Lecture: Perfect Competition
Lecture script · about 15–20 minutes spoken · Week 10
Opening
Picture a farmers' market on a busy morning. Stall after stall sells brown eggs, and the eggs all look the same. If one seller asks more than the rest, shoppers take two steps to the next table. Nobody at that market sets the price of eggs. The market does.
Now picture the chair workshop from last week. It sells plain wooden chairs into a market full of workshops making the same chair. Its owner can't raise the price either. So the owner is left with two questions: how many chairs should I make, and should I open the doors at all? A farmer at a crowded market and a small furniture maker face exactly those two decisions, and the cost table answers both.
Here's where we are. In Week 4 you built the market supply curve and found the equilibrium price. In Week 8 you learned to think at the margin: do one more unit while its extra benefit is at least its extra cost. And in Week 9 you built the workshop's costs, from its 60 dollars of daily rent and tools up to a total of 228 dollars for 6 chairs.
In this lecture a market price meets that cost table. I'll start with what makes a market perfectly competitive. Then we'll find how many chairs the workshop makes, read its profit, and ask when it should close. We'll finish with the long run, where new firms arrive and old ones leave. Next week, in Week 11, we turn to a seller with no close rivals.
1. The traits of a perfectly competitive market
Think about what lets a seller charge more. A famous brand can. The only shop in town can. A seller at that crowded egg market can't, and the reasons are worth naming.
Economists bundle them into one model. Perfect competition is a market with many buyers and many sellers, an identical product, buyers and sellers who know the going price, and free entry and exit, so that no single firm can move the price. A firm in that market is a price taker: a firm too small to affect the market price, which can sell as much as it wants at that price and nothing at a higher one.
Each trait does a job. Many sellers make each one a small slice of the market. An identical product gives buyers no reason to pay one seller more. Known prices mean a seller who asks more is found out at once.
This is a model, a clean benchmark. Markets for farm goods like eggs, wheat, and tomatoes come close to it. We'll treat the chair market the same way.
Pause and try this. If the workshop asked a little more than the going price for its chair, how many chairs would it sell?
Think about where those buyers would walk.
Here's the answer. It would sell none, because buyers can get the identical chair from the next workshop at the market price.
2. Price equals marginal revenue
Let's put a price on the chair. Say the market price is 40 dollars. The first chair the workshop sells brings in 40 dollars. So does the second. So does the sixth. Selling one more never pushes the price down, because the workshop is too small to move the market.
That idea has a name. Marginal revenue is the change in total revenue from selling one more unit of output. For a price taker, every unit sells at the market price, so marginal revenue equals the price.
Total revenue is the price times the quantity. At 40 dollars a chair, 5 chairs bring in 200 dollars and 6 chairs bring in 240. Each step up adds 40 dollars, every time.
Now picture a graph with chairs along the bottom and dollars per chair up the side. The demand this one workshop faces is a flat line across the graph at 40 dollars. That flat line doesn't mean buyers ignore price. It means they care so much that a seller asking more than 40 dollars loses every sale.
Pause and try this. At a market price of 40 dollars, how much does the 3rd chair add to the workshop's revenue?
Count what one more chair brings in.
Here's the answer. It adds 40 dollars, because for a price taker every chair, the 3rd included, sells at the market price.
3. The output rule: MR equals MC
Now we know what each chair brings in. Week 9 told us what each chair adds to cost. Week 8 gave us the rule that joins them.
Here's the plain idea. Make one more chair whenever it adds at least as much to revenue as it adds to cost. Stop when the next one would add more cost than revenue. That's the profit-maximizing rule: a firm earns the most profit by producing the quantity where marginal revenue equals marginal cost, written MR equals MC. Every profit-maximizing firm uses it.
For a price taker, marginal revenue is the price. So the rule becomes the P = MC rule, said aloud as "price equals marginal cost": the firm produces where price equals marginal cost, on the rising part of the marginal-cost curve.
Let's run it at 40 dollars. From Week 9, the six chairs add 30, 20, 16, 22, 32, and 48 dollars of cost. The first five each add no more than 40. The 6th adds 48, which is more than the 40 it brings in. So the workshop makes 5 chairs.
You can check that by computing profit, which is total revenue minus total cost. At 4 chairs, profit is 12 dollars. At 5 chairs, 20 dollars. At 6 chairs, back down to 12. Five chairs wins.
