05-09-2022

6
Unit

Firms in Perfect Competition

Pricing and Output Determination

Arjun Madan Ph D

Market structure

 Classifying the Markets

 Number of Firms
 Ease of entry into the market (Freedom of entry-exit)
 Product’s degree of uniformity (Homogenous /Differentiated)
 Implication for demand curve (Horizontal / Downward slopping)

 Types of Markets
 Perfect competition, and
 Imperfect competition
 Monopoly
 Monopolistic competition
 Oligopoly

Business Economics (Micro) – Market Analysis – Perfect Competition Arjun Madan Ph D 1

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Types and Features of the Markets

Examples Implication for
Types of Number of Freedom of Nature of
demand curve
Market Firms entry Product

Perfect Very/Many Unrestricted Homogenous Vegetables, Horizontal: Firm is

?
Competition Fruits, eggs, price taker

Monopolistic Many / Unrestricted Differentiated FMCG, Downward

?
Competition Several Consumer slopping: relatively
durables elastic

Oligopoly Few Restricted Homogenous Cement, Downward

?
/Differentiated Mobile slopping: relatively
telecom, inelastic – depends
Airlines on rival firms

Monopoly One Restricted of Unique Indian Downward

Completely ?
Railways slopping: relatively
Blocked inelastic – control
over prices

Business Economics (Micro) – Market Analysis – Perfect Competition Arjun Madan Ph D 2

Per fec t Competition

Business Economics (Micro) – Market Analysis – Perfect Competition Arjun Madan Ph D 3

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Perfectly Competitive Market

 Characteristics
 Fragmented
 Many small firms (and buyers), none of which have market power.
 Both buyers and sellers are price takers.
 Undifferentiated Products
 Products that consumers perceive as being identical/homogenous.
 Perfect Pricing Information
 Consumers have full awareness of the prices charged by all sellers in the market.
 Equal Resource Access (No barrier to entry)
 All firms have equal access to production technology and inputs
 Firms put together form an Industry under Perfect Competition

Business Economics (Micro) – Market Analysis – Perfect Competition Arjun Madan Ph D 4

Assumptions

 The firm operates in a perfectly competitive market and hence a price

taker.
 The firm makes the distinction between the short and long run.
 The firm’s objective is to maximize profits in the short run, or to
minimize loss.
 The firm includes its opportunity cost of operating as part of its total
cost.
 The going market price should enables the firm to earn a revenue that
covers not only its out-of-pocket costs, but also the opportunity cost.

Business Economics (Micro) – Market Analysis – Perfect Competition Arjun Madan Ph D 5

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Calculating TR, AR, MR

Fill in the empty spaces of the table.

Q P TR AR MR

0 ₹10 n/a

1 ₹10 ₹10

2 ₹10

3 ₹10

4 ₹10 ₹40
₹10
5 ₹10 ₹50
Business Economics (Micro) – Market Analysis – Perfect Competition Arjun Madan Ph D 6

Answers

TR ∆TR
Q P TR = P x Q AR = MR =
Q ∆Q
0 ₹10 ₹0 n/a
₹10
1 ₹10 ₹10 ₹10
Notice that ₹10
2 ₹10 ₹20 ₹10
MR = P ₹10
3 ₹10 ₹30 ₹10
₹10
4 ₹10 ₹40 ₹10
₹10
5 ₹10 ₹50 ₹10

Business Economics (Micro) – Market Analysis – Perfect Competition Arjun Madan Ph D 7

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MR = P for a Competitive Firm

 A competitive firm can keep increasing its output without affecting the
market price.
 So, each one-unit increase in Q causes revenue to rise by P, i.e., MR = P.

MR = P is only true for

firms in competitive markets.

Business Economics (Micro) – Market Analysis – Perfect Competition Arjun Madan Ph D 8

Profit Maximization

 What Q maximizes the firm’s profit?

 To find the answer, “think at the margin.”
If Q increases by one unit,
revenue rises by MR,
cost rises by MC.

 If MR > MC, then increase Q to raise profit.

 If MR < MC, then reduce Q to raise profit.

