1

Industrial Organization &

Perfect Competition
2
Perfectly Competitive Markets
Structure Assumptions
Many buyers and sellers
Homogeneous product or output
Note: these first two assumptions imply that the
perfectly competitive firm is a price taker.
P(x) = P* = where is the demand for the
individual firms output.
Also note that if P(x) is just P*, then mr=P*, too.
Free entry and exit
Full and symmetric information
3
Perfectly Competitive Markets
Every demander is a price-taker (no
buyer can influence the price).
Every supplier is a price-taker (no seller
can influence the price).
The market price is known to all
potential buyers and sellers and anyone
who wishes to trade at that price can do
so.
4
An Example
Jonathans farm
is perfectly
competitive and
uses the inputs
shown to
produce the
quantities of
apples indicated
on the table.
Jonathan's Apple Farm Production Function
Apples
(tons/year)
Land
(acres)
Labor
(hired)
Proprietor's
time (hours)
0 100 0 1,100
50 100 2,500 1,100
100 100 3,700 1,100
150 100 5,000 1,100
200 100 6,800 1,100
250 100 10,000 1,100
300 100 15,000 1,100
350 100 27,000 1,100
5
Production Detail
Apple Farm Production Function (detail)
Apples
(tons/year)
Land
(acres)
Labor
(hired)
Proprietor's
time (hours)
200 100 6,800 1,100
210 100 7,320 1,100
220 100 7,900 1,100
230 100 8,530 1,100
240 100 9,220 1,100
250 100 10,000 1,100
260 100 10,800 1,100
Here is some
finer detail
regarding the
apple farm.
6
Factor Prices
Jonathan is a
factor price
taker.
Use these
factor prices to
build the cost
tables.
Prices
Labor's time $8.00 per hour
Owner's time $12.00 per hour
Rent $124.00 per acre
7
Costs
Jonathan's Apple Farm Costs
Apples
(tons/year) Land
Hired
Labor
Proprietor's
time Total Cost
Average
Cost
Marginal
Cost
(midpoint
formula)
0 12,400 0 13,200 25,600
50 12,400 20,000 13,200 45,600 912 296
100 12,400 29,600 13,200 55,200 552 200
150 12,400 40,000 13,200 65,600 437 248
200 12,400 54,400 13,200 80,000 400 400
250 12,400 80,000 13,200 105,600 422 656
300 12,400 120,000 13,200 145,600 485 1,360
350 12,400 216,000 13,200 241,600 690
8
Finer Cost Details
Jonathan's Apple Farm Costs (detail)
Apples
(tons/year) Land
Hired
Labor
Proprietor's
time Total Cost
Average
Cost
Marginal
Cost
(midpoint
formula)
200 12,400 54,400 13,200 80,000 400
210 12,400 58,560 13,200 84,160 401 440
220 12,400 63,200 13,200 88,800 404 484
230 12,400 68,240 13,200 93,840 408 528
240 12,400 73,760 13,200 99,360 414 588
250 12,400 80,000 13,200 105,600 422 632
260 12,400 86,400 13,200 112,000 431
9
Graph of Jonathans Cost
Curves
The marginal cost of
each ton of apples is
shown as the red line.
The average cost is
shown as the blue
line.
Notice that the
marginal cost =
average cost at
average costs
minimum.
Jonathan's Cost Functions
0
100
200
300
400
500
600
700
800
900
1,000
0 100 200 300 400
Apples (tons/year)
$
/
t
o
n
Average Cost Marginal Cost (midpoint f ormula)
10
Profit Maximization
Profit () = total revenue(tr) - total cost(tc).
Profit depends on the firms output level (x).
So (x) = tr(x) - tc(x)
Define
marginal revenue (mr) = tr/x
marginal cost (mc) = tc/x
NOTE: Since we have a perfectly
competitive firm P=mr for all levels of
production.
11
Profit Maximization
General rules for profit maximization:
If x* maximizes , then
mr = mc at x*
x* is a profit max and not a profit min
at x* its worth operating
Reminder: since the firm is perfectly
competitive, P=mr for all values of x.
12
Jonathans Profit and Loss
Suppose the market
price is $600/ton.
The vertical
difference between
Jonathans total
revenue and total
cost curve is his
profit.
The profit maximum
occurs at 240
tons/year.
Total Cost and Revenue
0
50,000
100,000
150,000
200,000
250,000
300,000
0 50 100 150 200 250 300 350 400
Apples (tons/year)
$
Total Cost
Total Revenue
Maximum
Profit,
market
price=
marginal
cost
Total Cost,
slope=marginal
cost
Total Revenue,
slope=market
price
13
Finding Profit Maximizing Points
Using The Marginal Cost Curve
Jonathan will supply apples
to the market in increasing
quantities as the price
rises.
The points on the marginal
cost curve correspond to
profit maximizing quantities
at two different market
prices.
The quantity supplied at a
market price of $600/ton is
(about) 240 (black dot).
Consider another market
price, P=1,200 and note
that x* increases.
Marginal Cost of Apples
0
200
400
600
800
1,000
1,200
1,400
1,600
0 100 200 300 400
Apples (tons/year)
P
r
i
c
e

