Perfect Competition

The trouble with competitions is that somebody wins them. —George Orwell, 1944


Perloff 8, not 8.3; WB 14.
We examine the foundation of the Supply curve through the profit maximization problem for price-taking firms: how they decide whether or not to produce, and if so how much. We look at equilibrium in the long run, and will also briefly discuss firm behavior in the short run; see Perloff 8.3 for more details on equilibrium in the short run.

In applying the competitive model we will re-examine the effects of some market interventions with a better understanding of where the Supply and Demand curves come from.

Competitive firm behavior

Each firm must decide whether or not to produce, and if so how much. The firm's technology and the input prices it faces are captured by its cost function. We saw earlier how this can be done.

The entry-exit decision

Operating a firm or factory entails high fixed costs. If these costs are too high or the expected revenue is too low, the firm will exit. The good must fetch a sufficiently high price — above the break-even price — to make it worth it for the firm to enter (operate and produce). This is called the firm's shut-down rule.1 The firm will shut down when revenue falls below total cost R vs TC. Dividing both sides by quantity, we see that the firm shuts down whenever P < ATC.

  • Given a cost function, find the firm's break-even price.

Output choice

If the firm enters, it must choose how much to produce. We saw in class that for any profit-maximizing firm (also for oligopolists and monopolists), it is optimal to produce where MC = MR (marginal cost is equal to marginal revenue). For price-taking firms, the marginal revenue is the market price P.

Equilibrium

We only consider markets where all firms have the same cost function. In equilibrium, only n firms will enter and they will each make the same output choice q, leading to a total quantity supplied of QS = nq.

  • Given a common cost function and the market Demand, find the equilibrium number of firms n*, quantities produced by each firm q*, and price P*.

Short-run behavior

Capital is fixed in the short run. Now the shut down rule compares revenue and variable costs R vs VC, ignoring fixed costs. Dividing both sides by the quantity, we see that the firm will operate only if P > AVC. The short run marginal cost is w/MPL.

More resources

More information

  • The MC of pumping oil
    • Daniel Hamermesh on the marginal cost of pumping Texas oil
    • Oiligarchy, a (very political) free online game where, as an oil company, you find it optimal to upgrade oil rigs in response to regular price rises.

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