Business Economics (Micro) – Market Analysis – Perfect Competition Arjun Madan Ph D 9

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Profit Maximization

DProfit =
At any Q with MR > Q TR TC Profit MR MC
MR – MC
MC,
increasing Q raises 0 ₹0 ₹5 –₹5
₹10 ₹4 ₹6
profit. 1 10 9 1
10 6 4
2 20 15 5
At any Q with MR < 10 8 2
MC, 3 30 23 7
10 10 0
reducing Q raises
4 40 33 7
profit. 10 12 –2
5 50 45 5

Business Economics (Micro) – Market Analysis – Perfect Competition Arjun Madan Ph D

MC and the Firm’s Supply Decision

Rule: MR = MC at the profit-maximizing Q.

At Qa Costs
MC < MR. MC
So, increase Q
to raise profit.
At Qb MC > MR.
So, reduce Q P1 MR
to raise profit.
At Q1 MC = MR.
Changing Q Q
Qa Q1 Qb
would lower profit.

Business Economics (Micro) – Market Analysis – Perfect Competition Arjun Madan Ph D 11

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MC and the Firm’s Supply Decision

If price rises to P2,

then the profit-maximizing Costs
quantity rises to Q2. MC = S
The MC curve determines P2 MR2
the firm’s Q at any price.
Hence,
P1 MR

the MC curve is the

firm’s supply curve. Q
Q1 Q2

Business Economics (Micro) – Market Analysis – Perfect Competition Arjun Madan Ph D 12

The Optimal Output Level

 The Total Revenue – Total Cost Approach to Selecting the Optimal

Output Level
 The most logical approach to selecting the optimal level of output is to
compare the total revenue with the total cost schedules and find that
level of output that either maximizes the firm’s profit or minimizes its loss.

Business Economics (Micro) – Market Analysis – Perfect Competition Arjun Madan Ph D 13

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Q MR (P) TR TC MC ATC Profit /Loss

(P*Q) DTc/Dq (TR-TC)
0 - 0 15 - - -15.00
1 5 5 19.75 4.75 19.75 -14.75
2 5 10 23.5 3.75 11.75 -13.50
3 5 15 26.5 3.00 8.83 -11.50
4 5 20 29.5 2.50 7.25 -9.00
5 5 25 31 2.00 6.20 -6.00
6 5 30 32.5 1.50 5.42 -2.50
7 5 35 33.75 1.25 4.82 1.25
8 5 40 35.25 1.50 4.41 4.75
9 5 45 37.25 2.00 4.14 7.75
10 5 50 40 2.75 4.00 10.00
11 5 55 43.25 3.25 3.93 11.75
12 5 60 48 4.75 4.00 12.00
13 5 65 54.5 6.50 4.19 10.50
14 5 70 64 9.50 4.57 6.00
15 5 75 77.5 13.50 5.17 -2.50
16 Economics (Micro)
Business 5 – Market80 96
Analysis – Perfect Competition
18.50 Arjun Madan
6.00 Ph D -16.00 14

Short-run Profit Maximization

TC
TR
Cost / Revenue

TR – TC Approach
60
48
TR: upward sloping curve, slope = 5 = P
Max. eco. TC increases with output
π = ₹12
TC = ATC x Q = 4*12 = 48
15
TR = Q x P = 5*12 = 60
0 5 7 10 12 15 Q
MC Max. Eco. Profit: where TR
AC
exceeds TC by the greatest amount
AR /MR/MC

MR = MC Approach
5 MR : horizontal line at P = MR = 5
Profit D = MR
4 AC = 4; AR = 5 AR – AC = Profit
Max. Eco. Profit: at 12 units where
Q
MR = MC
0 5 7 10 12 15
Business Economics (Micro) – Market Analysis – Perfect Competition Arjun Madan Ph D 15
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Q MR (P) TR TC MC ATC AVC Profit /Loss

