Chapter Four

Perfectly Competitive Markets

4.1 Assumptions

Perfectly competitive markets have the following characteristics.

i) Large number of sellers and buyers

The industry or market is fragmented. It consists of many buyers and sellers. Each individual
firm supplies only a small part of the total quantity offered in the market. Each buyer’s purchases
are so small that they have an imperceptible effect on market price. Each seller’s output is so
small in comparison to market demand that it has an imperceptible impact on the market price. In
addition, each seller’s input purchases are so small that they have an imperceptible impact on
input prices.

ii) Identical (Homogeneous) Products

Firms in a perfectly competitive market sell identical or homogeneous products. The technical
characteristics of the product as well as the services associated with its sale and delivery are
identical. There is no way in which a buyer could differentiate among the products of different
firms.

The assumptions of large numbers of sellers and of product homogeneity imply that the
individual firm in pure competition is a price-taker: its demand curve is infinitely elastic,
indicating that the firm can sell any amount of output at the prevailing market price. The demand
curve of the individual firm is also its average revenue and its marginal revenue curve. No firm
can raise the price of its product above the price of other firms without losing most or all of its
business. Hence, the price of a commodity is determined by the aggregate demand and aggregate
supply in the whole industry.

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 Output Output
Figure 4.1: Determination of Market Price and Demand for Individual Firms

For instance, most agricultural products are homogeneous: Because product quality is relatively
similar among farms in a given region, for example, buyers of corn do not ask which individual
farm grew the product. Oil, gasoline, and raw materials such as copper, iron, lumber, cotton, and
sheet steel are also fairly homogeneous.

iii) Free entry and exit

Firms can enter and leave the market without any restrictions—in other words, there is free entry
and exit into and out of the market. There is no legal or market barrier on the entry of new firms
to the industry. Nor is there any restriction on the exit of the firms from the industry. A firm may
enter the industry or exit it at its will. Therefore, when firms in the industry make supernormal
profit for some reason, new firms enters the industry and supernormal profits are eliminated.
Similarly, when profits decrease or more profitable opportunities are available elsewhere, firms
exit the industry.

iv) Full (Perfect) Information

It is assumed that all sellers and buyers have complete knowledge of the conditions of the
market. This knowledge refers not only to the prevailing conditions in the current period but in
all future periods as well. Information is free and costless. Under these conditions uncertainty
about future developments in the market is ruled out.

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 v) Perfect mobility of factors of production

The factors of production are free to move from one firm to another throughout the economy. It
is also assumed that workers can move between different jobs, which implies that skills can be
learned easily. Finally, raw materials and other factors are not monopolized and labour is not
unionized. In short, there is perfect competition in the markets of factors of production.

vi) No government regulation

There is no government interventio0n in the market (tariffs, subsidies, rationing of production or

demand and so on are ruled out).

vii) Public goods and externalities do not exist

When all these conditions apply, the price mechanism will ensure that a competitive equilibrium
outcome will be reached such that individuals’ utility and firms’ profits are maximized.

4.2 The Revenue and Demand Curve of a Competitive Firm

A firm in a competitive market, like most other firms in the economy, tries to maximize profit
(total revenue minus total cost). Total revenue equals the market price P multiplied by the
quantity of output Q produced by the firm: TR(Q) = P × Q. It refers to the total amount of money
that the firm receives from the sale of a given amount of its output. The total-revenue curve is a
straight line through the origin, showing that the price is constant at all levels of output. The firm
is a price-taker and can sell any amount of output at the going market price, with its TR
increasing proportionately with its sales. Total cost TC(Q) tells us the total cost of producing Q
units of output. Because the firm is a price-taker, it perceives that its volume decision has a
negligible impact on market price. Thus, it takes the market price P as given. Its goal is to choose
a quantity of output Q to maximize its total profit.

Average revenue is total revenue (P*Q) divided by the quantity (Q). Therefore, for all types of
firms, average revenue equals the price of the good. For any firm (price taker or not), the rate at
which total revenue changes with respect to a change in output is called marginal revenue (MR).
It is defined by ΔTR/ΔQ. It is the slope of total revenue curve. For a price-taking firm, each
additional unit sold increases total revenue by an amount equal to the market price, ΔTR/ΔQ = P.

