Perfect Competition

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 Lecture Plan
• Market Morphology
• Features of Perfect Competition
• Demand and Revenue of a Firm
• Market Demand Curve and Firm’s Demand
Curve
• Equilibrium of Firm
• Short Run Price and Output for the Competitive
Industry and Firm
• Market Supply Curve and Firm’s Supply Curve
• Long Run Price and Output for the Industry and
Firm
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 Chapter Objectives
• To introduce the basics of market morphology and
identify the different market structures.
• To examine the nature of a perfectly competitive
market.
• To understand market demand and firm’s demand
under perfect competition.
• To help analyze the pricing and output decisions of a
perfectly competitive firm in the short run and long run.

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 Market
• Defined as the institutional relationship between buyers
and sellers.
• Market refers to the interaction between buyers and
sellers of a good (or service) at a mutually agreed upon
price.
• Such interaction may be at a particular place, or may
be over telephone, or even through the Internet!
• Sellers and buyers may meet each other personally, or
may not ever see each other, as in E-commerce.
• Thus market may be defined as a place, a function, a
process.

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 Market Morphology
 Markets may be characterized on the basis of:
 Number, size and distribution of sellers in any market
 Whether the product is homogeneous or differentiated
 Number and size of buyers:
 large number of buyers but small size of individual buyer, the market
will be evenly balanced between buyers and sellers.
 small number of buyers but their size is large, the market is driven by
buyers’ preferences.
 Absence or presence of financial, legal and technological
constraints
 Thus we have:
 Perfect Competition
 Monopoly
 Monopolistic competition
 Oligopoly
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 Market Morphology
Type of Number Nature of Number Freedom of Examples
market of firms product of entry and
buyers exit
Perfect Very Homogeneous Very Unrestricted Agricultural
competition Large (undifferentiated) Large commodities,
fuels,housing,
services,
financial
markets
unskilled
labour
Monopolistic Many Differentiated Many Unrestricted Retail stores,
competition FMCG
Oligopoly Few Undifferentiated Few Restricted Cars,
or differentiated computers,
universities
Monopoly Single Unique Many Restricted Indian
Railways,
Microsoft
Monopsony Many Undifferentiated Single Not Indian defense
or differentiated applicable industry
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 Features of Perfect Competition

Perfect competition may be defined as that market

where infinite number of sellers sell homogeneous good
to infinite number of buyers while buyers and sellers
have perfect knowledge of market conditions
 Features
 Presence of large number of buyers and sellers
 Homogeneous product
 Freedom of entry and exit
 Perfect knowledge
 Perfectly elastic demand curve
 Perfect mobility of factors of production
 No governmental intervention
 Price determined by market and Firm is a price taker.
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 Demand and Revenue of a Firm
dTR d
Marginal Revenue (MR) = dQ = dQ
PQ

dP dQ
= Q. dQ +P. dQ = P ……(1)
[P is assumed to be given (constant)].
• Firms are price takers and can supply as
much as they want at the existing price in
the market, thus:
AR= MR= P…………(2)

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 Profit, Revenue and Cost Curves of a Firm
• Profit (Π) = TR - TC.
π(q) = R(q) − C(q)
TC
TR
Revenue, • Profit curve (Π) begins from
Cost, B
the negative axis, implying
Profit
that the firm incurs losses at
an output less than OQ1.
Profit • At point A, i.e. output Q1 firm
Loss earns no profit no loss.
A
• Firm earns maximum profit
at output OQ*.
• At point B, TR=TC again;
O
Q1 Q* Q2 Output profit is equal to zero, at
output OQ2.
Maximum
Profit • Rational firm would try to
maximise profit.
O
Q1 Q2
Q*
Π
Output Δπ/Δq = ΔR/Δq − ΔC/Δq = 0
MR(q) = MC(q) 9
 Market Demand Curve and Firm’s
Demand Curve
• The market demand curve for the whole industry is a
standard downward sloping curve.
– An individual buyer is able to get the maximum amount of output
at each existing price, at a given time.
• The market demand curve is the horizontal summation of
individual demand curves..
• The demand curve for an individual firm is a horizontal
straight line showing that
– the firm can sell infinite volume of output at the same price.