Why the rising part? Marginal cost first falls, from 30 to 20 to 16, and then climbs. The firm's choice is always where marginal cost is climbing through the price.
Pause and try this. At 40 dollars, why doesn't the workshop make the 6th chair?
Compare the 6th chair's cost with what it brings in.
Here's the answer. The 6th chair adds 48 dollars of cost but only 40 dollars of revenue, so making it would cut profit.
4. Profit as a rectangle
There's a second way to see profit, and it gives you a picture. Profit is the price minus average total cost, times the number of chairs. In words, it's the profit on each chair times how many chairs.
At 40 dollars the workshop makes 5 chairs, and its average total cost at 5 chairs is 36 dollars. So each chair earns 4 dollars above its average cost. Four dollars times 5 chairs is 20 dollars, the same profit we found before.
Now raise the price to 50 dollars. The 6th chair's marginal cost of 48 is no more than 50, so the workshop makes 6 chairs. Average total cost at 6 chairs is 38 dollars. Each chair earns 12 dollars above its average cost, and 6 chairs bring a profit of 72 dollars. Revenue of 300 minus total cost of 228 agrees.
On the graph, draw the flat price line at 40 dollars. Below it sits the average-total-cost curve, shaped like a U, with its lowest point at 36 dollars and 5 chairs. Go across to 5 chairs. The profit is a rectangle. Its height runs from 36 up to 40, and its width runs from zero to 5 chairs. Its area is the profit, 20 dollars.
Pause and try this. At 40 dollars, is the workshop's profit 200 dollars or 20 dollars?
Ask whether the number subtracts any cost.
Here's the answer. The profit is 20 dollars, because 200 dollars is total revenue, and profit subtracts the 180 dollars of total cost.
5. The break-even price
Let the price slide down to 36 dollars. The workshop still makes 5 chairs, since the 5th chair's marginal cost of 32 is no more than 36, and the 6th chair's 48 is more. Revenue is 180 dollars. Total cost is 180 dollars. Profit is zero.
That price has a name. The break-even price is the price equal to the lowest point of a firm's average total cost, at which revenue exactly covers every cost and economic profit is zero. For this workshop it's 36 dollars, the bottom of the U-shaped curve.
Pause and try this. Which cost curve's lowest point gives the break-even price: average variable cost or average total cost?
Think about which costs revenue must cover to break even.
Here's the answer. It's average total cost, because breaking even means covering every cost, fixed and variable.
6. A loss worth taking
Now the price drops to 30 dollars, below the break-even price. Following the rule, the workshop makes 4 chairs: the 4th chair's marginal cost of 22 is no more than 30, and the 5th chair's 32 is more. Revenue is 120 dollars. Total cost is 148. That's a loss of 28 dollars.
So should it close? Here's a short story. Imagine you've already paid a month's rent on a market stall. On a slow day, you're deciding whether to show up. If you stay home, the rent is gone anyway. If you show up and your sales cover your supplies with a little left over, that little bit helps pay the rent. Showing up loses you less.
The workshop is in that spot. If it closes, it still owes the 60 dollars of rent and tools, so it loses 60. If it opens, its 120 dollars of revenue covers the 88 dollars of variable cost and leaves 32 toward the rent. The loss shrinks from 60 to 28. That's Week 8's sunk-cost idea at work: the rent can't be avoided by closing for the day, so it shouldn't drive the choice.
Pause and try this. At 30 dollars, does the workshop lose more by opening or by closing?
Put the two losses side by side.
Here's the answer. It loses more by closing, 60 dollars against 28, so it stays open even though it takes a loss.
7. The shutdown rule
There's a quicker test that gives the same answer every time. The shutdown rule says a firm keeps operating while the price covers average variable cost, even at a loss, and shuts down when the price falls below the minimum of average variable cost, losing only its fixed cost. That lowest point is the shutdown price.
Week 9 found the workshop's lowest average variable cost at 22 dollars, at 3 and 4 chairs. So its shutdown price is 22 dollars.
Try a price of 20 dollars. That's below 22, so no batch of chairs can pay for its own wood and labor. If the workshop made 4 chairs anyway, it would bring in 80 dollars against a total cost of 148, a loss of 68. Closing loses only the 60 dollars of fixed cost. So it closes for the day.
Now hold the two thresholds together. Below 22 dollars, the workshop closes. Between 22 and 36, it operates at a loss smaller than its rent. At 36 and above, it breaks even or earns a profit. And closing for a day isn't leaving the industry; the workshop can reopen when the price recovers.
