Perfect Competition

This is Unit Seven of Principles of Microeconomics, part two of two: the competitive industry over time, its long-run supply curve, and what competition achieves. Carry the same idea as part one: a price taker produces where marginal cost rises to the price. Followed into the long run, that choice makes entry and exit restore a zero-profit price, gives the industry a supply curve of its own, and delivers the two kinds of efficiency that every later structure is measured against. By the end you will be able to trace a demand decrease, a cost change and a fixed-cost change through the short and long run. To classify an industry by its long-run supply curve. To run the two efficiency tests on a quantity. To say what efficiency leaves out and why competition is the benchmark. And to follow one firm from profit to exit, and say why price equals marginal cost is the efficiency condition.

Three entries traced through: a demand decrease, a cost change, and a fixed-cost change.

The reverse case.

MIC 0627 Tracing a Demand Decrease

Shift demand left from long-run equilibrium. The price falls, each firm moves down its marginal cost curve and takes a loss, and the shutdown test decides who keeps operating. Losses drive exit, market supply shifts left, and the price recovers until it is back at minimum average total cost, with fewer firms and lower industry output. From twenty-five dollars and seven flats a farm, the price drops to twenty; each farm grows six flats and loses thirty, but twenty exceeds average variable cost of fifteen, so farms keep operating while losing. Over time some sell up, the price climbs back to twenty-five, and the survivors return to seven flats and zero profit. Exit comes from the long-run loss, not the short-run one, and it raises the price for the survivors.

A cost change traced through.

MIC 0628 A Cost Change in the Short and Long Run

A lower input price shifts every firm's marginal cost down and market supply with it. In the short run price falls by less than the saving, so firms profit; entry then passes on the rest. A three-dollar cost cut lowers price by two at first and three in the end. Consumers get the whole saving in the long run, which is how competition passes innovation through.

A cost that does not move supply.

MIC 0629 A Fixed-Cost Change

A new fixed cost, such as a license fee, raises average total cost and leaves marginal cost alone. In the short run nothing changes; in the long run losses cause exit until the price covers the fee, so the fee reaches the price only after firms leave. Short-run price and output depend on marginal cost alone; fixed costs reach the price through exit, never through supply.

Four entries on long-run supply: the three industry types, classifying one, and a confusion the anchor itself makes.

The first industry type.

MIC 0630 Constant-Cost Industry

In a constant-cost industry, expansion leaves input prices unchanged, so new firms have the same costs as old ones and the long-run supply curve is horizontal at minimum average total cost. A small industry buying inputs from vast markets barely nudges their prices. Horizontal long-run supply means any quantity at one price: demand sets the quantity, cost alone sets the price.

The other two.

MIC 0631 Increasing- and Decreasing-Cost Industries

In an increasing-cost industry, expansion bids up input prices, so long-run supply slopes up; house building bids up carpenters' wages. In a decreasing-cost industry, expansion lowers input prices, and long-run supply slopes down; a growing computer industry cheapened its chips. Every point on any long-run supply curve is a zero-profit point, and what differs is the price at which zero profit occurs.

Classifying an industry.

MIC 0632 Classifying the Industry and Its Long-Run Supply

Ask what entry does to the prices of the industry's inputs. If nothing, it is constant-cost and long-run supply is horizontal at the original price. If entry bids input prices up, it is increasing-cost and long-run supply slopes upward. If entry lowers input prices, it is decreasing-cost and long-run supply slopes downward. Then say where the price settles after a demand increase. Strawberry farming buys land and labor from large markets, so the price returns to twenty-five dollars. Custom carpentry draws on a limited pool of joiners whose wages rise as shops open, so the price settles at twenty-eight. Solar panel assembly buys cells whose makers gain economies of scale as orders grow, so the price settles at twenty-two. The classification is about input prices as the industry expands, and an upward-sloping long-run supply curve is still a zero-profit curve.

A confusion the anchor itself makes.

MIC 0633 Constant Cost Is Not Constant Returns

A constant-cost industry is about input prices staying put as the industry grows. Constant returns to scale is about one firm's average cost staying put as it grows. Different subjects, different curves: the first is the industry's long-run supply, the second a firm's long-run average cost. The anchor runs the two together; the course keeps them apart, following the witness.

Five entries on efficiency: the two tests, running them on a quantity, what the word leaves out, and the benchmark.

The first efficiency test.

MIC 0634 Productive Efficiency in Competition

Productive efficiency means producing at the lowest possible average cost, and competition delivers it in the long run, since entry pushes every firm to the bottom of its average total cost curve; no cheaper way to grow the flats exists than the surviving farms' way. Productive efficiency says the output is made cheaply, nothing yet about whether it is the right amount.

The second test.

MIC 0635 Allocative Efficiency: P = MC

Allocative efficiency means producing the quantity society values most: where price, the last unit's worth to a buyer, equals marginal cost. Competition delivers it, since each firm produces to price equals marginal cost, so the last flat is worth what it took to grow. Below that quantity a unit worth more than its cost goes unmade; above it, one costing more gets made.

