Perfect Competition

Price-Taking Behavior

Regarding perfect competition, and why this fairly dull market type is used as a standard for all others…you'd assume all businesses have at least some control over their prices. Someone has to decide how much to charge, doesn't? But a wheat farmer in Kansas, with 500 acres of hard red winter wheat, exactly the same as the wheat grown on thousands of acres from Nebraska to Oklahoma, has absolutely no power to set a price. Not one bit. They sell for whatever the Chicago Board of Trade states the price is that morning. If they tried to charge even a cent more, buyers would go to the farm next door. Selling for less is simply wasting money.

Economists call this a price taker. The business is faced with a totally flat demand line at the market price. At that price you can sell all you like, but increase it by even a little and you won't sell anything at all.

Four things create this situation: many small businesses, products that are all the same, complete information for everyone involved, and the ability to start or stop operating freely. No actual market completely meets all four of these. Agricultural goods are close, and so are some financial markets like US Treasury bills. However, the point of the model wasn't to be a perfect copy of the real world, it's more like a plan. And it happens to be surprisingly good at predicting prices, production levels, and how markets change over time.

Profit Maximization: P = MC

To maximize profit: P = MC. Every company, from a Kansas wheat farm to Apple, uses the same basic thinking: continue making things as long as each additional one earns more money than it costs to create.

In a competitive market, each extra bushel sold adds exactly the market price to your income. Therefore, MR = P. And because the rule for maximizing profit is MR = MC, this simplifies to P = MC. You locate where the market price line crosses the marginal cost line and where they meet is the best amount to make.

If you go beyond that point, making each additional item costs you more than you make from it. If you stop before that point, you're missing out on profits from items you could have made. A common error on AP free-response questions is students being given a cost breakdown and asked for the profit maximizing production and they choose the quantity at the lowest ATC instead of where P = MC. And that gets you no points.

Move the demand or supply line on the graph and observe how the market price changes. The business's production will adjust automatically to where P = MC falls on their cost line.

Short-Run Profit and Loss

In the short term, three outcomes are possible, and which one happens depends completely on where the market price is in relation to the business's cost lines.

If P > ATC: the business makes a true economic profit. Every item sold brings in more than the average cost to make it, and the difference between the price and ATC multiplied by the quantity is the profit (the shaded rectangle on the graph).

If P AVC: the business is losing money. But they continue to produce. Why would they? Because costs that don't change like the building lease and loan payments have to be paid whether the business makes anything or shuts down. As long as the money coming in covers all the changing costs and reduces some of the fixed costs, closing would actually increase the loss. The company will stay in business and absorb the loss.

If the price (P) is less than the average variable cost (AVC), it should be shut down. At that point, the money coming in won't even cover the direct costs of production, and each item made will only increase the losses. The company won't make anything, but it will still have to pay its fixed costs. That price is the point at which closing is necessary.

The Shutdown Condition

Let's consider a restaurant with $5,000 monthly rent (regardless of being open), and revenue of $8,000. Its variable costs (food, wages, utilities) are $7,000. Staying open yields $8,000 - $7,000 - $5,000 = a loss of $4,000. If it closes, the loss is just the $5,000 rent. So, staying open is $1,000 less bad.

But if revenue falls to $6,000, with the same $7,000 in variable costs, staying open gives $6,000 - $7,000 - $5,000 = a $6,000 loss. Closing still means a $5,000 loss. In this case, it's better to close, because continuing to operate will only make the loss larger. The simple rule is to shut down if P < minimum AVC; below this point, the company will supply nothing. Above it, the marginal cost (MC) curve shows how much to produce, and this portion of the MC curve above the minimum AVC is what creates the short-run supply curve.

On the 2018 AP Micro exam, a question gave an AVC of $12 and a price of $10 and asked whether the company should continue. Answering "yes, because the firm should always produce in the short run" would get you no credit. You must compare the price to the AVC, and can't simply assume the firm will keep going.

Long-Run Equilibrium

In the long run, profits draw in competitors, while losses cause them to leave. Those two sentences pretty much explain the whole long-run picture of perfect competition.

When companies are making an economic profit, people from outside the industry notice. New companies enter the market, increasing the supply and pushing the market price down. Profits get smaller, and more new businesses enter until there's nothing extra to attract them.

When companies are losing money, the weakest ones leave. Supply goes down, the market price rises, and the losses shrink for those remaining. This exiting continues until the companies that survive are just breaking even.

The final result is P = minimum average total cost (ATC) for all firms, and economic profit is zero.

That "zero" can confuse those new to economics. Zero economic profit doesn't mean the business is doing badly. It means the owners are earning what they could earn in their next best option, the opportunity cost of their capital and time. A business with zero economic profit could easily be showing $2 million in accounting profit. It's a perfectly fine business, just not making anything more than what it would earn if it moved its resources somewhere else.

Efficiency in Perfect Competition

Perfect competition achieves two types of efficiency that no other market structure can match in the long run, and that's why the model is important, even though no real market is perfectly competitive.

Allocative efficiency happens when P = MC - the price consumers pay for the last unit is equal to the marginal cost of making it. Resources go exactly to where consumers value them the most, and you can't change production without making someone worse off.

Productive efficiency means each company produces at the lowest point on its ATC curve. Nothing is wasted and output is made at the lowest possible cost per unit.

When your AP textbook says a monopoly creates deadweight loss or monopolistic competition leads to "excess capacity," perfect competition is the standard being used. Every other market structure falls short of at least one of these standards in ways we can measure. And this isn't a small academic detail; it's the basis for antitrust laws, regulatory economics and the bulk of the second half of AP Microeconomics.

Worked Example

Let's do an example. If the market price for something is $40, and a company's marginal cost (how much it costs to make one more item) is represented by the formula MC = 5 + 1.5Q (where Q is the quantity made), we can find the quantity the company should produce to make the most profit, and then calculate that profit.

To do this, we set the price (P) equal to the marginal cost (MC). Because the company has to take the price the market gives it, its marginal revenue (the money from selling one more) is the same as the price, so MR = P = $40.

That gives us the equation 40 = 5 + 1.5Q. Solving for Q, we get 35 = 1.5Q, and therefore Q = 23.33 units.

Now, let's figure out the profit. Assume the average total cost (ATC - the total cost of making all the items divided by the number of items) for 23.33 units is $32. The profit on each item is the difference between the price and the ATC: $40 - $32 = $8. Total profit is then $8 multiplied by 23.33, which is $186.67.

What if the market price fell to $28? We'd set 28 = 5 + 1.5Q, and solve for Q to get 15.33. If the ATC at that level of output is $33, the price is still above average variable cost (the cost of materials and labor that change with the number of items made). In this case, the company would continue to operate to pay off at least some of its fixed costs. But if the price falls below average variable cost, the company should shut down.