CHAPTER 10

under
Price-Outtput Determination
Perfect Competition

1.
INTRODUCTION
individual
of the ma: tothe extent to which
The competitiveness
to influen
influence
et refers
or the terms on which
their
have power market prices
firms
is sold.
in which it sells
product
an indiv1dual firm has t influence the market
less power
roduct, the more competitive that market is.
the
result in more
its product,

a large number of small-sized firms would

woua resuit in more competition;
Thus,
a smaller number of firms would deter competition.
larger-sized
conversely,

2. PERFECT COMPETITION
market structure obtains when there is a large number
A perfectly competitive In this situation
all
of firms
in an industry, producing a homogeneous product.
set
firm has zero market power. Each firm must accept the price
an individual
firms can sell as much
by the forces
of market demand and market supply. The
no power to influence
as they choose
at the prevailing market price and have
no buyer
that price. If any
firm chooses to charge a higher price, it would find
other firms would be at the market price that
for its product; many selling

buyers would go to them.

the market, it makes
none of the individual firms has any control over
Since
with one another.
no sense for individual firms to compete actively
This market structure applies directly to a number of real-world markets.
benchmark for comparison with other
Furthermore, it provides an important
market structures.

Assumptions of Perfect Competition Tnbut relted

The theory of perfect competition is built on a number of key assumptions

relating to the firm and to the industry. ndy

Se
a homogeneous product the consumers
'Allthe firms in an industry sell (i.e.,

product to another).
not show preference for one and
Buyers have about the nature of the product
knowledge
full
being sold

the prices charged by each firm.

he level of a firm's output at which 1S long-run average total cost reaches
the industry's total output.
to
minimum is small relative
It must passively accept the ruling
ndividual firm is a price-taker
market
price
 10.2 Essentials of Managerial Economics

There is freedom of entry and exit inthe industry; that is, any
net
free to enter the industry if it so Wishes, or any firm can firm
and stop prod
exit whenever it likes.
production

Price-taker Firm

A perfectlycompetitive market is the

characterised by
number of buyers and sellers. No individual seller, or a existence of a la
buyer, can exege
influence on the market supply and market demand of
any theproduct,
Market supply and market demand
collectively set up the market
price,
i.e., the price at which the
product
will be sold in the market.

Market supply curve has a

positive
slope, while market demand curve
will have a
negative slope, as shown
in Fig. 10.1.
In the given market, 0Q
quantity
would be offered for sale and S
demanded by the buyers at OP price ileg
per unit. Quantity supplied and
demanded are equal at this price OP.
OP is the equilibrium price, and 0Q Quantity tose
is the
equilibrium quantity. The S2nd otaoe00Fig. 10.1n
industry is in equilibrium. song
Individual firms have no influence over the market.
ew.as dto Xs3on boig
Therefore, they have no0
choice but to accept and sell their
product atthe price thathas been determined
by the industry
This is illustrated in Fig. 10.2.

Y Sebro1430g09t
aeiitoude 3sda
Industry y
oqFirm 1oehre9 to enoilqrmued

cotga rd e feinos osty og

sit od bas ar

3s
onsblos bolwotl ftsndero
enlonts O
GQuantity
D
xa s0 9EQuantity
X

Fig. 10.2
 Price-Output
eterminntion under Perfect Competition 10.3
be seen that an Determinatio
Itwould and individ
he and offers
offers
the industry, any firm accepts theprice, OP, determined by
ntity for sale at this price.
quantitu
is in
this sense that we say
Tt

is a price-taker.
tha at an industry
is price-maker, while a firm
a firm have
Why cannot
the basic depene
inherent
inherent in characterio policy? The answer to this is
nt pricing
nber of buyers and sellers,
numbe
on the
(iof
a competitive market, viz, (i) very large
of the and (iii) absence
of any barriers movementhomogeneity and product,
fa firm seeks to charge a of
producers buyers.
price the
find all of its customers higher than
higher
market price, it will soon
drivin
interest of the firm to be left out to the rival sellers. It will not be in the
with ncold It will
to fall back on the stocks. have no option but
equilibrium
. Likewise, a firm cannot afford
price.
The pressure of market to charge a price lowerthan the equilibrium
the equilibrium Competition,aswe will seebelow, ensures that
price equals the
a firm seeks to sell at a minimum average cost in the
price lower industry. 1f
that whole of its stocks than the equilibrium price, it will find
get exhausted very
losses. No firm can afford to
soon, and that it has incurred
incur losses for long.
Therefore, the only alternative
for a firm is to act as a
to accept the price price-taker firm, i.e.,
determined by the market.8 oftnt
Industry Demand Curve and A Firm's
Demand Curve
An industry's demand curve
under perfect
competition shows the relationship
between
quantity demanded and the different
in
prices the market. Industry's
demand curve is
negatively sloped, as shown in
Fig. 10.3(a).
Being a price-takerfirm, an
individual firm cannot
it has to sell
its
change the price at which
product. It has to sell at a
demand curve is a horizontal given price. Therefore, a firm's
straightline, parallel to the X-axis
[i.e., a perfectly
competitive firm faces a
perfectly elastic demand curve, as shown in
Fig.
10.3(6)

