Week #7 Notes – Perfect Competition ~ SR & LR Analyses

*Before reading this lecture, please make sure that you understand the previous lecture thoroughly, i.e.,
you should know MP, AP, ATC, AVC, AFC, and MC.

1. Characteristics of Perfect Competition:

a. Many sellers.
b. Homogeneous (identical) products. So products of a firm are perfect substitutes for
product of other firms.
c. Each firm has a very small market share.
d. Firms are unconcerned about their competitors’ marketing or production decisions.
e. Information is freely available.
f. Freedom of entry into and exit from the market.

2. Competitive Firm: is one that sells its product in a perfectly competitive market. A
competitive firm is characterized as a “price taker” because it can only react to the market
price and cannot by itself cause the market price to go up or down.

3. Some Important Notes: In a perfectly competitive market the number of sellers depends
on the profitability of selling the product. Free entry and resources ensure that the number
or sellers, and therefore market supply, will increase when it is profitable to sell a product
in a market. The key idea underlying the notion of perfect competition is that individual
firms react to market rather than influence the prices of the products they sell.

4. Market Price and the Demand for the Output of a Competitive Firm:

5. Total Revenue, Average Revenue and Marginal Revenue for Compt. Firm: Note that
since the price is given to the competitive firm, it can only change the quantity produced to
influence its revenue.
Total Revenue = TR = P *Q
TR P  Q
Average Revenue = AR = = = P ➔ AR = P (for Competitive Firm !)
Q Q
TR
Marginal Revenue = MR = ➔ MR = P (revenue for each unit is P)
Q
 AR = P = MR
6. Total Revenue, Total Cost, Profit and Marginal Profit: The total cost curve has the
shape typically assumed to exist in the short run. Its shape reflects the law of diminishing
marginal returns. The vertical distance between the total revenue and total cost curves
gives profit at each level of production.
➔Total Profit (Economic Profit) = Total Revenue – Total Cost (Economic Cost)
➔Here take the derivative of both sides then we get
 Marginal Profit = MR − MC
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7. Profit Maximization:
In the profit maximization, the first order condition gives us.
Marginal Profit = MR − MC = 0
 MR = MC ➔ MR = P = MC since AR = P = MR
➔ MR = MC = P is the condition which determines the quantity should be produced.

a. Note that the output at which profits are maximized is not necessarily the output at
which the plant achieves the minimum possible average cost of production. To find
out the output which maximizes profit, the firm should use MC = MR
b. A firm maximizes profits by continuing to produce up to the point at which
marginal profits is zero or in other words marginal revenue equals to marginal cost.
After that point profit starts to decline as shown in the graph.

Total Profit = P*Q – Total Cost

= P*Q – ATC*Q
= (P-ATC)*Q
➔So, determine the profit max point by using MR=MC=P, then use the above
formula to calculate the total profit.
➔Note that in the graph: Demand=MR=P
c. Zero Economic Profit and Shut Down Point:

i. At P1 the maximum possible profit is positive. At the quantity when

MC=MR=P1  ( P1 − AC )  Q  0

ii. At P2 the maximum possible profit is zero. At the quantity when MC=MR=P2
 ( P2 − AC )  Q = 0 * Q = 0

iii. When the positive profits are not possible, marginal analysis can be used to
pick the option that results in the smallest losses.

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 iv. At P3 the maximum possible profit is negative (losses are minimized). At the
quantity when MC=MR=P3  ( P3 − AC )  Q  0

v. Note that P3 is passing from the minimum possible point of AVC and we
know from the previous class that MC intersects the AVC at its minimum as
well. So at the quantity when MC=MR=P ➔ MC=P=AVC. Therefore we can
write the total profit as follows.

 Total Profit = (P3-AC)*Q = (AVC-AC)*Q = (-AFC)*Q = -FC➔ Loss =

Fixed Cost (in short-run with P3)

vi. Therefore, at P3 the firm shuts down and produces nothing in the short run.
The reason for that is the firm losses the same amount of money (fixed cost)
by shutting down, so why to bother producing.

vii. To sum up, the firm elects to continue operating at a loss in the short run
only if the price is larger than the AVC. This allows firm to generate revenue
to cover some of the fixed costs.

8. Short-run Supply Curve of The Competitive Firm: is the portion of its marginal cost
curve above the minimum point of its average variable cost curve. Short-run supply curve
slope upward because the firm’s marginal costs tend to increase eventually (due to the law of
diminishing marginal returns to the use of variable inputs) as output is increased. Note that
the points below the average variable cost curve are not included because firm shuts down
below AVC.