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Thus, for a price-taking (competitive) firm, marginal revenue is equal to the market price, or MR
= P. Thus, in perfect competition, MR = AR = P. In general, the demand curve facing the firm is
horizontal (perfectly elastic) and the market demand curve is downward sloping.

Revenue Revenue

Output
Output
Figure 4.2: TR and Demand Curve of a Perfectly Competitive Firm

4.3 Short-Run Equilibrium

The firm is in equilibrium when it maximizes its profits (Π) or minimizes its loss. Π is defined as
the difference between total revenue and total cost: Π = TR – TC. There are two ways to find the
level of output that maximizes a competitive firm’s profit: Total Approach (TR and TC
approach) and Marginal Approach (MR and MC approach).

Total Approach

The firm maximizes its profit at the output Q where the distance between the TR and TC curves
is the greatest. At lower and higher levels of output Q in Figure 4.3, total profit is not maximized:
at levels smaller than Q1 and larger than Q2, the firm has losses. Profit is negative at low levels of
output because revenue is insufficient to cover fixed and variable costs. As output increases,
revenue rises more rapidly than cost, so that profit eventually becomes positive. Profit continues
to increase until output reaches the level Q. Q is the profit-maximizing output (optimal output).

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When TR equals TC, a firm faces zero profit (neither profit nor loss). This is called a break-even
point.

Figure 4.3: Total Approach for Profit Maximization

Marginal Approach

The firm is in equilibrium (maximizes its profit) at the level of output defined by the intersection
of the MC and the MR curves. That is the firm maximizes its profit at the output where its
marginal profit is zero.

Thus, the first condition for the equilibrium of the firm is that marginal cost be equal to marginal
revenue. However, this condition is not sufficient, since it may be fulfilled and yet the firm may
not be in equilibrium. The second condition for equilibrium requires that the MC be rising at the
point of its intersection with the MR curve. This means that the MC must cut the MR curve from
below, i.e., the slope of the MC must be steeper than the slope of the MR curve. In figure 4.4, the
slope of MC is positive at E, while the slope of the MR curve is zero at all levels of output. Thus,
at E both conditions for equilibrium are

● MC = MR, or P = MC since P is equal to MR in perfect competition and

● (slope of MC) > (slope of MR).

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 Figure 4.3: Marginal Approach for Profit Maximization

To the left of E, profit has not reached its maximum level because each unit of output to the left
of Q brings to the firm a revenue which is greater than its marginal cost. To the right of Q, each
additional unit of output costs more than the revenue earned by its sale, so that a loss is made and
total profit is reduced. In summary:

● If marginal revenue is greater than marginal cost, the firm should increase its output.

● If marginal cost is greater than marginal revenue, the firm should decrease its output.

● At the profit-maximizing level of output, marginal revenue and marginal cost are exactly

equal.

The fact that a firm is in (short-run) equilibrium does not necessarily mean that it makes excess
profits. Whether the firm makes excess profits or losses depends on the level of the ATC at the
short-run equilibrium. If the ATC is below the price at equilibrium, the firm earns excess profits.
If, however, the ATC is above the price, the firm makes a loss. If ATC is equal to price at
equilibrium, the firm earns normal profits. In the latter case the firm will continue to produce
only if it covers its variable costs. Otherwise, it will close down, since by discontinuing its
operations, the firm is better off: it minimizes its losses. The point at which the firm covers its
variable costs is called the closing-down.

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 Figure 4.4: Losses Figure 4.5: Normal Profits

Figure 4.6: Abnormal Profits

The Firm’s Short-Run Decision to Shut Down

We need to distinguish between a temporary shutdown of a firm and the permanent exit of a firm
from the market. A shutdown refers to a short-run decision not to produce anything during a
specific period of time because of current market conditions. Exit refers to a long-run decision to
leave the market. The short-run and long-run decisions differ because most firms cannot avoid
their fixed costs in the short run but can do so in the long run. That is, a firm that shuts down

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temporarily still has to pay its fixed costs, whereas a firm that exits the market does not have to
pay any costs at all, fixed or variable.