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 Market Demand Curve and Firm’s
Demand Curve
• Market equilibrium is at the point of intersection (E) of the market
demand and market supply curves, where equilibrium output for the
industry is given at Q* and price at P*.
• Each perfectly competitive firm, being a price taker, takes the
equilibrium price from the market as given at P*.

INDUSTRY
Market
Price
Demand
S
Market
Supply Price FIRM
D

E P=AR=MR
P*

S
D
O Q* O
Output Output 11
 Market Demand Curve and Firm’s
Demand Curve
• Since a firm can sell all it wants at this price, it faces a
perfectly elastic demand curve for its product hence the
demand curve is straight horizontal line.
• It is not worthwhile for the firm to offer any quantity at a
lower price, since it can sell as much as it wants at the
prevailing market price.
• If it tries to charge higher price its demand will fall to
zero.
• Hence Total Revenue (TR) of a firm would increase at a
constant rate, i.e. Marginal Revenue would be constant.
– Average Revenue will be equal to Marginal Revenue.
• Hence the demand curve, coincides with the AR and MR
curves.
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 Equilibrium of Firm

• Two conditions must be fulfilled for a profit

maximizing firm to reach equilibrium:
d dR(Q) dC (Q)
– First order condition: MR=MC or dQ

dQ

dQ
=0

– Second order condition: Slope of MR curve < MC

dMR dMC
curve or dQ

dQ
<0

• The second order condition is a sufficient

condition, because if the inequality sign is
reversed, we arrive at a point of loss
maximization.
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 Short Run Price and Output for the
Competitive Industry and Firm

• In short run an individual firm may be in

equilibrium and may earn
– Supernormal profit: AR>AC
– Normal profit: AR=AC
– Losses: AR<AC

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 Supernormal Profit
• Firm is in equilibrium at OQ*
output at market price P*,
where both the conditions of
AR>AC equilibrium are fulfilled.
Price • TR= OP*EQ* (TR= AR.Q)
MC
AC • TC= OABQ* (TC=AC.Q)
• Profit = AP*EB
P* E AR=MR = (OP*EQ*-OABQ*)
A B • This is the supernormal profit
made by the firm in the short
run, because the market price
P* (AR) is greater than
average cost.
O Q Quantity
*
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 Supernormal Profit
• Firm is in equilibrium at OQ*
output at market price P*,
where both the conditions of
AR>AC equilibrium are fulfilled i.e.
Price point E.
MC
AC • TR= OP*EQ* (TR= AR.Q)
• TC= OABQ* (TC=AC.Q)
P E AR=MR • Profit = AP*EB
*A
B = (OP*EQ*-OABQ*)
• This is the supernormal profit
made by the firm in the short
run, because the market price
P* (AR) is greater than
O Q Quantity average cost.
*
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 Normal Profit
• In the short run some firms
may earn only normal profit
AC=AR=MC=MR (when average revenue is
equal to average cost).
Price • Firm is in equilibrium at OQ*
MC output at market price P*,
AC where both the conditions of
equilibrium are fulfilled.
P* E AR=MR • TR= OP*EQ*
• TC= OP*EQ*
• TR=TC
• Firm makes normal profit, and
actually ends up producing at
the break even level of output.
O Q Quantity
*
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 Subnormal Profit (or Loss)
• Firm is in equilibrium at OQ*
output at market price P*,
Price AR<AC where both the conditions of
equilibrium are fulfilled (point
AC E).
MC
• TC= OABQ*
• TR= OP*EQ*
A B
• Loss= P*ABE
P* AR=MR
E = OP*EQ* - OABQ*
• The firm incurs loss or
subnormal profit in the short
run because the AC of
producing this output is more
O than the market price hence
Q* Quantity
TR<TC.
• The firm continues to produce
at loss in the short run in
anticipation of price rise.
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 Exit or Shut Down of Production

FIRM • A firm incurring losses in the

short run will not withdraw from
Price the market, but will wait for
MC
AC market conditions to improve in
AVC the long run.
AVC’ • Firm would continue production
till price > average variable
A cost (P>AVC or AR>AVC).
P* AR=M • Point A denotes the shut down
R point, where price P* =
AVC=AR.
• Any increase in VC above A or
any fall in market price below
O P* will cause the firm to shut
Q* Quantity down.