(
$
/
t
o
n
)

mc
mr when P=600
mr when P=1,200
14
Finding the Value of Profit - Case A
If market price is P*,
then the firm supplies x*
where mr=mc.

Total Revenue=OACQ*

Total Cost=OBDQ*
Note: use the atc curve
to get the value of total
costs by multiplying atc
by x*

Profit = tr-tc=BACD
P* = mr
mc
atc
A
B
C
D
O
Quantity
x*
P
15
Finding the Value of Profit - Case B
If market price is P*, then
the firm supplies x* where
mr=mc.

Total Revenue=OBDQ*

Total Cost=OBDQ*

Profit = tr-tc=0

Note: economic profit = 0


P* = mr
mc
atc
B
D
O
Quantity
x*
P
16
Finding the Value of Profit - Case C
If market price is P*, then the
firm supplies x* where mr=mc.
Total Revenue=OACQ*
Total Cost=OBDQ*
Profit = tr-tc = -ABDC
Note: Profits are negative.
They are loses.
Should firm continue to
operate? Good question.
Now need to look at where
the average variable cost
curve is. Recall: produce at a
loss provided tr vc or
p avc
Since P>avc at x*, firm should
produce x*.
P* = mr
mc
atc
B
D
O
Quantity
x*
A
C
P
avc
17
The Firms Supply Curve
An individual perfectly competitive firms
supply curve (the srs
firm
) is its marginal cost
curve above its average variable cost curve.
For a perfectly competitive firm, choosing the
output at which market price equals marginal
cost maximizes profits.
Remember, its really mr=mc at x*, but since the
firm is a price taker, P=mr all the time, so P=mc at
x*.
18
Jonathans Supply Curve
At the market price
indicated on the vertical
axis, profit maximizing
apple production is given
by the marginal cost
curve, which is Jonathans
supply of apples curve.
The supply curve is the
the marginal cost curve
above average variable
cost because profit
maximizing behavior
means increasing
production until marginal
cost = market price.
Single Farm Supply of Apples
0
200
400
600
800
1,000
1,200
1,400
1,600
0 100 200 300 400
Apples (tons/year)
P
r
i
c
e

