Chapter 9

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
• Perfect Competition: Existence in Real World

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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 buyers entry and
exit
Perfect Very Homogeneous Very Unrestricted Agricultural
competition Large (undifferentiated) Large commodities,
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

dQ dP
= 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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 Demand and Revenue of a Firm
TC
Revenue, TR
Cost, Profit B

Profit
A

Q1 Q* Q2 Output

Maximum
Profit

Π Q1 Q* Q2 Output

Profit, Revenue and Cost Curves of a Firm

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 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

INDUS FIR
Pric TRY Pric M
e e
Mark S Mark
D et et
Dema Sup
nd ply
E
P* P=AR=
MR

S
D
O O
Q* Outp Outp
ut ut
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 Market Demand Curve and Firm’s
Demand Curve
• Market equilibrium is reached at the point of intersection of the
market demand and market supply curves, i.e. at E 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*.
• It cannot sell a single unit of its product at even a slightly higher
price.
• It is not worthwhile for the firm to offer any quantity at a lower price
either, since it can sell as much as it wants at the prevailing market
price.
• 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.
• 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.
• 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:
dπ dR(Q) dC(Q)
– First order condition: MR=MC or = − =0
dQ dQ dQ

– 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
Pri
AR>AC equilibrium are fulfilled.
ce
M • TR= OP*EQ* (TR= AR.Q)
C A
• TC= OABQ* (TC=AC.Q)
C
P* E • Profit = (OP*EQ* - OABQ*)
AR=
= AP*EB
A B MR
• This is the supernormal profit
made by the firm in the short
run, because the market price
P* (AR) is greater than
O Q average cost.
Quant
* ity
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 Normal Profit
• Not all firms earn
supernormal profits in the
short run.
• some firms may earn
Pric AR=AC normal profits (when
e M A average revenue is equal
C C to average cost).
E • TR= OP*EQ*
P* AR=
• TC= OP*EQ*
MR
• TR=TC
• Firm makes normal profit,
and actually ends up
O Q* Quant producing at the break
even level of output.
ity
• At this point:
AC=AR=MC=MR
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 Subnormal Profit (or Loss)

• TR= OP*EQ*
• TC= OABQ*.
AR<AC
Pric • Profit (Loss)= P*ABE
M A = OP*EQ* - OABQ*
e C
C • The firm incurs loss or
B subnormal profit in the short
A
AR= run because the average
P E cost of producing this output
* MR is more than the ruling
market price hence TR<TC.
• The firm continues to
produce at loss in the short
O Q* Quan run in anticipation of price
rise.
tity

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 Exit or Shut Down of Production

• A firm incurring losses in the

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

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 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

Pri
ce LMC1 LMC
LAC1

LAC
P1 E1

P* AR=
E*
MR

O Q1 Q* Quan
tity

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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.
• 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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