Perfect Competition

BASIC CONCEPTS:
Market: Market refers to transaction (buying and selling) of a particular product (goods or services) in a
particular geographical area within a particular financial period.
Example: Agricultural market in India of the financial year 2019-20.

Market Place: Market place is a premises where buyers and sellers of different commodities came to buy and
sell their products.
Example: Big Bazar. Krisan Mandi etc.

Classifications of Market:
Depending on the structure of the market we can classify markets broadly into four categories

1. Perfectly Competitive Market.

2. Monopoly Market.
3. Oligopoly Market. Imperfect Competition.
4. Monopolistic Competitive Market.

PERFECT COMPETITION:

Perfect Competition is characterized by:

1. Very Large number of buyers and sellers:
In a perfectly competitive market, there are a very large number of buyers and sellers. As a result a single
buyer or seller cannot influence the market price.
2. Homogeneous Product:
The products offered by different firms are homogeneous in every respect. The goods are identical in terms of
quality, size, packing, and other terms of deal etc. This feature ensures the uniformity of the price throughout
the market.
3. No Selling Costs:
With the help of selling cost (advertisement) firm cannot show it’s product different from other product.
4. Perfect Knowledge:
This feature implies that both sellers and buyers have perfect knowledge about the goods and their prices so
that it is not possible for a firm to charge a different price. It also ensures uniform price for the buyers and
uniform cost function for the producers.
5. Perfect Mobility:
The goods as well as the factors of production are perfectly mobile so that there is no restriction- legal or
monetary (involving expenditure in movement of goods). This feature ensures that the price throughout the
market tends to be uniform.

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6. Firm is a Price Taker:
The firm has to sell the goods at a price determined by the industry as the firm has no control over the price.
The market or industry determines this price on the basis of market demand and market supply as shown in
the figure. So industry is the price maker and firm is the price taker.
7. Free Entry and Exit:
Under perfect competition firms are free to enter into the market or exit from the market at any point of time.
This means that there is no obstruction from anywhere for a new firm to produce the same product produced
by the existing firms in the market; similarly if a firm wishes to exit then it is free to do so.

MARKET DEMAND CURVE FACED BY THE FIRM:

Under perfect competition, the demand curve for the firm is horizontal and perfectly elastic. It means that the
firm can sell any amount of the product at the price determined by the industry, but the firm cannot vary the
price.

REVENUE:
A firm earns revenue by selling the good that it produces in the market. Let the market determined price be ‘P’
and at this price firm sells ‘Q’ amount of output. Then:
Total Revenue (TR) = P x Q
Total Revenue Curve: TR
As under perfect competition price is fixed in the TR-Curve
market. So as output (Q) increases, TR increases
proportionately. That why TR curve which shown
graphical relationship between Q and TR is a upward
sloping straight line.

O Output

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Average and Marginal Revenue Curve:

Average revenue (AR) is TR per unit of output (Q). Therefore AR = TR/Q = (P.Q)/Q = P

Marginal revenue (MR) is increase in TR due to 1 unit increase output (Q).

Suppose initially firm sells Q unit of output at P price. Hence firm’s TR0=P.Q

Now firm increases output by 1 unit at same price. (As price is constant under perfect competition)

Therefore new TR1= P.(Q+1)

Therefore MR= TR1 - TR0= P.(Q+1) – P.Q = P.Q + P – P.Q= P

Hence under perfect competition AR=MR=P. So AR and MR curves are nothing but price line as shown in the
following figure. P, AR, MR

AR=MR=P

O Output

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Profit Maximization in short run under Perfect Competition:
Profit of a firm
Let us draw MC-curve and price line (P = MR = AR) as shown in the following figure.