If the firm shuts down, it loses all revenue from the sale of its product. At the same time, it saves
the variable costs of making its product (but must still pay the fixed costs). Thus, the firm shuts
down if the revenue that it would earn from producing is less than its variable costs of
production. However, the firm may produce in the short run if price is greater than average
variable cost but P < ATC, making economic losses. Thus, why does the firm produce given that
it is making a loss? The reason is that the firm reduces its loss by operating rather than shutting
down because its revenue exceeds its variable cost—or equivalently, the market price exceeds its
average variable cost.

Shut down if TR < VC.

By dividing both sides of this inequality by the quantity Q, we can write it as

TR/Q < VC/Q, i.e., AR < AVC, P < AVC

Mathematical derivation of the equilibrium of the firm

The firm aims at the maximization of its profit

Π = TR – TC

Clearly R = f(Q) and C = f(Q), given the price P.

There are two conditions that must be satisfied for the profit to be maximum:
i) The first-order condition (necessary condition) for the maximization of a function is that
its first derivative (with respect to Q in our case) be equal to zero. Differentiating the total-
profit function and equating to zero we obtain
dΠ dTR dTC
= − =0
dQ dQ dQ
dTR dTC
=
dQ dQ
Slope of TR = Slope of TC, i.e. MR = MC

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Since MR = P the first-order condition may be written as MC = P
ii) The second-order (supplementary) condition for a maximum requires that the second
derivative of the function be negative (implying that after its highest point the curve turns
downwards). The second derivative of the total-profit function is

2
d π
2
<0
dQ
2 2
d TR d TC
2
− 2
<0
dQ dQ
2 2
d TR d TC
2
< 2
dQ dQ
dMR dMC
<
dQ dQ
( Slope of MR ) < ( Slope of MC )
Thus, the MC must have a steeper slope than the MR curve.

The short-run supply curve of the firm and the industry

The supply curve of the firm may be derived by the points of intersection of its MC curve with
successive demand curves. Assume that the market price increases gradually. This causes an
upward shift of the demand curve of the firm. Given the positive slope of the MC curve, each
higher demand curve cuts the (given) MC curve to a point which lies to the right of the previous
intersection. This implies that the quantity supplied by the firm increases as price rises. The firm,
given its cost structure, will not supply any quantity (will close down) if the price falls below P o
because at a lower price the firm does not cover its variable costs. If we plot the successive
points of intersection of MC and the demand curves on a separate graph, we observe that the
supply curve of the individual firm is identical to its MC curve to the right of the closing-down
point Eo. Below Eo, the quantity supplied by the firm is zero. As price rises above P o, the quantity
supplied increases.

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A supply curve for a firm tells us how much output it will produce at every possible price. We
have seen that competitive firms will increase output to the point at which price is equal to
marginal cost, but will shut down if price is below average variable cost. Therefore, the firm’s
supply curve is the portion of the marginal cost curve for which marginal cost is greater than
average variable cost. That is the firm’s short run supply curve is the MC curve above the
minimum of its AVC curve.

Short-run supply curves for competitive firms slope upward for the same reason that marginal
cost increases—the presence of diminishing marginal returns to one or more factors of
production. As a result, an increase in the market price will induce those firms already in the
market to increase the quantities they produce.

Price, Revenue and Cost Price

Figure 4.7: Derivation of the Short-Run Supply Curve of a Perfectly Competitive Firm

In the short run, the number of firms in the market is fixed. As a result, the market supply curve
reflects the individual firms’ marginal cost curves. The quantity of output supplied to the market
equals the sum of the quantities supplied by each individual firms. Thus, to derive the market

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supply curve, we add the quantity supplied by each firm in the market. Hence, the market supply
curve is upward sloping.

4.4 Long-Run Equilibrium

In the long run, competitive firms can vary inputs that were fixed in the short run and all costs
are variable. In the short run, one or more of the firm’s inputs are fixed. The firm chooses the
quantity that maximizes its profit (minimizes its cost) using the same rules as in the short run.
The company will pick the quantity that maximizes long-run profit, which is the difference
between revenue and long run cost. Equivalently, it operates where long run marginal profit is
zero and where marginal revenue equals long-run marginal cost.

