Chapter 12: Perfect Competition and the Supply Curve

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Imagine stepping out during the holiday season and suddenly Christmas tree cellars are everywhere.

Vacant lots, parking lots, garden centers, they just pop up seemingly overnight.

You might think it's just festive cheer, but hidden beneath that seasonal appearance is, well, a fascinating world of economic principles.

Definitely.

Today, we're diving deep into that world, specifically exploring perfect competition and how it fundamentally shapes the supply curve.

It's a great example, really shows how markets respond to demand.

You know, before the 1950s, most people actually cut their own trees, but as demand grew, farmers saw a clear opportunity there.

They started cultivating and selling trees and it transformed this tradition into a huge organized market.

Use is right.

Yeah.

I mean, in 2018 alone, nearly 33 million farm trees were sold just in the U .S.

generating over $2 billion.

So this isn't just about holidays.

It's really about understanding how individual businesses respond to market signals.

Absolutely.

And our mission today is to cut through any jargon and give you a really crystal clear understanding of how industries respond to demand shifts, how individual businesses decide what to produce, and well, what truly makes an industry competitive.

Think of it as a shortcut, maybe.

Exactly.

A shortcut to being well -informed, ready maybe to apply these insights to your studies or just to better understand the world around you.

We're hoping for some real aha moments today.

Let's find them.

Okay.

So let's start with those Christmas tree farmers again, like Yves and Zoe, neighbors both growing trees.

They compete, sure, but probably not in the way you'd think of Apple and Samsung competing.

Right.

It's different.

If Yves decides to grow, say, a few more trees, it won't make a ripple in the overall Christmas tree market price.

Why?

Because there are thousands of farmers out there.

And this is really key to understanding perfect competition.

Farmers like Yves and Zoe are what economists call price takers.

Price takers, meaning they can sell all the trees they want at the going market price, but they can't influence that price themselves.

They just have to, well, take the prices given.

And the same applies to you as a consumer, right?

Your individual purchase of one tree isn't going to shift the market price either.

Almost never.

So when we talk about a perfectly competitive market, we mean one where all participants, buyers, and sellers are price takers.

And that fundamental supply and demand model, the one you've probably seen a bunch of times in textbooks, it really relies on this assumption.

It's the bedrock for figuring out prices and quantities in these super competitive markets.

Yeah.

Although it's worth noting, while consumers are pretty much always price takers, producers often aren't.

Think about, I don't know, Kellogg's or General Mills in breakfast cereals.

Oh yeah.

They definitely have some clout.

Right.

They can influence prices.

That's why the model of perfect competition doesn't fit every market, but it's such a crucial benchmark for understanding how truly competitive industries work.

So for an industry to actually be perfectly competitive, it needs two critical conditions.

First, you need many producers, and crucially, none of them should have a large market share.

Market share meaning their fraction of the total industry output.

Right.

So no single producer is big enough to swing the overall price.

Think about the wheat market.

Thousands of farmers, none big enough to affect the price.

Now contrast that with

Kellogg's and General Mills.

Exactly.

They dominate.

They hold a huge chunk of U .S.

cereal sales.

And you can bet Kellogg's executives know that if they flood the market with cornflakes, they'll probably push the price down.

Their actions matter.

They aren't price takers.

Precisely.

So that's condition one.

The second essential condition is that the industry must produce a standardized product, sometimes called a commodity.

Standardized meaning consumers see the products from all producers as basically the same, right?

Equivalent.

Wheat is the classic example.

Wheat is wheat.

Doesn't matter which farm grew it.

But definitely not true for breakfast cereals.

I mean, most people wouldn't see Cap 'n Crunch as a perfect substitute for Wheaties.

Exactly.

So the maker of Wheaties can probably raise its price a little bit without losing all their customers.

And what's really interesting here is that it often comes down to consumer perception.

Ah, so it's not just if they are identical, but if we think they are.

Precisely.

If consumers perceive a difference, then for economic purposes, the product isn't standardized.

Think about Champagne.

Oh, good one.

The French sparkling wine.

Right.

