Firms in perfect competition face the maximum amount of competition because there are many competing firms, each of which produces an identical product.
Firms in perfect competition maximize their profit by producing where MR = MC.
Perfect competition leads to an efficient allocation of resources.
I. What is Perfect Competition?
Perfect competition is an industry in which
Many firms sell identical products to many buyers
There are no restrictions on entry into the industry
Established firms have no advantage over existing ones
Sellers and buyers are well informed about prices
These characteristics of perfect competition arise when the minimum efficient scale for a firm is small relative to the size of the entire market.
Firms operating in perfect competition seek to maximize economic profit, which is the difference between total revenue (the price of the firm’s output multiplied by the quantity sold) and its total opportunity cost of production.
Firms in perfect competition are price takers, meaning that a firm that cannot influence the market price and so it sets its own price equal to the market price.
Because the firm is a price taker, its marginal revenue—which is the change in total revenue that results in a one-unit increase in the quantity sold—is equal to the market price and remains constant as output sold increases. The firm’s demand is perfectly elastic and the firm’s demand curve is a horizontal line at the market price.
II. The Firm’s Output Decision
Marginal Analysis and the Supply Decision
The firm produces the quantity of output for which the difference between total revenue and total cost is at its maximum because this difference is its economic profit.
Marginal analysis can be used to determine the profit maximizing quantity. The firm compares the marginal revenue (which remains constant with output) to the marginal cost (which changes with output) of producing different levels of output.
When MR > MC, then the extra revenue from selling one more unit exceeds the extra cost of producing one more unit, so the firm increases its output to increase its profit.
When MR < MC, then the extra cost of producing one more unit exceeds the extra revenue from selling one more unit, so the firm decreases its output to increase its profits
When MR = MC, then the extra cost of producing one more unit equals the extra revenue from selling one more unit, so the firm’s profit is maximized at this level of output.
In the figure the firm produces 4 units of output because that is the quantity that sets the firm’s marginal cost equal to its marginal revenue, that is, MR = MC. The firm then charges the going market price of $30 for its product.
Temporary Shutdown Decision
The firm will temporarily shut down in the short run when price falls below the shutdown point, which is the output and price that just allows the firm to cover its total variable cost. The minimum AVC is the lowest price at which the firm will operate because if it operated with a lower price, the firm’s loss would be greater than if it shut down. (The loss when the firm shuts down is equal to its fixed cost.)
The firm will continue operating in the short run even if it incurs an economic loss as long as the price exceeds the minimum AVC.
The Firm’s Supply Curve
As long as the firm remains open, it produces where MR = MC. So the firm’s supply curve is its MC curve above the minimum AVC. At prices below the minimum AVC, the firm shuts down and supplies zero.
The figure shows the firm’s supply curve as the heavy dark line.
At prices less than the minimum average variable cost, which equals P in the figure, the firm shuts down and supplies zero.
At prices greater than the minimum average variable cost, the firm supplies along its marginal cost curve. Hence the firm’s marginal cost curve is its supply, indicated in the figure by the S = MC curve.
III. Output, Price, and Profit in the Short Run
The short-run market supply curve