PERFECT COMPETITION

BY ANCHAL RANI (BCP/19/635)

SECTION - C
Unit 4: Perfect Competition
6.The firm short-run decision to shut
1.What is Perfect Competition? C down
O
2.Assumptions 7.The firm long run decision to exit or
N
enter a market
T
3.The revenue of a competitive 8.The supply curve in a competitive
E
firm market
N
9.Conclusion
T
4.Profit
maximization
5.Marginal cost curve
 What is Perfect Competition?
• Perfect market is a form of market where there are large no. of
buyers and sellers.
• Sellers selling homogeneous product at a price prevailing in the
market.
• Perfect competition marks a market structure whose assumptions
are strong and therefore unlikely to exist in most real world market.
• We can however take some useful insights from studying a world
of perfect competition and then comparing and contrasting with
“real world” imperfectly competitive market and industries .
ASSUMPTIONS BEHIND A PERFECTLY
COMPETITIVE MARKET
1 . Large no. of buyers and sellers
• Under perfect competition , there re large no. of buyers and sellers . Buyers and
sellers are so large in number that any increase or decrease in individual buyer and
seller hardly affect market demand and market supply .
• As a result , seller sell all its output at prevailing price in the market .
2.Homogeneous Product
• Under perfect competition , there are large no. of seller and buyer .
• Seller selling homogeneous product which are identical in shape , size , color ,
quality,
quantity , price and so on.
• Buyer have no reason to buy only from one seller.
• As a result , same price prevail in the market because seller cannot charge high
price, if he does so , he might lose his customer as they are fully aware about the
product.
 4 . Price Taker
• Firm under perfect competition is price taker .
prices are decided by industry on the basis of
intersection of demand and supply.

• The market price is set by the supply and demand of the industry (diagram on
right)
• This sets the market equilibrium price of P1.
• Individual firms (on the left) are price takers. Their demand curve is perfectly
elastic. Therefore MR=AR=D
• A firm maximises profit at Q1 where MC = MR
• At this price firms make normal profits – because average revenue (AR) =
average cost (AC)
3.Perfect knowledge
Both buyers and sellers have perfect knowledge about the market.
as a result , uniform price prevails in the market.

4. Absence of selling cost

There is no promotional cost because buyers already have the perfect knowledge
about the market.

5. Perfect mobility
Factors of production are perfect mobilize . There is no restriction or movement of
labour .so they move to the place where they are getting good salary.

6. Freedom of entry and exit

Under perfect competition , firms are free to enter and exit from the industry. There
is no artificial barriers as a result of this firm earn only normal profit in long run.
 THE REVENUE OF A COMPETITIVE FIRM
• Total revenue for a firm is the selling price times the quantity sold.
• TR =(P×Q)
• Total revenue is proportional to the amount of output.
• Average revenue tells us how much revenue a firm receives for the
typical unit sold.
• Average revenue is Total revenue divided by the quantity sold.
• In perfect competition , Average revenue equals the price of the good.
Average revenue = Total revenue
Quantity
= Price *quantity
Price
= Price
 THE REVENUE OF A COMPETITIVE FIRM
• Marginal revenue is the change in total revenue from an additional unit sold.
• Marginal Revenue Formula = Change in Total Revenue / Change in Quantity Sold
• For competitive firm , marginal revenue equals to the price of the good.
 PROFIT MAXIMIZATION
• An assumption in classical economics is that firms seek to maximize profits.
• Profit = Total Revenue (TR) – Total Costs (TC).
• Therefore, profit maximization occurs at the biggest gap between total revenue
and total costs.
• A firm can maximize profits if it produces at an output where marginal revenue
(MR) = marginal cost (MC)