(
$
/
t
o
n
)
19
Total Costs and Economic
Profits
Total costs include fixed costs, variable
costs (at market prices) and the
opportunity cost of owned factors (such
as the owners time, land, and
equipment owned by the business).
Economic profits are the difference
between total revenue from sales and
total costs, as defined above.
20
Back to Jonathans Farm...
The apple market is competitive.
Jonathan cannot control the price of
apples.
Consider, for the moment, a price of
say $528/ton now
To profit maximize Jonathan produces
until P (=mr) = mc
21
Jonathans Economic Profit
and Loss
At the market price of $528, the profit maximizing apple
production is the highlighted line.
Apple Farm Profits (detail)
Apples
(tons/year) Total Cost
Total
Revenue
Marginal
Cost
Marginal
Revenue
= Market
Price
Economic
Profits
200 80,000 105,600 25,600
210 84,160 110,880 440 528 26,720
220 88,800 116,160 484 528 27,360
230 93,840 121,440 528 528 27,600
240 99,360 126,720 588 528 27,360
250 105,600 132,000 632 528 26,400
260 112,000 137,280 25,280
22
Graph of Jonathans
Revenue and Cost
The vertical difference
between Jonathans total
revenue and total cost
curves is his economic
profits.
The slope of the total cost
line (marginal cost) is
equal to the slope of the
total revenue line
(marginal revenue =
market price)
Total Cost and Revenue
0
50,000
100,000
150,000
200,000
250,000
0 50 100 150 200 250 300 350 400
Apples (tons/year)
$
Total Cost Total Revenue
Maximum
Profit,
market
price=
marginal
cost
Total Cost,
slope=marginal
cost
Total Revenue,
slope=market
price
23
Graph of Jonathans
Economic Profits
The chart at the right shows
that Jonathans economic
profits are maximized at
apple production where the
market price is equal to the
marginal cost (230
tons/year).
Profits are maximized when
marginal cost is as close as
possible to market price,
without exceeding it.
The slope of economic profits
= zero at the profit maximum.
Economic Profits (detail)
25,000
25,500
26,000
26,500
27,000
27,500
28,000
200 210 220 230 240 250 260
Apples (tons/year)
$
24
Accounting Profits
Accounting profits are defined as total sales
revenue (the same as total revenue in the
economic profits definition) minus operating
costs (costs of goods sold + administrative
and sales costs for those who know some
accounting).
Accounting Profits = Sales Revenue -
Accounting Costs
25
Did Jonathan Make
Accounting Profits?
The blue line in the table illustrates that Jonathan makes an accounting
profit of $40,800 when the apple price is $528/ton.
Accounting Profits vs. Economic Profits (detail)
Apples
(tons/year)
Total
Revenue
Accounting
Costs
Accounting
Profits Total Costs
Economic
Profits
200 105,600 66,800 38,800 80,000 25,600
210 110,880 70,960 39,920 84,160 26,720
220 116,160 75,600 40,560 88,800 27,360
230 121,440 80,640 40,800 93,840 27,600
240 126,720 86,160 40,560 99,360 27,360
250 132,000 92,400 39,600 105,600 26,400
260 137,280 98,800 38,480 112,000 25,280
26
Economic Profits
Economic profits are the difference
between total revenue and total costs.
Economic total costs include the
opportunity costs of all inputs to the
production processin particular, the
opportunity costs of the owners time
and physical capital (equipment and
space).
27
Reconciling Economic and
Accounting Profits
The table to the right
shows that
Jonathans economic
profits equal his
accounting profits
minus the
opportunity cost of
his time.
Thus, when the price
of apples is $528/ton
and 230 tons/year
are sold, economic
profits = $27,600
Reconciling Accounting and Economic Profits (detail)
Apples
(tons/year)
Accounting
Profits
- Opportunity
Cost of
Jonathan's
Time
= Economic
Profits
200 38,800 13,200 25,600
210 39,920 13,200 26,720
220 40,560 13,200 27,360
230 40,800 13,200 27,600
240 40,560 13,200 27,360
250 39,600 13,200 26,400
260 38,480 13,200 25,280
28
Question 1
At a market price of $440/ton for
apples, what is the optimal annual
production of apples?
Use the data on your handout to
answer this question.
29
Answer 1
Marginal cost = market price = $440/ton
at a production level of 210 tons/year.
This is the profit maximizing level of
output when the market price is
$440/ton.
30
Question 2
At a market price of $440/ton for
apples, what are Jonathans accounting
and economic profits?
31
Answer 2
Total revenue = $440 x 210 = $92,400.
Total costs = $124 x 100 (land) + $8.00
x 7,320 (labor) + $12.00 x 1,100
(proprietors time) = $84,160 .
Economic profits = total revenue - total
costs = $92,400 - $84,160 = $8,240.
32
Answer 2 (continued)
Total revenue = $440 x 210 = $92,400.
Accounting costs = $124 x 100 (land) + $8.00
x 7,320 (labor) = $70,960.
Accounting profits = total revenue -
accounting costs = $92,400 - $70,960 =
$21,440.
Economic profits = accounting profits -
opportunity cost of owners time = $21,440 -
$13,200 = $8,240.
33
Question 3
At a market price of $400/ton for
apples, what are Jonathans accounting
and economic profits?
34
Answer 3
Optimal production = 200 tons/year.
Total revenue = $400 x 200 = $80,000.
Economic profits = total revenue - total
costs = $80,000 - $80,000 = 0.
Accounting profits = total revenue -
accounting costs = $80,000 - 66,800 =
13,200.
35
Question 4
Should Jonathan continue to operate
the apple farm if the market price of
apples is $400/ton?
36
Answer 4
Jonathans economic profits are zero when
the market price of apples is $400/ton
($0.20/pound, about the current price
wholesale price for first quality fresh apples).
Jonathan just recovers the opportunity cost of
his time ($13,200), so he is indifferent
between producing apples and taking a job at
$12/hour.
37
Producers Surplus Revisited
Producers surplus measures the gain to the firm from
selling all units at the market price.
Producers surplus is the supply-side equivalent of
consumers surplus.
Total producers surplus = the area above the marginal
cost curve and below the market price = economic profits
+ fixed costs.
Incremental producers surplus = the difference between
the market price and the marginal cost of the given unit
of production.
38
Jonathans Producers Surplus
Jonathans total
producers
surplus, when the
market price is
$528, is the sum
of his economic
profits ($27,600)
and his fixed
costs ($25,600) =
$53,200.
39
Producers Surplus and
Economic Profits
Producers surplus is not equal to
economic profits.
Producers surplus includes fixed costs.
Economic profits = producers surplus -
fixed costs.
Producers surplus = economic profits +
fixed costs.
40
The Market Supply Curve
The market supply curve is the sum of
the quantities supplied by each seller at
each market price.
Market supply, thus reflects the
marginal costs of each of the producers
in the market.
This is Short Run Market Supply (SRS)
41
Supply Curve for a New York
Apple Farm
The data used to construct
Jonathans supply curve
were representative of the
typical New York State
apple farm.
The supply curve for a
single apple farm is shown
to the right.
Single Farm Supply of Apples
0
200
400
600
800
1,000
1,200
1,400
1,600
0 100 200 300 400
Apples (tons/year)
P
r
i
c
e

