Decisions of the Competitive Firm

In 1999, the respective worldwide demand and supply curves for copper were: QD 15 10P and QS 3 14P, where Q is measured in millions of metric tons per year. Find

the competitive price and quantity. Suppose that in 2000 demand is expected to fall by

20 percent, so QD (.8)(15 10P) 12 8P. How much are world copper prices

expected to fall?

CHECK STATION 1

COMPETITIVE EQUILIBRIUM

Perfect competition is commonly characterized by four conditions.

1. A large number of firms supply a good or service for a market consisting of a large number of consumers. 2. There are no barriers with respect to new firms entering the market. As a result, the typical competitive firm will earn a zero economic profit. 3. All firms produce and sell identical standardized products. Therefore, firms compete only with respect to price. In addition, all consumers have perfect information about competing prices. Thus, all goods must sell at a single market price. 4. Firms and consumers are price takers. Each firm sells a small share of total industry output, and, therefore, its actions have no impact on price.

Each firm takes the price as given—indeed, determined by supply and demand. Similarly, each consumer is a price taker, having no influence on the market price.

It is important to remember that these conditions characterize an ideal model of perfect competition. Some competitive markets in the real world meet the letter of all four conditions. Many other real-world markets are effectively perfectly competitive because they approximate these conditions. At present, we will use the ideal model to make precise price and output predictions for perfectly competitive markets. Later in this and the following chapters, we will compare the model to real-world markets.

In exploring the model of perfect competition, we first focus on the individual decision problem the typical firm faces. Then we show how firm-level decisions influence total industry output and price.

Decisions of the Competitive Firm

The key feature of the perfectly competitive firm is that it is a price taker; that is, it has no influence on market price. Two key conditions are necessary for price taking. First, the competitive market is composed of a large number of sellers (and buyers), each of which is small relative to the total market. Second,

the firms’ outputs are perfect substitutes for one another; that is, each firm’s output is perceived to be indistinguishable from any other’s. Perfect substitutability usually requires that all firms produce a standard, homogeneous, undifferentiated product, and that buyers have perfect information about cost, price, and quality of competing goods.

Together, these two conditions ensure that the firm’s demand curve is perfectly (or infinitely) elastic. In other words, it is horizontal like the solid price line in Figure 7.3a. Recall the meaning of perfectly elastic demand. The firm can sell as much or as little output as it likes along the horizontal price line ($8 in the figure). If it raises its price above $8 (even by a nickel), its sales go to zero. Consumers instead will purchase the good (a perfect substitute) from a competitor at the market price. When all firms’ outputs are perfect substitutes, the “law of one price” holds: All market transactions take place at a single price. Thus, each firm faces the same horizontal demand curve given by the prevailing market price.

THE FIRM’S SUPPLY CURVE Part (a) of Figure 7.3 also is useful in describing the supply of output by the perfectly competitive firm. The cost characteristics of the typical firm in the competitive market are as shown in the figure. The firm faces a U-shaped, average cost curve (AC) and an increasing marginal cost curve (MC). (Recall that increasing marginal cost reflects diminishing marginal returns.)

Suppose the firm faces a market price of $8. (For the moment, we are not saying how this market price might have been established.) What is its optimal level of output? As always, the firm maximizes profit by applying the MR MC rule. In the case of perfectly elastic demand, the firm’s marginal revenue from selling an extra unit is simply the price it receives for the unit: MR P.

Here the marginal revenue line and price line coincide. Thus, we have the following rule:

A firm in a perfectly competitive market maximizes profit by producing up to an output such that its marginal cost equals the market price.

In Figure 7.3, the intersection of the horizontal price line and the rising marginal cost curve (where P MC) identifies the firm’s optimal output. At an $8 market price, the firm’s optimal output is 6,000 units. (Check for yourself that the firm would sacrifice potential profit if it deviated from this output, by producing either slightly more or slightly less.) Notice that if the price rises above $8, the firm profitably can increase its output; the new optimal output lies at a higher point along the MC curve. A lower price implies a fall in the firm’s optimal output. (Recall, however, that if price falls below average variable cost, the firm will produce nothing.) By varying price, we read the firm’s optimal output off the marginal cost curve. The firm’s supply curve is simply the portion of the MC curve lying above average variable cost.

Cost and Revenue per Unit

P = $8.00

AC = $6.50 MC

AC

P = MR

FIGURE 7.3

Price and Output under Perfect Competition

In part (a), the firm produces 6,000 units (where P MC) and makes a positive economic profit. In part (b), the entry of newfirms has reduced the price to $6, and the firm earns zero economic profit.

Q = 6 Output (Thousands of Units)

(a) A Competitive Firm’s Optimal Output

Cost and Revenue per Unit

MC

AC

P = $6.00 P = MR

Q = 5 Output (Thousands of Units)

(b) Long-Run Equilibrium in a Competitive Market