Chapter 10/The Firm and the Industry under Perfect Competition
CHAPTER 10
THE FIRM AND THE INDUSTRY UNDER
PERFECT COMPETITION
Chapter 10 develops the model of the perfectly competitive firm and the perfectly competitive
industry. It stresses the zero profit condition for long-run equilibrium.
CHAPTER OUTLINE
PERFECT COMPETITION DEFINED
Perfect competition exists when:
1. There are numerous small firms and customers.
2. The product of all the firms is homogeneous.
THE PERFECTLY COMPETITIVE FIRM
Under perfect competition the firm is a price taker. The firm has no choice but to accept the
price that has been determined by the market.
The Firm’s Demand Curve under Perfect Competition
A perfectly competitive firm faces a horizontal demand curve. It can sell as much as it wants
at the market price.
Short-Run Equilibrium for the Perfectly Competitive Firm
Because the demand curve is horizontal (i.e., the firm is a price taker), the firm’s demand
Short-Run Profit: Graphic Representation
A graph can be drawn to show the profit-maximizing output, together with the actual profit
level.
The Case of Short-Term Losses
The profit-maximizing output may lead to a loss, but if so it is the minimum possible loss.
Chapter 10/The Firm and the Industry under Perfect Competition
Shutdown and Break-Even Analysis
Rule 1: The firm will make a loss if total revenue (TR) is less than total cost (TC). In that
case, it should plan to shut down, either in the short run or the long run.
The Perfectly Competitive Firm’s Short-Run Supply Curve
The short-run supply curve is the portion of the marginal cost curve that lies above the
FARMING ECONOMICSL UNPREDICTABLE WEATHER DRIVES
DOWN CORN PRICES
Because farmers operate within a perfectly competitive market then they are price takers.
THE PERFECTLY COMPETITIVE INDUSTRY
The Perfectly Competitive Industry’s Short-Run Supply Curve
Summing the short-run supply curves of all the firms in the industry horizontally derives the
short-run supply curve of the competitive industry.
Industry Equilibrium in the Short Run
A competitive industry has a stable equilibrium at the output where supply equals demand.
Industry and Firm Equilibrium in the Long Run
In the long run, firms enter or exit the industry in response to profits or losses.
Zero Economic Profit: The Opportunity Cost of Capital
Economic costs include opportunity costs, so zero economic profit means that firms are
The Long-Run Industry Supply Curve
The long-run supply curve of the perfectly competitive industry is also the industry’s
long-run average cost curve.
Chapter 10/The Firm and the Industry under Perfect Competition
PERFECT COMPETITION AND ECONOMIC EFFICIENCY
In the long run, perfectly competitive firms are driven to produce at the minimum point of
their average cost curves.
In this case, output is produced at the lowest possible cost to society.
WHICH MORE EFFECTIVELY CUTS POLLUTION: THE CARROT OR
THE STICK?
The analysis of perfect competition can be used to show that if firms are offered a subsidy to
MARGIN DEFINITIONS
Perfect Competition: occurs in an industry when that industry is made up of many small firms
producing homogeneous products, when there is no impediment to entry or exit of firms, and
when full information is available.
Price Taker: a firm that has no choice but to accept the price that has been determined in the
market.
Variable Cost: a cost whose total amount changes when the quantity of output of the supplier
changes.
MAJOR IDEAS
1. The demand curve of the perfectly competitive firm is horizontal because so many other
firms are selling identical products and the firm’s output is so small a share of the
industry’s production that it cannot affect price (i.e., the firm is a price-taker). With a
horizontal demand curve, price, average revenue, and marginal revenue are all equal.
2. The short-run equilibrium of the perfectly competitive firm is at the level of output that
ON TEACHING THE CHAPTER
There is a lot of material in Chapter 10 and it is important material, not so much because of its
correspondence to reality, but for other reasons. It is an application of the principles of Chapter 8,
and helps to reinforce those principles. Furthermore, the case of pure competition constitutes a
Chapter 10/The Firm and the Industry under Perfect Competition
standard by which other market structures can be judged. The presentation flows so logically that
students should be able to understand the basics fairly easily.
