SummaryEven though perfect competition is hard to come by, it’s a good starting point to understand market structures. A deep understanding of how competitive markets work and are formed is the cornerstone to understand why it’s so hard to reach them. In this first Learning Path on perfect competition, we start by analysing firms’ cost structure, before analysing their interaction in the market.
Short run cost analysis would not be properly taught without the inclusion of demand and supply curves and their correct understanding, specially how its shifts may affect firms’ cost functions. The total supply of the industry is the aggregate of the supply of all the individual firms.
The amount that is produced by each individual firm is subject to its optimal level of production. We must consider that the optimum production level of a firm is that in which marginal revenue (price) equals marginal cost, as long as it also covers its average variable costs. If this is not the case the firm will not achieve its highest level of profit and could even be incurring in losses.
It is common that input prices vary over time, causing firms to have to make adjustments. In order to optimise, firms will have to constantly adapt their production to the changes in their marginal costs. If a firm fails to adequate its production to the new marginal costs, there will be a loss in profits.
The equilibrium point between the aggregate demand of a product and its aggregate supply will be subject to variations if one of them suffers a change, and thus producing a new equilibrium price and quantity. These shifts may come from either the demand or the supply side. Let’s analyse thoroughly what happens to quantity sold by a given firm when there is a shift in either the demand or the supply curve.
Examples of shifts in demand include changes in income or changes in the price of the substitute goods. It must be noted that the aggregate supply curve starts at X, and not before, because a lower quantity would get producers to incur in losses. Also, notice that we assume firms are getting at least some profits (area A) because in the short term only labour is variable, which means that there are no firms entering this market, even though profits exist. Let’s say there is an increase of consumers’ income, which would increase the aggregate quantity demanded at a given price, thus shifting the demand curve to the right (D’ would be our new demand curve). Because there are no changes affecting the supply curve, the new equilibrium would be E1, which means more quantity sold by each firm, as well as an increase in total quantity sold (Q1). Since the cost functions of each firm are the same, each firm would be selling more quantity at a higher price (p1), which would increase their profits (from area A to area B). To sum up, in the short term, an increase in demand would increase each firm’s profits by the area B-A, which would depend on both the marginal and average total cost, as well as the increase on quantity.
Shifts in the supply curve are caused by changes in outputs’ prices, technological innovations and changes in the number of firms in the industry. The last two cases, however, are not associated to the short-run. So let’s say there is a drop in the price of an input, used by all firms during their production process. This would decrease marginal costs and therefore average variable and total costs, which shifts each curve downwards (left, in red). Since the supply curve we consider is the aggregate of all firms’ supply, the aggregated supply curve also shifts downwards. Note that, since there are now lower marginal and average costs, the lowest point of the supply curve drops to X’. The new equilibrium would be E2, with a decreased price of p2. The new profits of each firm, C, is determined by both the new quantity produced and the drop in marginal and average costs. Even though in this case profits increase, profits can either increase or decrease. To sum up, in the short term, a reduction of inputs’ prices shifts the supply curve to the right and decreases market prices, but has undetermined effects on each firm’s profits.