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Chapter 7
Perfect Competition
CHECK STATION 2
The typical firm in a perfectly competitive market has a cost structure described by the equation C ⴝ 25 ⴚ 4Q ⴙ Q2, where Q is measured in thousands of units. Using the profit-maximizing condition, P ⴝ MC, write an equation for the firm’s supply curve. If 40 such firms serve the market, write down the equation of the market supply curve. LONG-RUN EQUILIBRIUM Perfectly competitive markets exhibit a third important condition: In the long run, firms can freely enter or exit the market. In light of this fact, it is important to recognize that the profit opportunity shown in Figure 7.3a is temporary. Here the typical firm is earning a positive economic profit that comes to ($8.00 $6.50)(6,000) $9,000. But the existence of positive economic profit will attract new suppliers into the industry, and as new firms enter and produce output, the current market price will be bid down. The competitive price will fall to the point where all economic profits are eliminated. Figure 7.3b depicts the long-run equilibrium from the firm’s point of view. Here the firm faces a market price of $6 per unit, and it maximizes profit by producing 5,000 units over the time period. At this quantity, the firm’s marginal cost is equal to the market price. In fact, long-run equilibrium is characterized by a “sublime” set of equalities:
P MR LMC min LAC. In equilibrium, we observe the paradox of profit-maximizing competition: The simultaneous pursuit of maximum profit by competitive firms results in zero economic profits and minimum-cost production for all.5 In short, the typical firm produces at the point of minimum long-run average cost (LAC) but earns only a normal rate of return because P LAC.
Market Equilibrium Let’s shift from the typical firm’s point of view to that of the market as a whole. Figure 7.4 provides this marketwide perspective. The current equilibrium occurs at E, where the market price is $6 per unit (as in Figure 7.3b) and the industry’s total quantity of output is 200,000 units. This output is supplied by exactly 40 competitive firms, each producing 5,000 units (each firm’s point of 5
Remember that a zero economic profit affords the firm a normal rate of return on its capital investment. This normal return already is included in its estimated cost.
