Suppose the demand curve in the market for rocking chairs is given by the following table:
|Price||Quantity of chairs Demanded/day||Price||Quantity of chairs Demanded/day|
Plot the market demand curve for chairs. Compute and plot the market supply curve, using the information you obtained for a single firm in part (c). What is the equilibrium price? The equilibrium quantity?
The following table shows the total output, total revenue, total variable cost, and total fixed cost of a firm. What level of output should the firm produce? Should it shut down? Should it exit the industry? Explain.
|Output||Total revenue||Total variable cost||Total fixed cost|
Suppose that the market for dry-erase pens is perfectly competitive and that the pens cost $1 each. The industry is in long-run equilibrium. Now suppose that an increase in the cost of ink raises the production cost of the pens by $.25 per pen.