Pause and try this. A classmate says the workshop should close at any price below 36 dollars. Using the shutdown rule, what's wrong with that?
Think about which cost the shutdown test uses.
Here's the answer. The test uses average variable cost, with its low point at 22 dollars, so between 22 and 36 the workshop stays open and loses less than its 60 dollars of rent.
8. Entry and exit in the long run
So far the price came from outside and stayed put. Over a longer stretch, it moves, because firms come and go. This is where free entry and exit does its work.
Start at 40 dollars, where the workshop earns a profit of 20 dollars. That profit is a signal: workshops here beat their owners' next-best options. So new workshops start making the same chair. Name the curve that moves: market supply. Name the direction: it shifts right. And the result: the market price falls. Entry keeps going while there's profit to earn, so it stops when the price reaches 36 dollars.
Now start at 30 dollars, where the workshop loses 28 dollars. Some owners leave when their leases run out. Market supply shifts left, and the market price rises. Exit keeps going while firms take losses, so it also stops at 36 dollars.
That resting point is the long-run competitive equilibrium: the price equals the minimum of average total cost, and each firm earns zero economic profit.
Pause and try this. When new workshops enter, which curve shifts, and which way does the price move?
Ask whether entry adds buyers or sellers.
Here's the answer. Market supply shifts right, because entry adds sellers, and the market price falls toward 36 dollars.
9. What zero economic profit means
Zero profit sounds bleak, as if the owners work for nothing. It isn't what the model says.
Remember Week 9. Accounting profit subtracts only the money a firm pays out. Economic profit subtracts the owner's implicit costs too: the pay the owner gives up and the return the owner's savings could earn. In this classroom model, the workshop's cost table counts all of those, so the profit we've been computing is economic profit.
So at 36 dollars, zero economic profit means the owner's time and money earn exactly what they could earn in their next-best use. The books, which leave out that implicit cost, still show a positive accounting profit. The owner is doing as well here as anywhere else, and that's exactly why nobody rushes in and nobody rushes out.
Notice too how marginal and average cost split the work. Marginal cost against the price says how many chairs. The lowest average variable cost, 22 dollars, says whether to open. Average total cost, with its low point at 36, says whether there's a profit. Carry it as one line: marginal cost says how many; average cost says whether.
Pause and try this. In the long run the workshop earns zero economic profit. Does its owner earn nothing?
Think about what economic profit already subtracts.
Here's the answer. No, because economic profit already subtracts the owner's forgone earnings, so zero means a normal return, as good as the next-best option.
10. The classic wrong turns
First, a firm doesn't shut down whenever it takes a loss. At 30 dollars the workshop loses 28 by opening and 60 by closing, so it opens. Second, output isn't set where price equals average total cost. Profit is the price minus average total cost, times quantity, so stopping where those are equal makes profit zero by design. Third, zero economic profit doesn't mean the owner earns nothing. And fourth, a competitive firm doesn't choose its price; the market does.
One more trap is worth flagging now. The rule MR equals MC holds for every firm. It becomes P equals MC only because a price taker's marginal revenue is the market price. A seller that has to lower its price to sell more has a marginal revenue below its price, and that's where we go next.
Pause and try this. Which rule holds for every profit-maximizing firm: P equals MC, or MR equals MC?
Think about what makes the two rules match.
Here's the answer. MR equals MC holds for every firm, and it reads as P equals MC only for a price taker, whose marginal revenue is the price.
Closing
Let's pull it together. In a perfectly competitive market, the price comes from the market, and each firm is a price taker. For a price taker, marginal revenue is the price. The firm makes every chair whose marginal cost is no more than the price, on the rising part of marginal cost; at 40 dollars that's 5 chairs. Profit is the price minus average total cost, times quantity, a rectangle on the graph. The break-even price is the bottom of average total cost, 36 dollars. Between 22 and 36 the workshop operates at a loss smaller than its rent, and below 22 it shuts down. In the long run, entry and exit push the price to 36 dollars and economic profit to zero, which is a normal return, not nothing.
Next in this module come the slide deck, the Readings and Resources page, the lecture tutorial, and the practice set. Then you'll take the quiz, join the discussion, and work the Model Workshop. And next week we turn to Monopoly, where a seller with no close rivals reads the MR equals MC rule a new way.
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