Lesson 6 Perfect Competition

Reference Books: Principles of Economics by Gregory Mankiw and

Economics by Irvin Tucker

Objectives:

By the end of this lesson, students should be able to:

1. Understand the key characteristics of a perfectly competitive market.

2. Analyze how equilibrium is reached in perfect competition.
3. Differentiate between short-run and long-run outcomes in a perfectly
competitive market.

I. Market Structure Characteristics in Perfect

Competition

In perfect competition, a market is characterized by several distinct features

that distinguish it from other market structures, such as monopoly,
oligopoly, or monopolistic competition. According to Mankiw and Tucker,
the following are the key characteristics:

a. Many Buyers and Sellers:

A perfectly competitive market has a large number of buyers and sellers,

each of whom is small relative to the market as a whole.

No single buyer or seller has the power to influence market prices. As a

result, the market price is determined by the overall supply and demand,
not by individual sellers or buyers.
b. Homogeneous Products:

All firms in a perfectly competitive market produce identical or

homogeneous products. This means consumers perceive no difference
between the products offered by different firms.

Since products are identical, there is no need for advertising, as buyers will
purchase from any seller offering the same product at the lowest price.

c. Free Entry and Exit:

Firms can freely enter or exit the market without facing significant barriers,
such as government regulations or high startup costs.

This free entry and exit are key to ensuring that firms can respond to
economic profits or losses, which leads to the long-run adjustments in the
market.

d. Perfect Information:

Buyers and sellers have complete knowledge of prices and products in the
market. This allows them to make informed decisions, ensuring that no firm
can charge a price above the market equilibrium price.

e. Price Takers:

Firms in a perfectly competitive market are price takers, meaning they

accept the market price as given. No single firm can influence the price by
adjusting its output level.
In summary, a perfectly competitive market is characterized by many
sellers and buyers, homogeneous products, easy market entry and exit,
perfect information, and firms being price takers.

Il. Equilibrium in Perfect Competition

In a perfectly competitive market, equilibrium occurs when the quantity

supplied equals the quantity demanded at the market price. According to
Mankiw and Tucker, this equilibrium can be analyzed in the short run and
long run.

a. Short-Run Equilibrium:

In the short run, some inputs (such as capital) are fixed, and firms cannot
easily adjust the scale of their operations.

Each firm maximizes profit by producing the quantity where marginal cost
(MC) equals marginal revenue (MR). Since firms are price takers, marginal
revenue equals the market price (P), meaning:

P = MR = MC

Economic Profits: If the market price is above the firm’s average total cost
(ATC), the firm earns economic profits.

Losses: If the market price is below the firm’s average total cost but above
the average variable cost (AVC), the firm operates at a loss but continues
producing in the short run.

Shutdown Condition: If the market price falls below the average variable
cost, the firm will shut down because it cannot cover its variable costs.
b. Long-Run Equilibrium:

In the long run, all inputs are variable, and firms can enter or exit the
market. As firms earn profits in the short run, new firms are attracted to the
market, increasing supply and driving down the market price. Conversely, if
firms are making losses, some will exit the market, reducing supply and
driving up the market price.

Long-run equilibrium occurs when firms earn zero economic profit (normal
profit), meaning they are just covering their opportunity costs.

In long-run equilibrium:

P = MC = ATC

3. Short-Run vs. Long-Run Outcomes in Perfect Competition

a. Short-Run Outcomes:

In the short run, firms can earn positive economic profits, break even, or
incur losses. The key factor here is the relationship between price and
average total cost (ATC).

● If P > ATC , firms earn economic profits.

● If P = ATC, firms break even (zero economic profit).

● If P < ATC but, P > AVC, firms operate at a loss but still produce in
the short run.
 ● If P < AVC, firms shut down.

b. Long-Run Outcomes:

In the long run, all firms in a perfectly competitive market will earn zero
economic profit (normal profit). This is because firms will enter the market if
there are profits and leave the market if there are losses, adjusting the
supply until price equals the minimum point of the average total cost curve.

Therefore, in the long run:

No firm will earn positive economic profits.

All firms will produce at the efficient scale (where ATC is minimized).

Conclusion:

A perfectly competitive market is characterized by many small firms

producing identical products and having no control over the market price.
Firms are price takers and must operate efficiently to remain competitive. In
the short run, firms can earn profits or incur losses, but in the long run,
firms will always earn zero economic profit as new firms enter or exit the
market. Equilibrium is reached when firms produce where price equals
marginal cost and price equals average total cost in the long run.

This market structure, while rare in the real world, provides a theoretical
foundation for understanding competitive behaviors and price dynamics in
various industries.

Computation of Short-Run and Long-Run Outcomes in Perfect Competition

Let’s go through a simple example to understand how short-run and
long-run outcomes are computed in a perfectly competitive market.

Example Scenario:

Imagine a company called LVQ Farms operating in a perfectly competitive

wheat market.

Price (P) of wheat (market price) = 100 pesos per unit

Total Cost (TC) of producing different quantities of wheat is given in the

table below.
The firm wants to determine its short-run and long-run outcomes based on
its cost structure.

1. Short-Run Outcome

In the short run, firms may earn profits, incur losses, or break even
depending on their cost structure. To calculate the firm’s outcome in the
short run, we need to compare the market price (P) with the average total
cost (ATC).

Step-by-Step Short-Run Analysis:

Market Price (P) = 100 pesos per unit

For each level of output, compare the price (P) to the Average Total Cost
(ATC).

At Q = 10, ATC = 120 pesos > P (100 pesos) → Firm is incurring a loss.

At Q = 20, ATC = 100 pesos = P (100 pesos) → Firm is breaking even

(zero economic profit).

At Q = 30, ATC = 100 pesos = P (100 pesos) → Firm is breaking even

(zero economic profit).

At Q = 40, ATC = 105 pesos > P (100 pesos) → Firm is incurring a loss.

At Q = 50, ATC = 110 pesos > P (100 pesos) → Firm is incurring a loss.
Conclusion for the Short Run:

The firm breaks even (earns zero economic profit) when it produces either
20 or 30 units, where the price equals the average total cost (P = ATC).

At any other quantity (such as 10, 40, or 50), the firm incurs a loss because
the ATC is greater than the price (P < ATC).

2. Long-Run Outcome

In the long run, firms in a perfectly competitive market will earn zero
economic profit (normal profit). This happens because:

If firms are making profits, new firms enter the market, increasing supply
and driving prices down.

If firms are incurring losses, some firms exit the market, reducing supply
and driving prices up.

Eventually, firms produce at the minimum point of their average total cost
(ATC), earning normal profit (zero economic profit).

Step-by-Step Long-Run Analysis:

In the long run, the firm will produce at the level of output where ATC is
minimized. From the table, we can see that the minimum ATC occurs at
Q = 20 and Q = 30, where ATC = 100 pesos.

The market price is P = 100 pesos, which equals the minimum ATC. Thus,
in the long run, the firm earns zero economic profit.
Conclusion for the Long Run:

In the long run, the firm will produce 20 or 30 units and earn zero economic
profit, as the market price equals the minimum point of the average total
cost.

Summary of Results:

Short-Run Outcome:
The firm earns zero economic profit (breaks even) when producing 20 or 30
units of output. At other levels of output, it incurs losses.

Long-Run Outcome:
In the long run, the firm produces at the quantity where P = ATC, which is
20 or 30 units, and earns zero economic profit.

This example demonstrates how in the short run, firms can experience
various outcomes (profits, losses, or break-even), but in the long run, all
firms in perfect competition will earn zero economic profit as they adjust to
market conditions.