Analysis of Perfectly Competitive Markets

A. Supply Behavior of the Competitive Firm

1. A perfectly competitive firm sells a homogeneous product and is too small to affect the market price. Competitive firms are assumed to maximize their profits. To maximize profits, the competitive firm will choose that output level at which price equals the marginal cost of production, that is, Diagrammatically, the competitive firm’s equilibrium will come where the rising MC supply curve intersects its horizontal demand curve.

2. Variable costs must be taken into consideration in determining a firm’s short-run shutdown point. Below the shutdown point, the firm loses more than its fixed costs. It will therefore produce nothing when price falls below the shutdown price.

3. A competitive industry’s long-run supply curve, must take into account the entry of new firms and the exodus of old ones. In the long run, all of a firm’s commitments expire. It will stay in business only if price is at least as high as long-run average costs. These costs include out-of-pocket payments to labor, lenders, material suppliers, or landlords and opportunity costs, such as returns on the property assets owned by the firm.

B. Supply Behavior in Competitive Industries

4. Each firm’s rising MC curve is its supply curve. To obtain the supply curve of a group of competitive firms, we add horizontally their separate supply curves. The supply curve of the industry hence represents the marginal cost curve for the competitive industry as a whole.

5. Because firms can adjust production over time, we distinguish two different time periods: (a) short-run equilibrium, when variable factors like labor can change but fixed factors like capital and the number of firms cannot, and (b) long-run equilibrium, when the numbers of firms and plants, and all other conditions, adjust completely to the new demand conditions.

6. In the long run, when firms are free to enter and leave the industry and no one firm has any particular advantage of skill or location, competition will eliminate any excess profits earned by existing firms in the industry. So, just as free exit implies that price cannot fall below the zero-profit point, free entry implies that price cannot exceed long-run average cost in long-run equilibrium.

7. When an industry can expand its production without pushing up the prices of its factors of production, the resulting long-run supply curve will be horizontal. When an industry uses factors specific to it, such as scarce beachfront property, its long-run supply curve will slope upward.

C. Special Cases of Competitive Markets

8. Recall the general rules that apply to competitive supply and demand: Under the demand rule, an increase in the demand for a commodity (the supply curve being unchanged) will generally raise the price of the commodity and also increase the quantity demanded. A decrease in demand will have the opposite effects.

Under the supply rule, an increase in the supply of a commodity (the demand curve being constant) will generally lower the price and increase the quantity sold. A decrease in supply has the opposite effects.

9. Important special cases include constant and increasing costs, completely inelastic supply (which produces economic rents), and backward-bending supply. These special cases will explain many important phenomena found in markets.

D. Efficiency and Equity of Competitive Markets

10. The analysis of competitive markets sheds light on the efficient organization of a society. Allocative efficiency occurs when there is no way of reorganizing production and distribution such that everyone’s satisfaction can be improved. Put differently, an economy is efficient when no individual can be made better off without making another individual worse off.

11. Under ideal conditions, a competitive economy attains allocative efficiency. Efficiency requires that all firms are perfect competitors and that there are no externalities like pollution or improved information. Efficiency implies that economic surplus is maximized, where economic surplus equals consumer surplus plus producer surplus.

12. Efficiency comes because (a) when consumers maximize satisfaction, the marginal utility (in terms of leisure) just equals the price; (b) when competitive producers supply goods, they choose output so that marginal cost just equals price; (c) since Thus the marginal social cost of producing a good under perfect competition just equals its marginal utility valuation in terms of goods or leisure forgone. It is exactly this conditionÑthat the marginal gain to society from the last unit consumed equals the marginal cost to society of that last unit producedÑwhich guarantees that a competitive equilibrium is efficient.

13. There are exacting limits on the conditions under which an efficient competitive equilibrium can be attained: There can be no externalities and no imperfect competition, and consumers and producers must have complete information. The presence of imperfections leads to a breakdown of the price ratio 5 marginal cost ratio 5 marginal utility ratio conditions, and hence to inefficiency.

14. The outcome of competitive markets, even when efficient, may not be socially desirable. Competitive markets by themselves will not necessarily ensure outcomes that correspond to the society’s ideals about the fair distribution of income and consumption. Societies may modify the laissez-faire equilibrium to change the income distribution to correct for a perceived unfairness of dollar votes of demand.