A most interesting point to ponder in class is the zero profit condition for long-run
equilibrium of the industry. It is a different kind of equilibrium condition than the text has dealt
PROBLEMS
1. The price of strawberries is $10 a bucket. Three competitive strawberry farmers, Jones,
Garcia, and Moon, face different cost conditions:
Total Cost (thousands of dollars)
Thousands
of Buckets Jones Garcia Moon
10 100 275 50
20 200 335 125
30 300 400 225
40 400 470 350
50 500 545 500
60 600 625 675
70 700 710 875
80 800 800 1100
a) For each farmer, calculate the marginal cost at each output level.
b) Describe in words the difference between the cost schedules of the three farmers.
c) What are the profit-maximizing output levels of the three farmers, and what are their
profits at those outputs?
d) Explain the differences and/or similarities in the outputs and profits of the three
farmers.
Chapter 10/The Firm and the Industry under Perfect Competition
Solution:
a)
Marginal Cost
Thousand
s
of buckets
Thousands of dollars
Jones Garcia Moon
10 10 5.5 5
20 10 6 7.5
b) Total cost and marginal cost are different for the three farmers. For Jones, marginal
cost is fixed at various levels of output. As output increases, marginal cost decreases
2. Farmer Dorr figures that her fixed costs are $2,000, and the relevant portion of her total
cost curve is:
Thousands of Total Cost
Bushels (in thousands of dollars)
10 10.70
11 11.45
12 12.25
13 13.10
14 14.00
15 15.00
16 16.10
17 17.32
18 18.75
19 20.30
a) Calculate Farmer Dorr’s schedules of average cost, marginal cost, total variable cost,
and average variable cost.
b) If Farmer Dorr is a perfect competitor, what level of output should she produce, and
what will her profits be, if the market price is:
(i) $1.50 (iii) $0.92
(ii) $1.00 (iv) $0.82
Chapter 10/The Firm and the Industry under Perfect Competition
Solution:
a)
Outpu
t
Total
cost AC MC TVC AVC
10 10.7 1.07 — 8.7 0.87
11 11.45 1.04 0.75 9.45 0.86
3. a) Draw the relevant diagrams for a typical farm, and for the market as a whole, when
the market for wheat is in long-run equilibrium.
b) Changes in tastes reduce the demand for wheat substantially. What happens to price
and output in the market for wheat? What happens to the price, output, and profits of
the individual wheat farmer in the short run? Illustrate with diagrams.
c) How does the market move to a new long-run equilibrium? Using diagrams, show the
new price and quantity of wheat in the market. Show also the new price, output, and
profits of the individual farmer.
Solution
a)
b) The decrease in demand throughout the industry would lead to a decline in the
c) The losses would eventually cause some firms to exit the industry. (Farmers would go
Chapter 10/The Firm and the Industry under Perfect Competition
4. Xander Harris is considering whether to buy a corn and soybean farm in Iowa. The farm
will cost $800,000, and Xander will be able to pay this from profits his recently deceased
mother made on the stock market and willed to him. He estimates that if he does not run
the farm, and keeps his current job as an economic forecaster, he will be able to earn
$40,000 a year. The prevailing interest rate is 9 percent. Xander’s only motive is to
maximize his income.
a) From the accounting perspective only, should he buy the farm and become a farmer if
his accountant tells him the annual profit from the farm is likely to be:
i) $160,000?
ii) $100,000?
iii) $50,000?
b) Because he is currently an economist, Xander decides to re-calculate the profit figures
according to the logic used by economists rather than accountants. What profit figures
does he come up with? Do these new figures cause him to change his mind about
becoming a farmer?
Solution:
a) Yes in all three cases (from an accounting viewpoint)
DISCUSSION QUESTIONS
1. Under what circumstances will drought help or hurt a farmer?
Suggested Answer: Students should discuss the effects of drought on an economy,
especially on farming, and possible government actions such as price ceilings and
2. When demand rises in a perfectly competitive market, do you think the long-run
equilibrium price will rise, fall, or stay constant? What will determine this?
Suggested Answer: In a perfectly competitive market, its long-run equilibrium price will
3. What examples of perfectly competitive markets can you think of in the economy?
Suggested Answer: Students should come up with their own examples that approximate
4. The text states that four conditions are necessary for the existence of a perfectly
competitive market. Discuss each one.
a) Numerous participants: Roughly how many sellers do you think are needed to make a
market perfectly competitive?
Chapter 10/The Firm and the Industry under Perfect Competition
b) Homogeneity of product: How would perfect competition be altered if buyers could
distinguish between the products of different producers?
c) Freedom of entry and exit: How might this condition be violated? What sorts of
barriers to entry or exit might exist?
d) Perfect information: What exactly needs to be known, and by whom, in order to make
competition perfect?
Suggested Answer:
a) The number of participants should be enough to ensure that no participant has control