(P*Q) DTc/Dq (TR-TC)
0 - 0 15 - - - -15.00
1 3 3 19.75 4.75 19.75 4.75 -16.75
2 3 6 23.5 3.75 11.75 4.25 -17.50
3 3 9 26.5 3.00 8.83 3.83 -17.50
4 3 12 29.5 2.50 7.25 3.50 -17.00
5 3 15 31 2.00 6.20 3.20 -16.00
6 3 18 32.5 1.50 5.42 2.92 -14.50
7 3 21 33.75 1.25 4.82 2.68 -12.75
8 3 24 35.25 1.50 4.41 2.53 -11.25
9 3 27 37.25 2.00 4.14 2.47 -10.25
10 3 30 40 2.75 4.00 2.50 -10.00
11 3 33 43.25 3.25 3.93 2.57 -10.25
12 3 36 48 4.75 4.00 2.75 -12.00
13 3 39 54.5 6.50 4.19 3.04 -15.50
14 3 42 64 9.50 4.57 3.50 -22.00
15 3 45 77.5 13.50 5.17 4.17 -32.50
16 Economics
Business 3 (Micro) – 48 96– Perfect Competition
Market Analysis 18.50 6.00 5.06 Ph D
Arjun Madan -48.00 16

TC

TR –TC Approach
TR
Cost / Revenue

40 TR: upward sloping curve, slope = 3 = P

30 TC > TR : loss
Min. eco.
loss = ₹10 Min. Eco. Loss: where TC exceeds TR
15
MR – MC Approach
0 5 7 10 15 Q
MR : horizontal line at P = 3
MC AC
MR = MC ₹3 < ATC = ₹4
Min. Eco. Loss: at 10 units
Unit Costs

4 AVC
Loss Should the firm continue to produce in
3 the short-run?
D = MR
2.50
P = ₹3, and > AVC = 2.50

Q
Yes, so long as P > AVC
0 5 7 10 15
Business Economics (Micro) – Market Analysis – Perfect Competition Arjun Madan Ph D 17
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Firms in Short-run

 Price is determined at industry level by supply and demand forces

 Each firm has a horizontal demand curve at the market price
 Demand, average revenue and marginal revenue curve are same
 Equilibrium Condition: P = AR = MR = MC
 Firms make supernormal profits

Business Economics (Micro) – Market Analysis – Perfect Competition Arjun Madan Ph D 18

Price Determination under Perfect Competition

P
Market Equilibrium Firm’s Demand
S
Price per unit

P AR
D =P = AR = MR

Q Quantity Quantity

A firm in a perfectly competitive market can earn profits in the

short-run but is going to break even in the long-run due to the
very nature of market structure it is operating in.

Business Economics (Micro) – Market Analysis – Perfect Competition Arjun Madan Ph D 19

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Short- run Profit Condition - Normal Profit

Market Equilibrium Firm’s Equilibrium
P
MC ATC
S
AR = ATC
Price per unit

Pe AR
D = P = AR = MR

P = MC = min. ATC
D

Qe Quantity Qef Quantity

Profit maximizing output condition is MR =MC The firm cannot earn economic profit by
Profit Condition is AR = ATC or AR – ATC = 0 increasing or decreasing output

The firm is producing at min. ATC covering all its

cost of production including normal profit.

Business Economics (Micro) – Market Analysis – Perfect Competition Arjun Madan Ph D 20

Short- run Profit Condition – Economic Profit

Market Equilibrium Firm’s Equilibrium
P
S ATC
ATC MC
Price per unit

P’ AR’ D’= MR’ = MC’

Economic Profit
Pe AR
D = P = AR = MR

D’
D

Qe Quantity Qef Q’ Quantity

An increasing in demand will shift the industry Determine what happens to the ATC
demand curve to the right to D’. Prices rise.
Only a small increase in ATC lower than
Higher price will lead to increase in supply by the firm’s AR leading to AR > ATC
the firms, producing at MR’ = MC’ resulting in economic profits.

What happens to the firm’s profits?

Business Economics (Micro) – Market Analysis – Perfect Competition Arjun Madan Ph D 21
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Long-run Profit Condition – Return to Normal Profits?

Market Equilibrium Firm’s Equilibrium
P ATC
S MC
S’
Price per unit

P’ AR’ D’= MR’ = MC’

Economic Profit
Pe Pe
D =P = AR = MR

D’
D

Qe Q’ Quantity Qef Q’ Quantity

Economic profits earned by existing firm will attract Economic profits will be competed away be
new firms in the industry. new firms.

