PERFECT COMPETITION IN THE SHORT RUN

Let’s Pretend!

Perfect competition is the kind of hypothetical situation that economists love to talk about even though it exists in the same fairy-tale realm as unicorns and sea dragons. Perfect competition is the made-up idea that businesses will behave in certain ways if we stipulate that all of the businesses in a particular industry are playing on a level field. The theory of perfect competition allows economists to describe what would happen if only people would listen to them. These economics lectures usually include charts containing complicated formulas but we’re omitting them here. You’re welcome.

PERFECT COMPETITION IN FOUR EASY PIECES

What constitutes the aforementioned level playing field? For starters:

• Consumers and producers have perfect knowledge—they know all there is to know about the product and the market—and they make rational decisions. That means consumers are trying to maximize utility (i.e., happy points) and producers are trying to maximize profit, and both groups have all the information they need to be able to do these things.
• Businesses can enter and exit the market without barriers. Here we pretend that businesses don’t have to beg venture capitalists for start-up funds or hold going-out-of-business sales.
• All producers make things (“outputs” or finished goods) that are identical and all of them have inputs (e.g., labor) that are the same. In Perfect Competition World, a pair of Keds and a pair of Dolce & Gabbana shoes are exactly equivalent and require exactly the same resources to produce.
• Lots of producers are competing in the same area, meaning that no producer (business) has pricing power—none is big enough or monopolistic enough to manage it. Everyone prices their goods in relationship to everyone else. If Blue Skies Coffee Company sells a pound of arabica coffee beans for $20, then Green Earth Coffees Inc. will have to sell their arabica coffee beans for about the same amount of money or the business won’t have any buyers. Remember, in this scenario, all outputs are the same and all consumers have perfect knowledge, so they know Blue Skies coffee is just as good as Green Earth coffee.

In other words, businesses must compete against each other without any advantages (or disadvantages!). The result is that the industry sets the price rather than individual businesses, and demand is perfectly elastic. (Remember that if a good has many acceptable substitutes, the demand is price sensitive, which is another way of saying demand is elastic.)

COMPETITION AND THE SHORT RUN

For an industry, the short run is the period of time in which firms are unable to enter or exit the market because they are only able to vary their labor and not their fixed capital. That is to say, if demand plummets, a business cannot quickly reduce their fixed costs; if demand skyrockets, they cannot quickly expand to produce more. In the short run, it is possible for firms in a perfectly competitive industry to earn economic profits or even operate at a loss as supply and demand for the entire industry’s output changes.

For example, assume that the glazed doughnut industry is perfectly competitive. Imagine that scientists working in New Zealand discover that glazed doughnuts, when consumed with coffee, are extremely beneficial to consumers’ health. As a result of this great news, the demand for doughnuts increases. This results in a new, higher equilibrium price. Remember that the market price represents the firm’s marginal revenue, so for firms in the doughnut industry, their total revenue has increased by more than their total economic cost. This means that glazed doughnut firms are earning economic profits.

Six months later, scientists in California reveal that the earlier New Zealand doughnut research was flawed, and that, in fact, consuming large amounts of glazed doughnuts with coffee might pose a risk to consumers’ health. First there is denial, then consumers slowly awaken to the reality that they are fifty pounds heavier and finding it difficult to sleep. At this point, the demand for glazed doughnuts decreases below its original equilibrium. For many firms in the doughnut industry, this decrease in the market price means that they are now producing at a short-run loss, because their total revenue is less than their total cost of production.