The Firm’s Long-Run Decision to Exit or Enter a Market

Decisions about entry and exit in a perfectly competitive market depend on the incentives facing
the owners of existing firms and the entrepreneurs who could start new firms. If firms already in
the market are profitable (TR > TC or I.e., TR/Q > TC/Q, P > ATC), then new firms will have an
incentive to enter the market. This entry will expand the number of firms, increase the quantity
of the good supplied, and drive down prices and profits. Conversely, if firms in the market are
making losses (TR < TC. I.e., TR/Q < TC/Q, P < ATC), then some existing firms will exit the
market. Their exit will reduce the number of firms, decrease the quantity of the good supplied,
and drive up prices and profits. At the end of this process of entry and exit, firms that remain in
the market must be making zero economic profit. Here, a firm’s long-run decision to exit a
market is similar to its shutdown decision. If the firm exits, it will lose all revenue from the sale
of its product, but now it will save not only its variable costs of production but also its fixed
costs.

We can write a firm’s profit as

Profit = (P - ATC) * Q.

An operating firm has zero profit if and only if the price of the good equals the average total cost
of producing that good. If price is above average total cost, profit is positive, which encourages

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new firms to enter. If price is less than average total cost, profit is negative, which encourages
some firms to exit. The process of entry and exit ends only when price and average total cost are
driven to equality.

Thus, in long-run equilibrium, price P equals marginal cost MC, so the firm is maximizing profit.
Price also equals average total cost ATC, so profit is zero. New firms have no incentive to enter
the market, and existing firms have no incentive to leave the market. Hence, the condition for the
long-run equilibrium of the firm is that the marginal cost be equal to the price and to the long-run
average cost. LMC = LAC = P

Price, Cost

Figure 4.8: Long-Run Equilibrium

The Competitive Firm’s Long-Run Supply Curve

The competitive firm’s long-run supply curve is the portion of its long run marginal-cost curve
that lies above the minimum of average total cost (because all costs are variable in the long run).
If the price falls below average total cost, the firm is better off exiting the market.

Numerical Example

1) Given that a competitive firm’s short-run cost function is C(Q) = 100Q – 4Q2 + 0.2Q3 + 450,
A) what is the firm’s short-run supply curve?
B) If the price is P = 115, how much output does the firm supply?

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Solution:

A) The firm’s supply curve is its marginal cost curve above its minimum average variable cost.

MC(Q) = dC/dQ = 100 – 8Q + 0.6Q2 and AVC(Q) = VC/Q = 100 – 4Q + 0.2Q2.

We also know that the marginal cost curve cuts the average variable cost curve at its minimum,
so we can determine the Q where the AVC reaches its minimum by equating the AVC and MC
functions:
100 – 4Q + 0.2Q2 = 100 – 8Q + 0.6Q2
-4Q + 0.4Q2 = 0
0.4Q2 = 4Q
0.4Q = 4
the minimum is Q = 10,
An alternative approach is to set the derivative of the AVC function equal to zero, to find the
output
at which the AVC curve is at its minimum: dAVC/dQ = 0 = -4 + 0.4Q, so Q = 10

Thus, the supply curve is the MC curve for output greater than or equal to 10. If we substitute Q
= 10 into the equation of the AVC, we find that the minimum level of AVC equals 80. For prices
below 80 (the minimum level of average variable cost), the firm will not produce. For prices
above 80, we can find the supply curve by equating price to marginal cost and solving for Q: P =
100 – 8Q + 0.6Q2.

B) At P = 115, the firm produces the quantity Q such that P = MC

115 = 100 – 8Q + 0.6Q2
0.6Q2 – 8Q – 15 = 0
Q = 15
2) Suppose TC and TR functions of a perfectly competitive firm are given as follows:
TC = 100 + 60Q -12Q2 + Q3
TR = 60Q

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Find profit maximizing quantity and check the second order condition

Solution
MC = dTC/dQ = 60 - 24Q - 3Q2, MR = dTR/dQ = 60
The necessary condition
MR = MC, 60 = 60 – 24Q + 3Q2
– 24Q + 3Q2 = 0, 3Q2 = 24Q, 3Q = 24
Q=8
The second-order condition
2
d π
2
<0
dQ
dMR dMC
<
dQ dQ
0 < (-24 + 6Q)
At Q = 8, 0 < (-24 + 6*8), 0 < 24

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