Legal protections mean only wine from that specific region in France can be called Champagne, even if other sparkling wines taste, you know, pretty similar.

So that perceived difference lets them charge more.

It does.

And you see similar things like Korean kimchi producers trying hard to differentiate their product from Japanese kimchi, arguing it's not the real thing.

If consumers buy that argument, it stops being a perfectly standardized market.

Fascinating.

Okay.

So many producers, small market share, and a standardized product.

Yeah.

Those are the two necessary conditions.

That's right.

But most perfectly competitive industries also share a third common feature, which is really important for how they adjust over time.

Free entry and exit.

Free entry and exit.

Meaning it's easy for new companies to start up in the industry and easy for existing ones to leave if things aren't working out.

Exactly.

No major obstacles like, say, needing a super expensive government license or controlling the only source of a key raw material.

So new firms can jump in if there's profit to be made and existing firms can pack up if they're losing money.

Right.

Now, it's not strictly necessary.

You could have, say, Alaskan crab fishing, where there are, quote, as limiting boats, but maybe enough boats operate that individual fishermen are still price takers.

Okay.

But free entry and exit is usually there, and it's really critical for how these industries adjust to changing market conditions in the long run.

We actually see this playing out, or the lack of it, in industries like pharmaceuticals, right?

With patents.

Oh, yeah.

Patents grant a temporary monopoly, so that's definitely not perfect competition initially.

But what happens when the patent expires?

Generics flood in.

Right.

Generic drugs enter, competition ramps up, and prices plummet.

Lipitor, the cholesterol drug, is a famous case.

When its patent expired, generic versions hit the market at like 8 % of the original price, and Lipitor lost 90 % of its market share almost overnight.

Wow.

But sometimes the original patent holders tried to block that competition using these pay -for -delay deals.

They'd literally pay generic company not to launch its cheaper version.

Seriously, that sounds anti -competitive.

It was.

The Federal Trade Commission, the FTC, thought so, too.

They argued these deals cost consumers billions by keeping prices artificially high.

So what happened?

Well, the FTC took it to court, and in 2014, the Supreme Court basically said, yes, the FTC can prosecute these deals.

And did it make a difference?

Big time.

The number of those deals dropped dramatically, and there were huge settlements.

Tiva Pharmaceuticals had a $1 .2 billion settlement and had to pay back almost $66 million directly to consumers.

So that's regulators actively pushing for more competition.

Exactly.

Pushing markets closer to that perfectly competitive ideal, which generally benefits consumers through lower prices.

Okay, so we've got a good handle on what perfect competition is.

Now let's get down to the nitty -gritty.

How does an individual firm, let's go back to Noel's Christmas Tree Farm, decide how much to produce to make the most profit?

Assume the market price is, say, $72 per tree, and she's a price taker.

Okay.

Well,

the basic calculation is simple.

Profit equals total revenue minus total cost.

Total revenue is just price times quantity, p times q.

So she sells 50 trees at $72 each.

That's $3 ,600 in revenue.

Right.

And let's say her total cost for producing those 50 trees is $2 ,880.

Her profit is then $3 ,600 minus $2 ,880, which comes out to $720.

And if she calculated this for different quantities, she'd find that 50 trees gives her the highest profit.

Exactly.

But we can figure this out more efficiently using marginal analysis.

Remember the optimal output rule.

Produce where marginal revenue equals marginal cost.

MR, MRC.

You got it.

Now define marginal revenue again.

It's the extra revenue you get from selling one more unit.

Perfect.

And here's the crucial point for a price -taking firm.

Because selling one more tree doesn't change the $72 price she gets for any of her trees.

Her marginal revenue for each additional tree is always.

$72, the market price.

Exactly.

For a price -taker, marginal revenue always equals the market price.

So the profit maximizing rule simplifies.

A price -taking firm maximizes profit where price equals marginal cost.

P equals MC.

Okay, that's a key shortcut.

So Noelle looks at her marginal cost for each extra tree.

Right.

Let's say we have a table showing her costs.

Her MR is constant at $72.