NECESSARY CONDITION:
Consider point B:
At this point price line cuts the MC-curve. That means both P=MC= BQ4
Now consider an output level left of Q4, say Q2.
At Q2; P=PQ2 and MC= C1Q2.
Now, P.Q2> C1Q2.
That means P>MC.
That means, increase in TR > increase in TC due to 1 unit increase in output. [P=MR under perfect competition]
So if the firm increases output, TR will increase more than TC. That means if the firm increases output it’s
profit will increase. Therefore profit maximizing firm will increase output.
Suppose firm increases output from Q2 to Q3; at this level of output P is still greater than MC. That means firm
will continue to increase its output. Firm will stop this process of increasing output level when P=MC holds.

Now consider an output level right of Q4, say Q6.

At Q2; P=PQ2 and MC= C1Q2.
Now, P.Q2> C1Q2.
That means P<MC.

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That means, decrease in TR < decrease in TC due to 1 unit decrease in output.
So if the firm decreases output, TR will decrease less than TC. That means if the firm decreases output it’s
profit will increase. Therefore profit maximizing firm will decrease output.
Suppose firm increases output from Q6 to Q5; at this level of output P is still less than MC. That means firm will
continue to decrease its output. Firm will stop this process of decreasing output level when P=MC holds.

From the above two cases we can conclude that P=MC is necessary to maximise firm’s profit.
Therefore P=MC is necessary condition for profit maximization. It is also called first order condition.

SUFFICIENT CONDITION:
However P=MC is not sufficient for profit maximization. For example consider point A where firm produces Q1
level of output and P=MC holds.

Consider a point left of Q1, say Q’. At this point P<MC. That means if the firm reduces output, it’s profit will
increase. So profit maximizing firm will be induced to decrease output. That means it will never come back to
the point A from the left of A.

Now consider a point right of Q1, say Q’’. At this point P>MC. That means if the firm increases output, it’s
profit will increase. So profit maximizing firm will be induced to increase output. That means it will never come
back to the point A from the right of A.

This is happening because MC is downward sloping at point A.

Therefore P=MC where MC upward sloping is the necessary and sufficient condition for profit maximization
of the firm under perfect competition.

SHUT DOWN CONDITION:

In the short run firm continues production till it recovers it’s TVC. That means if it’s TR <TVC , it will shut down.
P, MC In the left side figure, at point ‘E’ P=MC and MC is
MC AC upward sloping.
At this equilibrium, firm accepts ‘OP’ level of price
W
AVC and produces ‘OQ’ level of output.
B At this output level firm’s TR= Area OQEP
A At this output level firm’s TVC = Area OQBA
P E Clearly Area OQBA > Area OQEP. That means firm
cannot recover it’s TVC. So firm will shut down in the
O Q Output short run, even if P=MC and MC is upward sloping.
So final condition for firm’s equilibrium (Profit Maximization): P=MC where MC rising and P>=AVC.
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SUPER NORNAL PROFIT:
Profit = TR –TC
If TR > TC , then profit>0. In that case we say firm earns super normal profit equals to the amount (TR – TC) as
shown in the following figure. Cost, Price
MC
AC
P E
A Super Normal Profit (Area ACEP)
C

Output.
O Q
SHORT RUN SHUT DOWN POINT:
In the short run if firm cannot recover it’s TVC its shuts down. Now we will explain this with the help of
following figure.
Cost, Price AC
MC
P E2 Price Line
AVC

E1
P Price Line

Output.
O Q1 Q2
If price line passes through minimum point of AVC where MC cuts AVC at it’s minimum point , then firm’s
profit maximizing equilibrium occurs at point E1. At this point :
Firm’s TVC = Area OQ1E1P
Firm’s TR = Area OQ1E1P
Therefore firm’s TR is just equals to it’s TVC. That means firm just recovers it’s TVC. This point is called shut
down point. Because if price goes below this point, firm will shut down. So condition for shut down point is.
P=MC= Minimum point of AVC
BREAK EVEN POINT:
The point at which firm’s TR is just equals to it’s TC is called Break-Even point. It occurs when price line passes
through minimum point AC where MC cuts AC at it’s minimum point (E2) as shown in the above figure.
At E2, TR = Area OQ2E2P = TC. Profit earned by firm at this point is called Normal Profit.
So condition for break even or normal profit, P=MC= Minimum point of AC

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