Lecture 8 Perfect Competition

Administrative

1. Turn in Problem Sets NOW.
   
2. Desired answers will be posted to the Web page 'soon' (this afternoon?)
   

A. Conditions for Perfect Competition

1. Firms sell a standardized product. Consumers have equal 'reservation values' or 'willingness-to-pay' for any firm's product in the market. Usually means that products have the same features.

2. Factors of production are perfectly mobile in the long run. Any firm can mimic any other firm and produce with the same costs. If one firm has an advantage in a key asset, (i.e., a better technology), then this 'factor of production' may not be perfectly mobile, even in the long run.

3. Firms are price takers. Firms take the prices as given. In fact, a firm's output decisions can affect prices because it increases industry supply. However, any one firm is likely to have a minuscule effect, unless there are few firms or they collude.

4. Firms and consumers have perfect information. Consumers know exactly all the alternative products they can purchase and they know the prices of these products.

B. Entry, Rents and Output at the Firm Level

1. One cost curve that we did not talk about last time was the average cost curve (fig 1). This average cost is equal to total costs divided by output. Two features of average costs are 1) that when MC is below AC, AC is falling and 2) when MC is above AC then AC is rising.

2. The average cost curve allows us to see if a firm is earning profits or not. The price is the average revenue. When average revenues exceed average costs, the firm must be earning profits (fig 2). In the short run, firms equating price with marginal costs could earn profits.

3. Our conditions listed above imply that any other firm could enter the market and also earn profits. Since firms are profit maximizing, some firm (firms) will enter. To attract customers, they will offer slightly lower prices, that every other firm must match (fig 3). At these lower prices, price equals marginal cost at a lower level of output (output falls) and the firms earns fewer profits (since average revenue falls.

4. So long as there remain profits to be had, firms will continue to enter. Their doing so, drives prices down to the point of minimum average cost (fig 4). At this point, two things are true, 1) price equals marginal costs (firms are maximizing profits) and 2) price equals average costs (firms are not earning any profits). The point at which we get zero entry is where we have zero profits.

5. A feature of competitive markets, then is that production occurs in the least costly way. Each firm is at the minimum of their average cost curves and only the technology with the lowest average cost will survive.

C. Implications of Entry, for Rents and Output at the Industry Level

1. Q: Why are industry supply curve for competitive industries not horizontal then? As more firms enter, the industry supply curve gets flatter and flatter (fig. 5).

2. A: 1) They often are horizontal. 2) Sometimes, a factor input is scarce. As firms demand more and more of this input, less and less productive inputs are used (Ex. of marginal land in farming). This raises the price of the factor input to everyone (fig. 6).

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