tloei xod enoiaineb owi

Sositg sd n souboe blrode

o Industry's
demand curve
Firm's

demand
bluorle
curveibtre
dosm woll

D
bluorfenoteioslb
9tem sdteoood yideotele
D

O00
Quantity09B
bavu (a)o o 9

Fig. 10.3
Quantity
 10.4 Essentials of Managerial Econonetcs

The perfectly elastic demand curve does not mean that the firm could
sell an amount atthe going price. It means, rather, that the actualu.
infinite
in production that it will variatio
normally be Possible for the firm to make
will la
price virtually unchanged because their effect on total ave
industry output will
negligible. be
Relationship between a Firm's Demand Curve and Revenue Curve
its
A firm's demand curve shows the relationshipbetween the price of the
and the quantity sold.
product t
From our earlier discussion,we know price of a is also
product the avera.
revenue for the firm. age
Therefore, the demand curve als0
shows the average revenue for
different quantities sold by the firm.
Likewise, from the average revenue
curve, marginal revenue curve for
the firm can also be derived.
As we know, a perfectlycompetitive
firm faced with a
is
perfectly elastic
ITGSL AR MR Price
demand curve, i.e., it has to sell all of
itsoutput at a given price. It follows
that the average revenue for a firm
at different levels of sales remains
the same. And since every additional
unit is sold at the given price, the Quantity O
marginal revenue equals the average
revenue (or the price). Fig. 10.4

Thus, firm'sdemand curve becomes its revenue curve also, asshown in Fig. 10.4.

Price-Output Determination
B098m 9vititsque

A price-taking (perfectlycompetitive) firm has no market power; it cannot

change the market price. But it can take two decisions by itself
1. Should it produce at the given market price?
2. How much should it produce?
That an individual firm has to take a decision about its existence in the
is,

market, and once it finds that it should continue to exist, it has to decide about
the level of output

The first Should

decision it
produce?-is influenced more by the
relationship between the market price of the product and the firm's variable
costs.

A firm's total costs are the sum total of fixed costs and variable costs. As
faras fixed costs are concerned, once these have been
incurred, these cannot
be recovered even if the firm stops production. Once incurred
they are spent.
Therefore, whether to produce or not at the given is decided more in
price
 Price-Output
relation to the tmination under Perfect Competition
variable 10.5
ifat any level of costs.
output,
The
rule of the thumb is: a firm will

AR (i.e.,
AR 2 AVCc.
produce
price) may or
as it
it is
equal to or
equal to may not
greater
greater th qual AC (average total cost), but as
produce. an the AVC, it is in the long
firm's interest
The second decision to
maximisation (orloss
-how m
loss
firm.It would decide
minimh should it
produce?-reflects on the profit
tominimisatioy
ion) of
profits (or incurs e a
produce behaviour the perfectly competitive
minimum
minimum level of output at which it earns
A level of output at losses maximum
es).
elastic which a firn
demand curve) OVA
m
would De earns maximum profits (given
conditions:
the one that satisfies the perfectly
Condition 1: MR =MC, following two
and
Condition 2: MC cuts
MR m
from
below.
The two conditions
are
Fig. 10.5. shown in
Itwould be seen
in Fig. MC
10.5 that
MR MC at
output levels
and OQ Both these 0Q,
the points
first
condition. satisfy
MR AR
Butat point L, MC
cuts MR from
above, whereas at point
cuts MR from below.
K, MC
point K can be taken Therefore,
as the
Quantity
equilibrium point since it
the second

Rules of Profit
condition also.
serves

Maximisation: Mathematical
ST Fig. 10.5

Three Presentation
following conditions have to
be satisfied:
1. At some level of
output, the price should be
average variable equal to or greater than the
cost.
2.MR should be ole sdl ioeuiav