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 CHOOSING OUTPUT IN THE SHORT RUN

The Short-Run Profit of a Competitive Firm

A Competitive Firm Incurring

Losses
A competitive firm should
shut down if price is below
AVC.

The firm may produce in

the short run if price is
greater than average
variable cost.

Shut-Down Rule: The firm should shut down if the price

of the product is less than the average variable cost of
production at the profit-maximizing output.
 Market Supply Curve and Firm’s
Supply Curve
• Condition I: If Price<minimum AVC, then shut down
– For such price, the supply curve would coincide with the vertical
axis.
• Condition II: If Price ≥ minimum AVC, then choose any
output that would maximize profit.
• For any price above minimum AVC, the firm would
choose an output level that would satisfy the conditions
of profit maximization.
– The supply curve of the firm would be identical to the short run
marginal cost curve above the minimum point of the AVC curve.

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 Long Run Price and Output for the
Industry and the Firm
• In the long run perfectly competitive firms earn only normal profits.
AR=MR=MC=AC
• The reason is the unrestricted entry into and exit of firms from the
industry in the long run.
• When existing firms enjoy supernormal profits in the short run new
firms are attracted to the industry to gain profits.
– The supply of the commodity in the market increases. Assuming no
change in the demand side, this lowers the price level.
• When firms are making losses in the short run, some may be forced
to leave the industry in the long run.
– Their exit from the industry causes a reduction in the supply of the
product and as a result the equilibrium price rises.
• This process of adjustment continues up to the point where the price
line becomes tangential to the AC curve.
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 Long Run Price and Output for the
Industry and the Firm
•Prevailing price is OP1,
Price AR=MR=MC=AC Equilibrium at Point E1 and
Output OQ1
LMC •Firms earn supernormal
LAC
profit (AR>AC)
P1 E1 •This will attract more firms,
E*
AR=MR
increase in supply will reduce
P* the price till AC=AR, i.e. at P*
P2 E2
•Prevailing price is OP2,
Equilibrium at Point E2 and
O Output OQ2
Q2 Q* Q1 Quantity
•Firms earn loss (AR<AC)
•Some firms will exit,
decrease in supply will
increase the price till AC=AR,
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i.e. at P*
 CHOOSING OUTPUT IN THE LONG RUN

Long-Run Profit Maximization

Output Choice in the Long Run

The firm maximizes its profit by

choosing the output at which price
equals long-run marginal cost
LMC.
In the diagram, the firm increases
its profit from ABCD to EFGD by
increasing its output in the long
run.

The long-run output of a profit-maximizing competitive firm is

the point at which long-run marginal cost equals the price.
 •
• Stable price and heterogenous cost •
Supply curve derivation :done on board.
Long Run equilibrium : :price is unstable and COP is homogenous:done on board
conditions :done on the board in the class • Long Run:marginal and intramarginal firms:done on board.
 Summary
• In the short run firms can earn supernormal profits, or normal profits,
or even loss. This depends on the position of the short run cost
curves.
• The supply curve of the firm would be identical to the short run
marginal cost curve above the minimum point of the AVC curve.
• The industry supply curve is obtained by the horizontal summation
of the supply curves of all firms in the industry.
• In the long run perfectly competitive firms earn only normal profits. If
firms are making supernormal profits in the short run, this would
attract new firms and if firms are incurring losses; some firms would
exit the market, leaving existing firms with normal profits in either
case.

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 Summary
• A market is a place / process of interaction between sellers and
buyers that facilitates exchange of goods and services at mutually
agreed upon prices.
• Perfect competition is defined as a market structure which has many
sellers selling homogeneous products at the market price.
• The equilibrium price is determined by demand and supply in the
market
• Each firm sells a very small portion of the total industry output;
hence it can not affect the price in the market and has to accept the
price given to it by the market. As such, it is regarded as a “price
taker”.
• A firm faces a perfectly elastic demand curve; hence average
revenue is constant and is equal to marginal revenue.
• Profit maximizing output is that where marginal cost is equal to
marginal revenue while marginal cost is increasing.

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