Diagram of Profit Maximisation

To understand this principle look at the above diagram.
• If the firm produces less than Output of 5, MR is
greater than MC. Therefore, for this extra output,
the firm is gaining more revenue than it is paying in
costs, and total profit will increase.
• At an output of 4, MR is only just greater than MC;
therefore, there is only a small increase in profit,
but profit is still rising.
• However, after the output of 5, the marginal cost of
the output is greater than the marginal revenue.
This means the firm will see a fall in its profit level
because the cost of these extra units is greater than
revenue.
 MARGINAL COST CURVE
Marginal-cost curve (MC) = Upward Sloping
Average-total-cost curve (ATC) = U-shaped
Marginal-cost curve crosses the Average-total-cost curve at the minimum of average total
cost
The figure also shows a horizontal line at the market price (P). The price line is horizontal
because the firm is a price taker: The price of the firm’s output is the same regardless of
the quantity that the firm decides to produce.
The Firm Short-Run Decision To Shut
Down
• A shutdown refers to a short run decision not to produce anything
during a specific period of time because of current market conditions.
• The firm shuts down if the revenue it gets from producing is less than
the variable cost of production.
a. Shut down if TR<VC
b. Shut down if TR/Q < VC/Q
c. Shut down if P < AVC
• Sunk costs – have already been committed and can’t be recovered
(fixed costs) So we ignore these costs in the short run
• Firm’s short run S curve =MC curve above AVC.
 MC CURVE AS THE SUPPLY CURVE
Because the marginal cost curve determines the Q of the good
firm is willing to supply at any price , the MC curve is also the
competitive firms supply curve .
 CASE STUDY : NEAR EMPTY RESTRAURANTS AND OFF SEASON
MINIATURE GOLF
1. NEAR EMPTY RESTRAURANTS
❑ SUMMARY – 1.A restaurant for lunch and found time almost empty because the
restaurant even not bother to stay open .
2. It might seem that the revenue from the few customers could
not possibly cover the cost of running the restaurant.
❑ MICRO PROBLEMS – 1. Restaurant kitchen , equipment , tables , plates and so on
are fixed.
2. Shutting down during will not reduce these cost.
3.In other words these costs are sunk in the short run.
4. Variable costs the price of the additional food and the
wages
of the extra staff.
5.Variable costs are changeable.
❑ Alternatives – 1. Shut down if revenue from lunch < variable costs
2.Stay open if revenue from lunch >variable cost
❑ CONCLUSION – Restaurant should be open in lunch time because make a revenue
generate .
 2.Off season miniature golf
❑ SUMMARY – A miniature golf is almost empty because they even bother to stay
not open.
It might seem that the revenue from the few player
could not possibly cover the cost .
❑ Micro problems – Miniature golf costs land and building so on are fixed .
Shutting down during season time would not reduce these costs
In other words these costs are sunk in the short run.
Variable costs are changeable.
❑ Alternatives – Shut down if Revenue < Variable cost
stay open if Revenue > Variable cost
❑ Conclusion – Miniature golf should be open in lunch time because it make a
evenue generate.
THE FIRM LONG RUN DECISION TO EXIT OR ENTER A MARKET

• In the long run , the firm exits if the revenue it would get from
producing is less than its total cost .
1. Exit if TR <TC
2. Exit if TR/Q <TC/Q
3. Exit if P < ATC

• A firm will enter the industry if such an action would be

profitable.
1. Enter if TR>TC
2. Enter if TR/Q >TC/Q
3. Enter if P>ATC
Measuring Profit in Our Graph for the Competitive Firm

• Profit = TR – TC
• Profit = (TR/Q - TC/Q) ×Q
• Profit = (P - ATC) × Q
The supply curve in a competitive market
• Short - Run Supply Curve
▪ The portion of its marginal cost curve that lies above average variable cost.
• Long - Run Supply Curve
▪ The marginal cost curve above the minimum point of its average total cost
curve.
▪ Market supply equals the sum of the quantities supplied by the individual
firms in the market.
The short run market supply with a fixed number of firms
• For any given price , each firm supplies a quantity of output so that its marginal
cost equals price.
• The market supply curve reflects the individual firms marginal cost curves.
The long run : Market Supply With Entry and exit
• Firms will enter or exit the market until profit is driven to zero.
• The process of entry or exit ends only when price and average
total cost are driven to equality.
• At the end of the process of entry and exit , firms that remain
must be making zero economic profit.
• In the long run , price equals the minimum of average total cost
or the efficient scale.
• The long run market supply curve is horizontal at this price.
• Long-run equilibrium must have firms operating at their
efficient scale.
WHY DO COMPETITIVE FIRM STAY IN BUSINESS
IF THEY MEKE ZERO PROFIT ?
• Profit equals total revenue minus total cost.
• Total cost includes all the opportunity costs of the firm.
• In the zero profit equilibrium , the firm ‘s revenue
compensates the owners for the time and money they
expand to keep the business going .
• Also remember that economists and accountants see profit
differently.
• So, even when economic profit is 0 , accounting profit is
positive.
A SHIFT IN DEMAND IN THE SHORT RUN AND LONG RUN
• An increase in demand raises price and quantity in the short run.
• Firms earn profits because price now exceeds average total cost.
Why the Long - Run Supply Curve Might Slope
Upward ?
• Some resources used in production may be available only in limited
quantities.
• Firms may have different costs.
• Marginal Firm
▪ The marginal firm is the firm that would exit the market if the price
were any lower.
▪ This firm earns 0 profit, but firm with the lower costs earn positive
profit even in the long run.
• So, the LR Supply Curve may be upward sloping, indicating that a higher
price is necessary to induce a larger Qs.
• But, because firms can enter and exit more easily in the long run than in
the short run, the LR Supply Curve is typically more elastic than the SR
Supply Curve
 CONCLUSION
1. Because a competitive firm is a price taker , its revenue is proportional
to the amount of output it produces.
2. To maximize profit , a firm chooses a quantity of output such that MR =
MC.
3. Thus the marginal cost curve is its supply curve.
4. In short run firm will choose to shutdown when :
Price of the good > AVC
5. IN LONG RUN , firm will choose to exit if
P>ATC
6. In a market with free entry and exit , profits are driven to zero in the
long run.
7. Changes in demand have different effects over different time horizons.