Introduction

Concepts of Competition

Whether a firm can be regarded as competitive depends on several factors, the most important of which are:

The number of firms in the industry. As the number of firms increases, the effect of any one firm on the price and quantity in the market declines.

The degree of rivalry. If firms are vigorously trying to claim market share at each other's expense, each firm will be more constrained in its choices.

The degree of homogeneity of the product. Differences in quality or other properties mean that the products of different firms are not perfect substitutes for each other, and that means customers will absorb some price differences among firms.

The ease of entry and exit. If new producers can easily enter and exit the market, existing firms may behave as though there are more firms than there appear to be, because there are more potential competitors.

Firm Demand Under Perfect Competition

When a market has a large number of firms, free entry and exit, and a relatively homogeneous product, it can generally be modeled as perfectly competitive, or PC for short. The key condition for a competitive market, as discussed in the previous lecture, is pricetaking. Every firm - and every consumer - must take the market price of the good as given. No one can unilaterally affect the price by their choice of how much to buy or sell. This means the individual firm will face a horizontal demand curve. It will be horizontal at the market price, established by supply and demand on the market as a whole. Recall, from the previous lecture, that the perfectly competitive firm will maximize its profits by setting MC = p*. (Why? Because profit maximization for any firm means setting MC = MR, and for a perfectly competitive firm, MR = p*.)

Deriving the Firm's Supply Curve

We can use what we know about profit maximization under perfect competition to derive the firm's individual supply curve. Remember that a supply curve shows how much quantity is produced at each price. A market supply curve shows how much quantity all firms together will produce at each price. An individual firm's supply curve shows much quantity that firm will produce at each price. To derive this curve, we need to consider the firm's response to different market prices. Consider three different prices, p1 < p2 < p3. For each of these prices, we can figure out the quantity that a PC firm will produce. From these choices we can see the firm's supply curve taking shape: it looks just like the MC cost curve.

There is one exception to the rule that the firm's supply curve is identical the MC: when p* < AVC, the firm's shut-down condition is satisfied. If we follow the MC down to the AVC, we can see that for any price above the minimum point of the AVC will induce the firm to stay open and produce. But for prices below the minimum AVC, the firm will shut down and produce q ...