Perfect Competition

Perfect Competition
Determination of price and output in

perfect competition
Definition & assumptions
A perfectly competitive market is defined as a
market in which there is complete absence of
rivalry among the competitive firms. The
following assumptions characterize a
competitive market:
Large number of small firms
Product homogeneity
Free entry and exit
Perfect information
Continued:
On the basis of the following assumptions we can
define a perfectly competitive market as the one
where there are large number of small firms
producing a homogenous product and which has
easy entry and exit and complete information
about the market.
The first two assumptions imply that the firm has
no control over the price of the product and
therefore a perfectly competitive firm is a price
taker.
Continued:
This implies that the demand curve facing the
perfectly competitive firm is horizontal to the
X-axis indicating that the firm can sell as many
units as it can at the going market price.
Note that the demand curve is also its average

revenue curve and marginal revenue curve
The example
Units of output Price per unit Total revenue Average Marginal
revenue revenue
1 10 10 10 10
2 10 20 10 10
3 10 30 10 10
4 10 40 10 10
Short run equilibrium: TR and TC
Approach
Quantity of Total revenue (TR) Total cost (TC) Profit (TR-TC)
tomatoes (Q)
1 18 30 12
2 36 36 0
3 54 44 10
4 72 56 16
5 90 72 18
6 108 92 16
7 126 116 10
From the table we see that the profit is
maximized at an output level of 5 units when
the difference between TR and TC, that is
profit is the highest(18). But we can gain more
insight into the profit maximizing choice of
output by viewing it as a problem of marginal
analysis.
Using Marginal analysis to choose the
profit maximizing output
Defining MR and MC
MR = TR/Q and MC= TC/Q
MR= Change
Change in total revenue
in quantity of output
MC = Change
Change in total cost
in quantity of output
Short-run equilibrium using MR and
MC
Quantity of Variable Total cost Marginal Marginal Net gain
tomatoes cost (VC) (TC) cost (MC) revenue (MR-MC)
(MR)
1 16 30 16 18 2
2 22 36 6 18 12
3 30 44 8 18 10
4 42 56 12 18 6
5 58 72 16 18 2
6 78 92 20 18 -2
7 102 116 24 18 -6
Short-run equilibrium of the
competitive firm
Two conditions for short-run equilibrium:
MR = MC and
Slope of MR curve< slope of MC curve at the
profit maximizing level of output (at the point
of equilibrium.
If MR > MC, it is profitable to increase output
If MR< MC, it is necessary for the firm to
reduce output.
Now the question is What if MR and MC
are not exactly equal?
In that case one should produce the

largest quantity for which MR exceeds
MC.
The simpler version of optimal output

rule applies when production involves
large numbers, such as hundreds and
thousands of units. In such cases, MC
comes in smaller increments and there is
always a level of output at which MC
almost exactly equals MR
Diagram showing firms short-run
equilibrium
SMC SAC
Minimum average
w Total cost
Price Fig. 3 Price SMC
SAC
SAC
e
e P Loss
P f P=MR P=MR
Profit
O Q output
O Q1 Q2 output
Fig.1 Fig. 2
Explanation of Fig.1 and Fig.2
Note that at point e both conditions of
equilibrium are satisfied. At e, MR=MC and slope
of MC is rising while slope of MR is constant.
Also Note that in fig. 1, the firm experiences

profit (since SAC curve is below the demand
curve) and in fig. 2, the firm experiences loss
(since SAC is above the demand curve).
Fig. 3 shows normal profit, no loss no gain.
Continued:
we can now state that
if the firm produces a quantity at which P> ATC,
the firm is profitable
If the firm produces a quantity at which P=ATC,
the firm breaks even
If the firm produces a quantity at which P < ATC,
the firm incurs a loss
Another rule for a price taking firm for
maximizing profit
The price taking firms profit is maximized by

producing the quantity of output at which the
market price is equal to marginal cost.
That is P=MC at the price taking firms optimal
quantity of output (Q2 in fig 1 and Q in fig. 2)
Continued: The shut down point
Cost SMC
SATC
SAVC
P2
w R
P1
Po C
Shut down point
O Q Qo output
Fig.3
In order to analyze the optimal production
decision in the short-run, we need to consider
two cases:
When the market price is below minimum AVC
When the market price is greater than or
equal to minimum AVC
Continued
When P< minimum AVC, the price the firm receives per unit
is not covering its variable cost.
The firm should stop production immediately
Because there is no level of output at which the firms TR
covers its VC---the costs it can avoid by not operating.
In this case the firm maximizes output by not producing at
all----that is by minimizing its losses.
It will still incur a fixed cost in the SR, but it will no longer
incur any VC.
This means that the minimum AVC is equal to shut down
price, the price at which the firm ceases production in the
short run ( point W in figure 6)
Continued:
When market price is greater than AVC ,
however, the firm should produce in the SR.
In this case, the firm maximizes profit---or
minimizes loss---by choosing the output
quantity at which MC=P
Supply curve of a perfectly competitive
firm
SMC
Price, SAVC S
MC
P3 c C
P3=MR3
b B
P2 P2=MR2
P1 a P1=MR1 A
Po Po=MRo S
Output
Fig.5
Fig.4
Explanation of the Graph 4 and 5
We know that profit maximizing quantity of output in the short-run

depends on the price.
That is, where P=MC is the profit maximizing level of output.
Consider point b which is an equilibrium point where P2 =MC and at that
price the quantity supplied is Q2.
Similarly, as the price falls to P1, the quantity supplied falls to Q1 as shown
by point a and as price rises to P3, the quantity supplied falls to Q3 as
shown by the equilibrium point c.
Thus points A, B & C in diagram 5 are the corresponding points of a, b & c
in graph 4.
The points when joined becomes the supply curve of the firm drawn
directly from the upper portion of the MC curve.
Thus upper portion of MC curve of the competitive firm becomes its
supply curve
Because at any price below the minimum AVC, the firm shuts down.
Short run industry supply curve
In the SR, the no. of producers in an industry is
fixed----there is no entry and exit.
The industry supply curve is the horizontal sum of
the individual supply curves of all producers
Here we assume that all producers are alike and
each has same cost
And each farm will produce the quantity of
output at which MC =P
For example, if there are 100 farms and each
farm produces 5 units of output, then 100 farms
will produce 500 units of output.
Short-run equilibrium of the
competitive industry
The industry is in equilibrium in the short-run

when total quantity demanded equals total
quantity supplied at the prevailing market
price. S
D
Po
S D
QO
Long-run equilibrium of the
competitive firm and the industry
The firm is in long-run equilibrium when
LAC=P. That is when each of the firm in the
industry is earning only normal profit.
The industry is in long run-equilibrium when

the quantity demanded equals quantity
supplied, given that sufficient time has
elapsed for entry into and exit from the
industry to occur. See Figure 6a and 6b.
Long run equilibrium of firm and
industry
Industry
Firm
Price Price
S
LAC D
E
P e P
S D
Q output Q output
Fig. 6a Fig. 6b
Long-run entry and exit of the firm in
the industry
LAC
D
LMC
S1
SMC
S2
SAC
Profit
S1
D
S2
Q1 Q2 Q1 Q2

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Perfect Competition

Determination of price and output in

Note that the demand curve is also its average

In that case one should produce the

The simpler version of optimal output

Price Fig. 3 Price SMC

Also Note that in fig. 1, the firm experiences

The price taking firms profit is maximized by

We know that profit maximizing quantity of output in the short-run

The industry is in equilibrium in the short-run

The industry is in long run-equilibrium when

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