She looks at the marginal cost of the first tree, the second, and so on.

As long as the marginal cost is less than $72, producing that tree adds to her profit.

And she keeps going until.

Until the marginal cost of the next tree would be more than $72, or ideally exactly $72.

If her MC for the 50th tree is, say, $70, and the MC for the 51st tree is $75, she stops at 50.

Because producing the 51st would actually reduce her profit.

Correct.

The net gain, MRMC, turns negative.

So visually, if you imagine a graph, you've got a horizontal line for marginal revenue at the market price, $72, and this typically upward sloping marginal cost curve.

Where they intersect, that's your profit maximizing quantity.

For Noelle, that point E is at 50 trees.

Got it.

What if, you know, the numbers don't line up perfectly, like MC never exactly equals MR?

Good point, especially with discrete items like trees.

In that case, you produce the largest quantity where marginal revenue is still greater than marginal cost.

You don't want to produce that unit where MC jumps above MNR.

Right, don't overshoot.

Okay, so PMC tells her the quantity,

but does that guarantee she's actually making money?

Not necessarily.

It tells her the profit maximizing output, which might still be a loss, or it could be the loss minimizing output.

To know if she's actually profitable, we need to bring in costs again.

And importantly, we're always talking about economic profit here, right?

Not just accounting profit.

Crucial distinction.

Economic profit includes all costs, the explicit ones you pay cash for, like wages, and the implicit ones, like the opportunity cost of Noelle's time or the capital she's invested.

Firms base their decisions on economic profit.

So how do we check for profitability?

We compare the market price, P, to her average total cost, APC, at that profit maximizing quantity.

Remember, ATC is total cost divided by quantity.

Okay, so find the quantity where PMC, then look at the ATC for that quantity.

Exactly.

The ATC curve is typically U -shaped.

Let's say Noelle's minimum ATC is $56, and that occurs when she produces 40 trees.

That $56 is her break -even price.

Break -even price, meaning if the market price is $56, she makes zero economic profit.

Correct.

Now, the rule is if P is greater than ATC at the PMC output, she's profitable.

If P equals ATC, she breaks even.

If P is less than ATC, she incurs a loss.

Can we visualize that, like on a graph?

Absolutely.

Imagine that graph again with price line MR at $72 and the MC curve crossing it at 50 trees, point E.

Now add the U -shaped ATC curve.

At 50 trees, find the point on the ATC curve.

Let's call it Z.

Suppose the ATC there is $57 .60.

Okay, so price $72 is above ATC $57.

Right.

The vertical distance between the price line and point Z $57 .60 is her profit per tree.

Multiply that by the quantity, 50 trees, and that rectangle represents her total profit.

$14 .40,

50 equals $720.

And what if the price was lower?

Say $40.

Okay, new scenario.

Price line drops to $40.

Find where PMC now.

Let's say that's at 30 trees, point A.

Now find the ATC at 30 trees, call it point Y.

Suppose ATC there is $58 .67.

So now price $40 is below ATC $8 .67, which is her loss per tree.

Multiply that by the quantity, 30 trees, and that rectangle shows her total loss.

$18 .67, $30, roughly $560.

So the breakeven price, $56 for Noelle, is the minimum point on that ATC curve.

Price above it, profit.

Price below it, loss.

Precisely.

But incurring a loss doesn't automatically mean she should shut down production immediately.

At least not in the short run.

Ah, the short run versus the long run distinction again.

Why wouldn't she shut down if she's losing money?

Because of fixed costs.

In the short run, some costs are fixed.

Think of the rent for her refrigerated truck maybe.

She has to pay that whether she produces zero trees or 50 trees.

They're sunk costs in a way for the short -term decision.

Essentially, yes.

They're irrelevant to the decision of whether to produce something versus produce nothing in the short run because she pays them either way.

What matters are the variable costs.

Like wages for temporary workers or the cost of the saplings themselves.

Costs she can avoid if she doesn't produce.

Exactly.

So the decision to operate or shut down in the short run hinges on whether the price covers her average variable cost, AVC.

Okay, so not average total cost, but average variable cost.