(
$
/
t
o
n
)
It is the same as the supply
curve we have been using,
based on the marginal cost
curve of a single farm.
42
Market Supply Curve:
Horizontal Summation
Farm As Supply of Apples
0
200
400
600
800
1,000
1,200
1,400
1,600
0 100 200 300 400
Apples (tons/year)
P
r
i
c
e

(
$
/
t
o
n
)

Farm Bs Supply of Apples
0
200
400
600
800
1,000
1,200
1,400
1,600
0 100 200 300 400
Apples (tons/year)
P
r
i
c
e

(
$
/
t
o
n
)

At a price of $1000/ton, add Farm As supply to Farm Bs supply to
get market supply (about 560 tons/year). Add over all farms.
The market supply curve is the horizontal summation of the firms
supply curves.
43
Short Run Equilibrium -
Summary
The firm is profit maximizing - no desire at
current market price to change the quantity
supplied.
Firm is on its short run supply curve
Market Demand = Short run Market Supply
No tendency for market price to change
Note: number of firms fixed, technology
given and firms capital fixed.
Get: (P*, X*, x*)
Firms can have +/0/- profit.
44
Profit Signal
When profit in the short run is positive there
are firms at the margin that want to enter the
market and it is assumed that they can.
When profit in the short run is negative there
are firms at the margin that want to exit the
market and it is assumed that they will.

45
Long Run Equilibrium
All the short run equilibrium properties.
But alsono firms wish to exit the
market nor do firms want to enter.
Get: (P*, X*, x*, N*)
Note: For there to be neither entry or exit,
need economic profit to be zero. This is a
long run equilibrium requirement. Otherwise
the number of firms in the market will still be
in flux.
46
Long Run Equilibrium Position
Profit max implies that mr=lrmc at x*.
Zero profit implies P=lratc at x*.
Since the firm is perfectly competitive, P=mr at all
values of x.
By substitution, P=lratc at x* and P=lratc at x*.
Therefore lrmc=lratc at x*.
This implies that x* is at the minimum of the typical
firms lratc. x* is at MES.
P* must be the price consistent with the minimum
value on the lratc curve.
N* and X* determined by position of market demand.