Condition 1
equal
3.MC should cut MR
to
from
MO oidoslsoct
ot dogls ed
below.omotade odormoe
oisperonk
srdd
oot
tiaontdo
otntateiaaa E
Profits (T) are defined as follows:
T R - (F + V) eqno yibeheto avu0
vggue
where, R is total revenue
ioitulhetg o
F is total
V is
fixed

total variable cost. A

10.6 Essentials of Managerial Economics

Now let subscript 0 stand for a state where there is no production and
a state where there is production.The rm will produce if there is at least.one
1 for
fo

level of production for which

When the firm

TTo
does not produce, R and V are zero, so the above
conditio
ition
becomes

or
R-F-V2n-F
R2V.
Dividing both sides by output (Q), we get:uhogokebioob biuo a
Price2 AVC.
Condition 2
TR C,
where C is total cost (F+V). Both revenues and costs vary with output, ie.
= =
R R(Q) and C C(Q). Thus, we may write
T R(Q) - C(Q). Matus soitibro

A necessary condition for the maximisation of profits is

dT
Aa R(Q)- CQ) =0.
Note: A
dQ
prime has been useda derivative above.go ta OM
for
.0
o98 sd bisow 1
M
or R)=CQ). oesitdiod auog
0bue
Both these derivativesdefine marginal revenue and marginal cost, so we have
MR MC.
Condition 3
To ensure that we have a maximum and not a minimum for profits, we require
o

da2 R(Q) - C(Q) < 0

di soniedeioq mId
dQ 0elscoaibnoo bno09e sr

d(MR)d(MC) roltseimbxslM 3o19 to a9lu

dQ dQ
enoilibcosgnivzolloit ooul
or d(MR)
dQ
a
dQ
iiedesois erdt duuo o fovel
srto
A
which meansthatthe algebraicvalue of the slope of the MC curve must exceed,
at the point of intersection, the algebraic value of the slope of the MR curve.
This translates into the geometric statement that the MC curve should cut the
MR curve from below.
Supply Curve of a Perfectly Competitive Firm bagtab91 ()
From our discussion of 'shut-down point' of a firm we know that a firm will

continue to be in production if

il,Jndotiei
P2AVC
even if the price does not cover the total average cost (i.e.,
AVC +AFC).
 under Perfect Competition 10.7
Determination
Price-Oulput
will induce the firm to sell more.
increase an
price
curve,an ncrease in
ing MC curve, a higher level of output. This can
a rising ill be determined at
will
With
With rissilibrium darop
equilibrium
firm's 10.6.
i.e.,

be seen
in Fig.
uilibrium
in equilibrium at point E equilibrium output is OQ
tirm is P.
At price
As price
Po,
goes up to
equilibrium
Pand P2
output wolod otM
ctively. It
corresponding and
up to Q, Q
respectiv
that at a price
MC
AVC
roes
be rememberedisnot rdilip9 3T E
must the firm willingto AR
than Po,
less
any output. E
(sell) AR
produce we can
this information,
Using firm's supply
draw this Alo

separately we make use

curve.
For this purpose
10.7.
of Fig.
(a)
we have located different
Inpanel
equilibrium output corres X
levels of
to different prices. Thus, at
ponding Quantity
firm is willing to
price OP the at OP, 0Q,,
supply 0Q, output, Fig. 10.6
output
and at OP2 0Q output.
these coordinates in panel (6) we get the firm's supply curve.
Joining

Thus, we reach the conclusions:

of a firm
The short-run supply curve in perfect competition is precisely its

curve for all rates of output equal to or greater than the rate of
marginal cost
with minimum average variable cost. For market prices
output associated
lower than minimum average variable cost, equilibrium quantity is zero.

MC

P.

Quantity Quantity

(a) (b)

Fig. 10.7

Supply Curve of a Perfectly

Competitive Industry
upply curve an industry is a horizontal summation of supply curves of
of
that more quantity
dual
will be firms, It will have a positive slope to indicate
supplied at a higher price, and vice versa.
10.8 Essentials of Managerial Eeonomics

3. SHORT-RUN EQUILIBRIOM OF A COMPETITIVE

FIRM
Short-run equilibrium of a firm is attained at a level of output which
the following two conditions: sati.
sfies
1. MC = MR, and
2. MC cuts MR from below.
It is not necessary that a firm makes zero
profits at this level of
When output
it is in short-run
equilibrium,a perfectly competitive firm
in any of the following conditions: may find itaale
1. It sufferslosses. gpooas(fea)onubo
2. It earns profits.
3. Itbreaks even.
1. It suffers losses
A firm sufferslosses, if at the
equilibrium level of output, its average cost
is more than its (AC
average revenue (AR) or the market price. This is
in Fig. 10.8(a). illustrated