Right.

Find the minimum point on the AVC curve.

That minimum value is called the shutdown price.

For Noelle, let's say her minimum AVC is $40,

and it occurs at 30 trees.

So $40 is her shutdown price.

What does that mean?

It means if the market price falls below $40, she should shut down immediately.

Stop production for the season.

Why?

Because at a price below $40, she can't even cover her variable cost per tree.

So producing would mean losing money on the variable costs plus losing all the fixed costs.

Shutting down means she only loses the fixed costs.

Exactly.

She minimizes her loss by shutting down if P minimum AVC.

Okay.

And if the price is at or above the minimum AVC, $40.

Then she should produce, she should still follow the PMC rule to find the optimal quantity.

Even if the price is say $48, that's above the shutdown price, $40, but still below her breakeven price, $56.

She's still making an economic loss, right?

Correct.

She is making a loss.

But crucially, at $48, the price is covering all her variable costs, $40, and contributing $8 per tree towards covering her fixed costs.

So if she produced, her loss would be less than if she shut down and lost the entire fixed cost.

Precisely.

That's the tricky middle ground.

If minimum AVC equal P minimum ATC, the firm operates at a loss, but it's better than shutting down.

This explains why seasonal businesses, like maybe an outdoor water park or those Maine lobster shacks, operate during parts of the year when they might technically be losing money overall.

As long as they cover their variable costs and chip away at some fixed costs.

Exactly.

They only shut down completely in the deep off season when prices or expected customer flow fall below their minimum average variable costs.

So putting this all together, an individual firm's short run supply curve is basically its marginal cost curve, but only the part that lies above the shutdown price, minimum AVC.

Below that price, the quantity supplied is zero.

Perfect summary.

It's often shown as a curve that starts at the minimum AVC point and then follows the MC curve upwards.

Okay, great.

So that's the individual firm.

Now, how do we get from the Will's supply decision to the supply for the entire Christmas tree industry?

Good question.

We need to distinguish the individual supply curve from the industry supply curve, which is what people usually mean when they just say market supply curve.

And the key difference in the short run is?

In the short run, the number of producers is fixed.

No new farms are starting up instantly and no existing farms are disappearing overnight.

So you just add up what all the existing firms want to supply at each price?

Exactly.

It's the horizontal sum of all the individual firms short run supply curves.

If we assume there are say a hundred identical farms, just like Noel's.

And at a price of $72,

Noel's supplies 50 trees.

Then the total industry supply at $72 would be a hundred farms times 50 trees each, which is 5 ,000 trees.

Okay.

And since each farm supply curve slopes up above the $40 shutdown price, the short run industry supply curve will also slope upwards starting from that $40 price point.

Correct.

You can picture on a graph, the short run industry supply curve S starts at $40 on the price axis and slopes up where it intersects the market demand curve D that gives you the short run market equilibrium.

Maybe at 72 and $5 ,000 trees.

Okay.

That's the short run fixed number of firms,

but the long run is where things get more dynamic.

Right.

Because firms can enter or exit.

Exactly.

This is the big difference.

Free entry and exit changes everything.

Think about that short run equilibrium where the price is $72.

We established that Noel makes a profit at $72 because it's above her break even price of $56.

Right.

And if Noel is making a profit, chances are those other 99 identical farms are too.

And what does economic profit do?

It attracts attention.

Other potential farmers see there's money to be made in Christmas trees.

Precisely.

Positive economic profit acts like a signal, drawing new producers into the industry.

That's entry.

Conversely, if the market price were consistently below $56,

firms would be making losses and eventually some would give up and exit the industry.

So let's follow the entry story.

Price is $72, firms are profitable, new farms start entering.

What does that do to the supply curve?

As new firms come in, the short run industry supply curve shifts to the right.

There's more total supply at any given price.

And what does a rightward shift in supply do to the market price?

It pushes the price down.

So maybe the price falls from $72 to say $64.

Okay.

Price is lower.

What about profits for the existing firms like Noel?

Profits fall too because the price is lower.

But at $64, it's still above the $56 break even price.

