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the firms’ outputs are perfect substitutes for one another; that is, each firm’s

output is perceived to be indistinguishable from any other’s. Perfect substi-

tutability usually requires that all firms produce a standard, homogeneous,

undifferentiated product, and that buyers have perfect information about cost,

price, and quality of competing goods.

Together, these two conditions ensure that the firm’s demand curve is per-

fectly (or infinitely) elastic. In other words, it is horizontal like the solid price

line in Figure 7.3a. Recall the meaning of perfectly elastic demand.The firm can

sell as much or as little output as it likes along the horizontal price line ($8 in

the figure). If it raises its price above $8 (even by a nickel), its sales go to zero.

Consumers instead will purchase the good (a perfect substitute) from a com-

petitor at the market price. When all firms’ outputs are perfect substitutes, the

“law of one price” holds: All market transactions take place at a single price.

Thus, each firm faces the same horizontal demand curve given by the prevail-

ing market price.

THE FIRM’S SUPPLY CURVE Part (a) of Figure 7.3 also is useful in describing

the supply of output by the perfectly competitive firm. The cost characteristics

of the typical firm in the competitive market are as shown in the figure. The

firm faces a U-shaped, average cost curve (AC) and an increasing marginal cost

curve (MC). (Recall that increasing marginal cost reflects diminishing mar-

ginal returns.)

Suppose the firm faces a market price of $8. (For the moment, we are not

saying how this market price might have been established.) What is its optimal

level of output? As always, the firm maximizes profit by applying the MR MC

rule. In the case of perfectly elastic demand, the firm’s marginal revenue from

selling an extra unit is simply the price it receives for the unit: MR P.

Here the marginal revenue line and price line coincide. Thus, we have the

following rule:

A firm in a perfectly competitive market maximizes profit by producing up to an

output such that its marginal cost equals the market price.

In Figure 7.3, the intersection of the horizontal price line and the rising

marginal cost curve (where P MC) identifies the firm’s optimal output. At

an $8 market price, the firm’s optimal output is 6,000 units. (Check for your-

self that the firm would sacrifice potential profit if it deviated from this output,

by producing either slightly more or slightly less.) Notice that if the price rises

above $8, the firm profitably can increase its output; the new optimal output

lies at a higher point along the MC curve. A lower price implies a fall in the

firm’s optimal output. (Recall, however, that if price falls below average variable

cost, the firm will produce nothing.) By varying price, we read the firm’s opti-

mal output off the marginal cost curve. The firm’s supply curveis simply the

portion of the MC curve lying above average variable cost.

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