Testing a quantity.

MIC 0636 Testing Efficiency at a Quantity

Given a market's demand curve, a firm's marginal and average total cost, and a proposed quantity, run two tests. Allocative: compare the price buyers pay for the last unit with its marginal cost; price above means too little, marginal cost above means too much, equality passes. Productive: compare average total cost at the quantity with its minimum; equality passes. In the strawberry market buyers pay twenty-five dollars for the last flat and marginal cost at seven flats brackets the price, while average total cost at seven is at its minimum: both tests pass. A rule holding every farm to five flats fails both, since buyers would pay thirty for the last flat while marginal cost is sixteen, and average total cost at five is twenty-six, above its minimum. The tests are separate, and efficiency is a judgment about waste, not about fairness.

What the word leaves out.

MIC 0637 What Efficiency Does Not Mean

Efficiency is a specific term, not a synonym for desirable. Willingness to pay reflects the income distribution, so an efficient allocation can still be one a society finds unfair; a market can efficiently serve the rich and leave the poor unserved. The model also assumes away pollution, poverty, public goods and bad information, and the later units are where those assumptions come off.

Why the model is kept anyway.

MIC 0638 Competition as the Benchmark

Perfect competition is the benchmark the other structures are measured against. Monopoly, oligopoly and monopolistic competition each fail one or both efficiency tests, and the shortfall is measured from here; units eight and nine each begin by asking what changes when firms set prices. A benchmark is not a recommendation; it is the yardstick the next units use.

Two capstones: one firm's whole story from good times to exit, and why price equals marginal cost matters.

One firm's whole story.

MIC 0639 One Price-Taking Firm from a Price Cut to Exit

One cost table answers every question this unit asks, in the order a firm meets them. With the price high, the firm applies the marginal rule and reads its profit as price minus average total cost times the quantity; that profit draws entry. The price falls; the same rule gives a smaller quantity, now at a loss, and the firm runs the shutdown test: at or above average variable cost it operates at a loss, below it shuts down and still pays the fixed cost. In the long run it can shed its fixed inputs, and if the price has not recovered it exits, which raises the price for the survivors until they earn a normal profit. Two breakpoints organize everything: the break-even price at minimum average total cost separates profit from loss, and the shutdown price at minimum average variable cost separates operating at a loss from producing nothing. The strawberry farm, fixed cost sixty: at thirty dollars it grows eight flats and earns thirty-eight; entry pushes the price to twenty-five and it earns about zero at seven; a slump to twenty has it growing six at a loss of thirty, still above average variable cost of fifteen; a worse season at twelve puts the rule's four flats below average variable cost of thirteen fifty, so it shuts down and loses the sixty of fixed cost instead of sixty-six; and if twelve persists it sells its land and exits. The rule never changes, the shutdown test uses average variable cost, and exit, not shutdown, is what restores the price.

Why price equals marginal cost matters.

MIC 0640 Why Price Equals Marginal Cost Is the Efficiency Condition

Price equals marginal cost is the most important equality in this course. Price, on a demand curve, is the most some buyer would pay for one more unit, its marginal benefit to the person who values it most. Marginal cost, on a supply curve built from firms' marginal costs, is what one more unit costs society in resources drawn from other uses. Where they are equal, the last unit was worth exactly what it cost and no unit worth more than its cost was left unmade: allocative efficiency, the marginal rule of unit one applied to a whole market. Competition delivers it without anyone intending it, and in the long run adds productive efficiency, since entry pushes each firm to minimum average total cost. The benchmark says no surplus is wasted, given who has the money to express demand; it does not say that distribution is right, and it fails when a firm can set its price, when a cost falls on an outsider, when a good cannot be withheld from non-payers, or when one side knows what the other does not. In the strawberry market at twenty-five dollars and seven thousand flats, the last flat's buyer would pay twenty-five and it costs its farm between twenty-four and twenty-eight; force output down to five thousand and the last flat is worth thirty while costing sixteen, so value goes unmade; force it up to nine thousand and the last flat is worth about twenty while costing above twenty-eight, so resources worth more elsewhere are spent. Price equals marginal cost, not average cost, is the allocative condition, and it fails in exactly the places the outline lists as market failure.

Look at what you can now do. You can trace a demand decrease through losses, the shutdown test and exit until the price recovers, and see that a cost cut is passed through by entry while a fixed cost reaches the price only through exit. You can classify an industry by what entry does to its input prices, draw its long-run supply curve flat, rising or falling, and keep constant cost apart from constant returns. You can run the two efficiency tests, price against marginal cost and average cost against its minimum, and say why a competitive long-run equilibrium passes both. You can say that efficiency is about waste, not fairness, and that competition is a yardstick rather than a recommendation. And you can follow one farm from profit to exit across its two breakpoints, and explain why price equals marginal cost is the condition every later unit measures a departure from. Unit eight begins by breaking it, with the single seller.