So firms are still making some positive economic profit.

Which means more firms will still want to enter.

You got it.

Entry continues.

The short run supply curve keeps shifting right and the price keeps falling.

Until when?

When does the entry stop?

It stops when the market price falls all the way down to the break even price $56 in our example.

Because at $56 firms are making zero economic profit.

Exactly.

There's no longer any incentive for new firms to enter because they'd just be breaking even earning only what they could in their next best alternative.

And there's no incentive for existing firms to leave either.

So the industry reaches a long run market equilibrium where price equals the minimum average total cost and firms earn zero economic profit.

That's the core idea.

The market adjusts through entry or exit if prices were too low until economic profits are competed away.

Okay.

Let's see how this plays out if demand changes.

Suppose we start in that long run equilibrium price is $56.

Zero economic profit.

Now imagine a surge in demand for Christmas trees.

The demand curve shifts right.

Okay.

What happens first in the short run?

Well the demand curve shifts right along the existing short run supply curve S1.

So the price jumps up maybe back to $72 again.

Right.

And industry output increases somewhat along S1 as existing firms like Noel ramp up production because PMC is now at a higher quantity for them.

Crucially at $72 these existing firms are suddenly profitable again.

Bingo.

And what do profits attract?

New entrants.

Exactly.

So now the long run adjustment begins.

New firms enter attracted by the profits.

This shifts the short run supply curve to the right.

Let's call it S2.

And as supply shifts right the price starts to fall back down from $72.

Falling back towards the breakeven price of $56.

So where does the industry end up?

It ends up at a new long run equilibrium where the new demand curve intersects a new further right short run supply curve S2 and the price is back down to $56.

Wow.

So the price comes all the way back down.

In this simple model with identical firms and constant costs.

Yes.

The price returns to the minimum ATC level.

But look what happened to quantity.

Industry output must be much higher now.

Right.

To meet that increased demand at the $56 price.

Exactly.

And here's a really neat insight.

Compare the initial long run equilibrium price $56 quantity QX with the final one.

Price $56 quantity QZ where QZ is much bigger than QX.

How much did Noel's output change between the start and the end?

Well if the price went from $56 up to $72 then back down to $56.

Her final PMC point is the same as her initial one.

Her individual output didn't change in the long run.

Exactly.

The entire increase in industry output from QX to QZ came from the new firms that entered the market.

Existing firms just rode the price wave up and then back down.

That's fascinating.

So the long run industry supply curve LRS.

Yeah.

What does that look like?

It connects the initial long run equilibrium point price $56 quantity QX and the final long run equilibrium point price $56 quantity QZ.

In this case since the price returned to $56 the LRS is a horizontal line at the break even price.

Meaning supply is perfectly elastic in long run.

Producers will supply any quantity demanded at that break even price given enough time for entry or exit.

That's often the assumption for industries where inputs are readily available and new firms face basically the same costs as old firms think maybe agriculture or bakeries.

We call these constant cost industries.

But is the long run supply curve always horizontal?

Not always.

Sometimes as an industry expands it might bid up the price of essential inputs that are in limited supply.

Think about beach front land for hotels.

Right.

As more hotels are built the price of the remaining beach front land goes up.

Exactly.

This increases costs for all firms in the industry.

In this case the long run industry supply curve will slope upwards.

It's an increasing cost industry.

So the price has to rise in the long run to coax out more supply.

Correct.

It's still flatter or more elastic than the short run supply curve because entry still happens but it's not perfectly horizontal.

Are there decreasing cost industries where the LRS slopes down?

They're rarer but theoretically possible if there are say strong network effects or external economies of scale where costs fall for everyone as the industry grows.

Maybe early days of tech components sometimes showed this.

Okay.

But the main takeaway is the long run supply curve reflecting entry and exit is always flatter more elastic than the short run curve where the number of firms is fixed.

Absolutely.

The market can adjust quantity much more significantly in the We saw a pretty dramatic real world example of the supply dynamics with the global pork market a few years ago didn't we?

Oh yeah.

The African swine fever outbreak in China around 2018.