47
Long Run Equilibrium Picture
lratc
x
x*
X*
P* P* mr
SRS w/N*
D
X
A
a
typical firm market
48
Steps to Draw The Picture?
Doesnt matter how you draw it, as long
as you draw it correctly in the end.
Draw-a-person test.
49
Whats not ok...
50
Increases in Demand
When demand increases and is expected to
remain at the increased level, the short run
response is to move along the short run
supply curve--higher price and greater
quantity supplied.
The long run response is to have entry in the
market, movement along the long run supply
curve--price returns to the minimum average
total cost and quantity supplied increases.
51
Long Run Adjustment Picture
lratc
x
x*
X*
P* P* mr
SRS w/N*
D
X
A
a
typical firm market
D new
P P
mr
B
srmc
sratc
b
X
x
52
Long Run Equilibrium Picture
lratc
x
x*
X*
P* P* mr
SRS w/N*
D
Q
A
a
typical firm market
D new
P P
mr
B
srmc
sratc
b
X
x
SRS
w/N**
C
X**
LRS
53
Long Run Supply in the
Market
Both points A and C
in the previous picture
are long run
equilibrium points.
Point B is a temporary
short run equilibrium
point.
If you connect all
points like A and C
you get the market
long run supply curve
in a perfectly
competitive market.
X*
P*
SRS w/N*
D
X
A
D new
P
B
X
SRS
w/N**
C
X**
LRS
54
Long Run Supply in the
Market
The long run supply curve in
the market is horizontal at the
long run equilibrium price P*.
P* is sometimes called the
normal price.
P* is the price consistent with
the typical firms minimum long
run average total cost.
Note: important assumption is
that the position of the firms
cost curve is unaffected by
entry (or exit) of firms in the
market.
X*
P*
SRS w/N*
D
X
A
D new
P
B
X
SRS
w/N**
C
X**
LRS
55
Example: Long Run Supply in
the System-fixer Market
The market demand for system
installations is shown by the blue
line in the graph.
The market is very much larger than
firms at the efficient scale, so we
expect competitive conditions to
prevail.
The long run supply (in red) reflects
the technological and competitive
conditions in the market: surviving
firms must operate at the scale of
firm B at a minimum average total
cost of $26/installation.
Short run supply is shown in brown.
Market for System Installations
0
5
10
15
20
25
30
35
40
45
50
0 2,000 4,000 6,000 8,000 10,000 12,000 14,000 16,000
Quantity (Installations/week)
P
r
i
c
e

(
$
/
i
n
s
t
a
l
l
a
t
i
o
n
)
Demand
Long Run Supply
Short Run Supply
56
Question
How many firms are there in the long
run in the system-fixer market?
57
Answer
Firms with the efficient scale do 8
installations per week at an average
total cost of $26/installation.
At $26/installation the market demand
is 8,000 installations per week.
Therefore, there are 1,000 firms in the
market.
58
Increase in Demand in the
System-fixer Market
Demand increases in the market as
indicated by the new (black)
demand curve.
The short run response is an
increase in price with not much
additional quantity supplied (point
A), movement along the short run
supply curve.
The long run response is a return to
the original price of $26/installation
and an expansion of quantity
supplied along the long run supply
curve (point B).
Increase in Demand
0
5
10
15
20
25
30
35
40
45
50
0 2,000 4,000 6,000 8,000 10,000 12,000 14,000 16,000
Quantity (Installations/week)
P
r
i
c
e