Bad news for existing firms making economic profits. Leading to all firms earning normal profits.

As new firms enter, supply will increase leading to Entry Eliminates Economic Profits !
fall in prices.
Business Economics (Micro) – Market Analysis – Perfect Competition Arjun Madan Ph D 22

Short-run Loss Condition

Market Equilibrium Firm’s Equilibrium
ATC
S MC
Price per unit

AVC
ATC
Pe Pe D =P = AR = MR
Economic Loss
P2 AR2
AVC D2= AR2 = MR2 = MC2

D
D2
Q2 Qe Quantity Q2 Qef Quantity

If for some reason, demand falls, the demand curve At Q2 the firm is able to recover AVC.
will shift to the left. Prices will fall to P2. New eq’m. AR2 > AVC.
The firm will reduce Q to Q2, at MR2 = MC2 As the losses increase some firms may leave
the market. S P  Normal Profit Returns.
ATC > AR2  Firms making losses equal to the
yellow shaded area. Exit Eliminates Losses !
Business Economics (Micro) – Market Analysis – Perfect Competition Arjun Madan Ph D 23
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Shut-down Condition
 When should a firm shut down rather than staying in the market?
 In the previous lesson we learnt that a firm should produce a profit
maximization output where its MR = MC.
 We also saw that in the long-run the firm will earn zero economic profit
 The firm will be able to recover all the explicit cost, and a little bit of
opportunity cost too.
 Lets examine when would a firm shut-down.

Business Economics (Micro) – Market Analysis – Perfect Competition Arjun Madan Ph D 24

1
Shut-down Condition
Market Equilibrium Firm’s Equilibrium
ATC
Price

S MC
Price per unit

AVC
ATC
Pe Pe D =P = AR = MR
Economic Loss
P1 AR1
AVC D1= MR1 = MC1

D
D1
Q1 Q Quantity Q1 Q Quantity

If for some reason, demand falls, the demand curve Should the firm Shut down?
will shift to the left. Prices will fall to P1. New eq’m. If the firm shuts down, what does it loose?
The firm will reduce Q to Q1, at MR1 = MC1 … The FC
So we need to examine the firm’s FC, by
ATC > AR1  Firms making losses equal to the comparing TFC to total losses of remaining
yellow shaded area. open
Business Economics (Micro) – Market Analysis – Perfect Competition Arjun Madan Ph D 25
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2
Shut-down Condition
Market Equilibrium Firm’s Equilibrium ATC
S MC
Price per unit

AVC
ATC
Pe Pe D =P = AR = MR
P1 AR1
AVC D1= MR1

D
D1
Q1 Qe Quantity Q1 Qef Quantity
At any level of output the difference between AVC Clearly the firm should not Shut down. The
and ATC is AFC i.e. ATC – AVC = AFC demand is still high and its total loss is <
AFC * Q = TFC, The yellow rectangle + The TFC
blue rectangle represents TFC The firm is said to be in a loss minimization
AR1 > AVC, the firm is able to recover its variable position.
cost even if the price fall from Pe to P1 What have to happen for the firm to shut
down?
Business Economics (Micro) – Market Analysis – Perfect Competition Arjun Madan Ph D 26

3 The Shut-down Rule: If the TFC is less than

Shut-down Condition total loss the firm should shut down !
Market Equilibrium Firm’s Equilibrium
S MC
ATC

ATC
Price per unit

D =P = AR = MR
Pe
AVC
Pe Economic
TFC
Loss
AVC
P2
AR2
D D2= MR2 = MC2
D1
Qe Quantity Q2 Qef Quantity
If the demand fall substantially low to D2 the prices Does this necessitate shutting down the
fall to P2.. MR < MC operations?
Even if the firm produces at the point where the Again compare total losses to TFC i.e. ATC
MC is lowest, it faces an ATC which is significantly – AVC = AFC
higher then the price. Multiplying AFC by Q will give TFC which is
The firm’s total economic loss is ATC – AR2= the equal to the area of green rectangle
yellow rectangle
Business Economics (Micro) – Market Analysis – Perfect Competition Arjun Madan Ph D 27