It was devastating.

It wiped out something like 40 percent of China's pig herd which is huge because China consumes about half the world's pork.

A massive supply shock.

What happened to prices?

They went through the roof in China.

Producer prices for pork shot up by 125 percent at one point.

Wow.

And that must have rippled outwards globally.

Big time.

Pork and bacon prices surged everywhere as China started importing massively to fill the gap.

So high prices.

Yeah.

What did the theory prediction happen next?

High prices signal profit opportunities and sure enough pork producers in other countries Brazil, Australia, the EU, the US saw this and ramped up production specifically targeting the Chinese market.

They entered that market effectively.

So that entry increased the market.

So they're trying eventually to bring prices back down or at least stop them rising further.

Exactly.

It's a real world illustration of that long run adjustment process entry happening on a global scale in response to a major price signal caused by a supply shock.

It really shows how interconnected these markets are.

Okay so we've traced the logic from the individual firm up to the industry in both the short and long run.

What are the big conclusions we can draw about perfect competition when it reaches that long run equilibrium?

Well there are three really key takeaways about efficiency.

First, in long run equilibrium the marginal cost of production is the same for all firms in the industry.

Why?

Because they're all price takers facing the same market price and they all produce where P equals MC.

So their MCs must all equal that same price.

Precisely.

Second, we already established that with free entry and exit each firm ends up earning zero economic profit.

And this happens when they're producing at the very bottom of their U -shaped average total cost curve.

They're operating at their minimum cost output level.

Right.

Which means the total cost of producing the industry's output is minimized.

No resources are being wasted by firms operating inefficiently above their minimum cost point.

And again zero economic profit isn't bad.

It means resources are earning exactly what they should covering all opportunity costs.

Okay so MC is equal across firms and total cost is minimized.

What's the third conclusion?

The third is that the long run market equilibrium in perfect competition is efficient.

Efficient in what sense?

In the sense that all the gains from trade are realized.

Every consumer who is willing to pay a price at least as high as the marginal cost of production gets the good.

Every producer who can supply the good at a marginal cost less than or equal to the market price does so.

There no missed opportunities for mutually beneficial transactions.

The market coordinates everything perfectly in a way.

Essentially yes.

This force of competition pushes producers to be incredibly responsive to what consumers want and to adopt the most efficient production methods to keep costs down because if they don't they'll be driven out of business by firms that do.

Which is why economists often use perfect competition as that benchmark that ideal state of efficiency to compare other structures against.

Exactly right.

It represents the theoretical maximum for efficiency and responsiveness in a market setting.

Okay so we've covered a lot of ground today.

We journeyed from defining perfect competition, those key conditions of many firms,

standardized product, and often free entry exit all the way through how individual firms make output decisions using marginal analysis PMC when they decide to shut down Keman AVC and how these up to the industry supply curve.

And we really highlighted the crucial differences between the short run with a fixed number of firms and the long run where entry and exit drive the industry towards zero economic profit and minimum average total cost.

We saw how firms respond to price signals, how industries adjust to demand shifts, and ultimately how competition pushes towards an efficient outcome.

From Christmas trees to global pork markets the principles are the same.

It's a chunk of the economy works or at least how it would work under ideal competitive conditions.

All right now for that final provocative thought we like to leave you with.

Think about an industry you know pretty well.

Maybe it's fast food, maybe clothing retail, maybe ride sharing apps, or online streaming services.

Yeah pick one you interact with often.

And ask yourself how closely does it actually resemble this model of perfect competition we've been discussing?

What features does it have that align with the model?

And maybe more interestingly what features push it away from perfect competition?

Think about market share, product differentiation, barriers to entry.

Are firms price takers or do they have some pricing power?

And then consider what do those deviations from perfect competition imply about the prices you pay, the profits those firms might be making, and the choices available to you as a consumer in that industry?

It's a great exercise to apply these concepts to the real world around you.

You something to mull over.

Thanks for diving deep with us today on perfect competition and the supply curve.

We hope this exploration helps you see the markets around you in a new light.

We hope it was helpful.