(
$
/
i
n
s
t
a
l
l
a
t
i
o
n
)
Demand
Long Run Supply
Short Run Supply
New Demand
A
B
59
Question
What would be the long run result of a
fall in demand for system installations
when the quantity demanded at
$26/installation is 4,000.
60
Answer
Now, only 500 firms operating at the
minimum efficient scale will survive.
The industry will shrink by exit of some
system fixer firms. Of the original 1,000
firms, only 500 survive.
61
External Economies and
Diseconomies of Scale
If the industry exhibits no external economies or diseconomies
of scale, then the industry long run supply curve is perfectly
elastic (horizontal). The industry grows by replicating firms at
the efficient scale. Entry and exit leaves the position of cost
curves intact. This is called a constant cost industry.
If the industry exhibits external diseconomies of scale, then the
industry long run supply curve is upward sloping. The minimum
average total cost of all firms in the industry rises as the size of
the market grows. This is called an increasing cost industry.
If the industry exhibits external economies of scale, then the
industry long run supply curve is downward sloping. The
minimum average total cost falls as the size of the industry
grows. This is called a decreasing cost industry.
62
Constant Cost Industry
When we draw the long run supply curve as
a horizontal line, we are asserting that there
are no external economies or diseconomies
of scale.
Lack of economies or diseconomies of scale
means that growth of the industry doesnt
foster technological improvements and
doesnt change the prices of inputs.
63
External Diseconomies of
Scale
When an industry long run
supply curve slopes upward,
the industry exhibits external
diseconomies of scale.
This can occur because the
prices of the inputs rise as
the industry expands.
This can also occur because
the industry becomes
congested and the minimum
average total cost at the
efficient scale rises.
Quantity
P
r
i
c
e

Long run supply with
external diseconomies of
scale in the industry
64
Examples of Long Run Supply
Curves that Slope Up
As a competitive industry grows its demand for certain
specialized factors increases (information systems specialists
in the accounting service industry, fabrication equipment in
the microprocessor industry).
Increased demand for specialized factors means that the
equilibrium price of these factors will increase (movement
along a factor supply curve--increased quantity and increased
price of the factor).
So as the industry (not the firm) grows, the price of these
specialized factors increases and the minimum average total
cost rises.
Thus, the long run supply curve slopes upward.
65
Long Run Competitive
Equilibrium - Reviewed
The firms in a perfectly competitive market are in
long run equilibrium when
Quantity supplied = Quantity demanded at the
current market price.
Firms are profit maximizing so that marginal
revenue (= Price) = marginal cost for all firms in
the market.
Price = minimum average total cost for all firms in
the market, implying zero economic profit.
No firm wants to enter the market.
No firm currently in the market wants to exit.
66
Why are there zero economic
profits in the long run?
Zero economic profits means that all factors used in
production make exactly their opportunity cost.
Purchased factors receive their market price, which is
equal to their opportunity cost.
Owned factors receive the same compensation that they
would receive in their next best use, which is also equal to
their opportunity cost.
Thus, no firm wants to enter the market because it cannot
make any more money than it is currently making.
Similarly, no firm wants to leave the market because it
cannot make any more money in any other business.
67
Performance
Efficiency:
Allocative efficiency: (look at market) The level of
output traded is allocatively efficient if it
maximizes net social surplus.
Productive efficiency: (look at the firm) The firms
output level is productively efficient if it is at the
minimum of the firms long run average total cost
curve, that is, if it is at least as large as minimum
efficient scale of production.
Equity:
Is the outcome of the allocatoin process fair?
Equitable? Just?
68
Long Run Competitive
Equilibrium - Performance
Efficiency:
The market equilibrium is allocatively efficient. That is, at
X*, net social surplus is maximized.
Each firm is productively efficient. That is each firm
operates at, at least, minimum efficient scale. Each firm
operates at the minimum of its long run average total cost
curve.
Equity: Is the outcome of the competitive process
fair? Equitable? Just?
Good questions that we do not answer here and now.

69
Allocative Efficiency - Proof
If X* is allocatively efficient, then net social
surplus should be as high as it can feasibly
be.
Net Social Surplus = $TB
society
- $TC
society

When net social surplus is as high as it can
be, $MB
society
= $MC
society
Question: Is the outcome of the competitive
process allocatively efficient?

70
Answer
Demand=Supply at X*.
Demand represents $marginal benefit.
Supply represents $marginal cost.
Somarginal benefit equals marginal cost at
X*.
Sonet social surplus is maximized at X*.
There is no transaction among the buyers
and sellers that improves the welfare of at
least one person without reducing the welfare
of at least one person.
71
Productive Efficiency - Proof
Profit max implies that mr=lrmc at x*.
Zero profit implies P=lratc at x*.
Since the firm is perfectly competitive, P=mr at all
values of x.
By substitution, P=lratc at x* and P=lratc at x*.
Therefore lrmc=lratc at x*.
This implies that x* is at the minimum of the typical
firms lratc. x* is at MES.
P* must be the price consistent with the minimum
value on the lratc curve.