What happens in short run under perfect competition?

The consequence of the preceding assumptions is that all exchanges in a perfectly competitive market will quickly converge to a single price. Since the good is viewed as being of identical quality and utility, regardless of the seller, and the buyers have perfect information about seller prices, if one seller is charging less than another seller, no buyer will purchase from the higher priced seller. As a result, all sellers that elect to remain in the market will quickly settle at charging the same price.

In Chapter 2 "Key Measures and Relationships" and Chapter 3 "Demand and Pricing", we examined the demand curves seen by a firm. In the case of the perfect competition model, since sellers are price takers and their presence in the market is of small consequence, the demand curve they see is a flat curve, such that they can produce and sell any quantity between zero and their production limit for the next period, but the price will remain constant (see Figure 6.1 "Flat Demand Curve as Seen by an Individual Seller in a Perfectly Competitive Market").

It must be noted that although each firm in the market perceives a flat demand curve, the demand curve representing the behavior of all buyers in the market need not be a flat line. Since some buyers will value the item more than others and even individual buyers will have decreasing utility for additional units of the item, the total market demand curve will generally take the shape of a downward sloping curve, such as Figure 6.2 "Demand Curve as Seen for All Sellers in a Market".

Figure 6.1 Flat Demand Curve as Seen by an Individual Seller in a Perfectly Competitive Market

Any amount the firm offers for sale during a production period (up to its maximum possible production level) will sell at the market price.

The downward sloping nature of the market demand curve in Figure 6.2 "Demand Curve as Seen for All Sellers in a Market" may seem to contradict the flat demand curve for a single firm depicted in Figure 6.1 "Flat Demand Curve as Seen by an Individual Seller in a Perfectly Competitive Market". This difference can be explained by the fact that any single seller is viewed as being a very small component of the market. Whether a single firm operated at its maximum possible level or dropped out entirely, the impact on the overall market price or total market quantity would be negligible.

Although all firms will be forced to charge the same price under perfect competition and firms have perfect information about the production technologies of other firms, firms may not be identical in the short run. Some may have lower costs or higher capacities. Consequently, not all firms will earn the same amount of profit.

Figure 6.2 Demand Curve as Seen for All Sellers in a Market

Although one seller sees a fixed price for its supply, if all sellers were to increase production, the maximum price that customers would pay to buy all the units offered would drop.

As described in the description of the shutdown rule in Chapter 2 "Key Measures and Relationships", some firms only operate at an economic profit because they have considerable sunk costs that are not considered in determining whether it is profitable to operate in the short run. Thus not only are there differences in profits among firms in the short run, but even if the market price were to remain the same, not all the firms would be able to justify remaining in the market when their fixed costs need to be replenished, unless they were able to adapt their production to match the more successful operators.

Pure or perfect competition is rare in the real world, but the model is important because it helps analyze industries with characteristics similar to pure competition. This model provides a context in which to apply revenue and cost concepts developed in the previous lecture. Examples of this model are stock market and agricultural industries.

1. Many sellers: there are enough so that a single seller�s decision has no impact on market price.

2. Homogenous or standardized products: each seller�s product is identical to its competitors�.

3. Firms are price takers: individual firms must accept the market price and can exert no influence on price.

4. Free entry and exit: no significant barriers prevent firms from entering or leaving the industry.

The individual firm will view its demand as perfectly elastic. A perfectly elastic demand curve is a horizontal line at the price. The demand curve for the industry is not perfectly elastic, it only appears that way to the individual firms, since they must take the market price no matter what quantity they produce. Therefore, the firm�s demand curve is a horizontal line at the market price.

Marginal revenue (MR) is the increase in total revenue resulting from a one-unit increase in output. Since the price is constant in the perfect competition. The increase in total revenue from producing 1 extra unit will equal to the price. Therefore, P= MR in perfect competition.

Short Run Analysis

In the short run, the firm has fixed resources and maximizes profit or minimizes loss by adjusting output. Firms should produce if the difference between total revenue and total cost is profitable (EP >0), or if the loss is less than the fixed cost (EP> - FC). The firm should not produce, but should shut down in the short run if its loss exceeds its fixed costs. By shutting down, its loss will just equal those fixed costs. Fixed cost in real life would be rent of the office, business license fees, equipment lease, etc. These cost would have to be paid with or without any output. Therefore, fixed cost would be the loss of shut down at any time. If by producing one unit of output, this loss could be lowered, then this unit should be produced to minimize the loss. However, if by producing one unit of output, this loss would be higher , then this unit should not be produced. The firm should shut down, just pay for the fixed cost.

If EP< - FC  firm should shut down. Then its lost will be the Fixed cost. EP = - FC. In order for EP < - FC, market price, P, must be lower than the minimum AVC.

If EP>- FC, firm should produce. That is when market price is greater than minimum AVC.

Marginal revenue and marginal cost (MC) are compared to decide the profit-maximizing output.

If MR > MC, then the firm should continue to produce.

If MR = MC, then the firm should stop producing the additional unit. As the additional unit�s MC would be higher according to law of diminishing returns, MR would be less than MC; that is, the firm would loss profit by producing additional units. Therefore, this is the profit maximizing output level.

If MR < MC, then the firm should lower its output.

In conclusion:

The shutdown point is the level of output and price at which the firm just covers its total variable cost. If the MR of the product is less than the minimum average variable cost (min AVC), the firm will shut down because this action minimizes the firm�s loss. In this case, the firm�s economic loss equals its total fixed costs. If MR < min AVC, then each additional unit produced would increase the loss. For pure competition, MR is equal to price as the firm is facing a perfectly elastic demand. Therefore, for short run, if Price < min AVC, then the firm should shut down. If Price > min AVC, then the firm should produce. Price and MC are compared to find the profit maximizing or loss minimizing output level. The supply curve of the pure competition firms would be the portion of the MC curve above the min AVC.

1. If EP < - FC or Market P < Min AVC, firm should shut down. Output = 0 , and EP = -FC

2. If EP > - FC or Market P > Min AVC, firm should produce. Firm's output level should be at where MR=MC or P=MC.  Use EP = TR - TC to get economic profit of the firm.

What happens in the long run and short run in a perfectly competitive market?

What is short run supply under perfect competition?

Where is short run equilibrium in perfect competition?

What happens to firms in the short run?