AC
MC sco MC
AC

AR MR
AR MR g
Quantity
Quantity
(a)
(6)

MC
AC

AR MR
()

Quantily0 Vito@ho8io bvuo yiequ

Fig.10.8 Hba boilggue sdiw

 under Perfect Competition 10.9
Price-Output Determination

would be seen as follows:

E(MR =
it

InFig. 10.8(a),
point
:E(MR =MC)
MC)
Equilibrium
output
: 0Q
Equilibrium QE
revenue
Average QK
Average
cost
unit
= QK QE =EK
Loss per EK x 0Q =Area PEKT.
Total loss

2. It earns profits:
ir at the equilibrium AR>AC.This is shown
fir m wOuld earn profits output

in Fig. 10.8(6).
10.8(6) as follows
It would be seen in Fig.
revenue QE
Average
cost QK
Average
.. Profit per unit QE QK =EK
Total profit
EKx OQ =Area PEKT.
3. It breaks even:

A firm breaks even when atthe equilibrium level of output its AR =AC. This
is shown in Fig. 10.8(¢).

It would be seen as follows:

Average revenue QE
Average cost QE
The firm breaks even.
Shut-down Point for a Competitive Firm
In Fig. 10.8(a) we have illustrated a firm that sufferslosses in the
short-run,
while being in equilibrium. The firm suffers losses because at this level of
Output its AR < AC.
Should this firm continue
produce or should it shut down?
to
An answer to this
question can be provided only if we look at the structure of
cOsts of this firm.As we
already know, the total costs of a firm are the sum
total of fixed costs and
variable costs.
Xed once incurred, cannot be recovered even if the firm shuts down.
costs,

neretore, the decision to shut down is determined by variable costs

alone
fir l
fall continue to produce if at the equilibrium level of output, the
following condition
obtains:
AR 2AVC.
Otherwise,the firm will shut down. We can illustrate three different situations
as in
Fig.10,9
In
Fig. 10.
hesawob3u
at the cost is more than
the avero
erage
equilibrium output, average variable
revenue. This firm will not produce. If it produces and seusa
aeoprice (QE), it suffers an additionalloss of EF in addition to the loss on
e
account of
fixed costs.
10.10 Essentials of Managerial Eeonomics

In Fig. 10.9(6) it really does not abter whether the

firm conti
production or decides to shut own-its AVC
considered as the shut-down point for the firm
(= QE).
This
AR
nues with
with
his can
be

MC AC MC
AVC AC

AVC

AR MR E AR MR

Quantity Quantity
(6)

MC
AC 6.01

AVC

AR MR

Q
Quantity
(c)

Fig. 10.9
In Fig. 10.9(c), at the equilibrium level of output, AVC = QK, whereas
AR = QE. By continuing production, the firm not only recovers wholeof
in
its
in
variable costs, but addition also recovers a part (though not fully) of fixed
costs. Its total losses would be less if it continues in
production than if it were
to close down its operation.
Qualification Shut-down. From the above analysis, in actual
to
operations
need not necessarily be concluded thatproducers should shut down operations
every time price drops below AVc. In many cases, substantial costs are
incurred when a production process is shut down and also when it is restarted.
Also, a firm that shuts down and then reopens may find that its customers
buying from many other suppliers.These costs must be taken into accoun
These suggest that a decision to shut down will be made only if it is expected
that price will remain below AVC for an extended
period of time.
 Price-Output Determination der Perfect Competition 10.11

Exercises
practice
Practical that
t a perfectlycompetitive firm has no knowledge
of the exact
1. Suppose itstotal
tote cost It that total
PE of curve. knows its fixed costs are
shape
shap assumes that its average variable cOsts are
nd it as
and
Rs. 200, constant at
Rs. 5.
the firm can sell any amount of the commodity at the
(a) If price of
Rs. 10 per unit, draW a figure the sales volume
and at which the
even.
firm breaks
IAN How can an increase in the price of the commodity, in the total
fixed costs of the firm and its average variable costs, be shown in
the figure as a part ot this problem?

Solution:
(a) In Fig. 10.10 the slope of
curve refers to
theTR
the constant price of
1000
Rs. 10 at which the per
fectly competitive firm 800 TC
can sell its output.
TC curve indicates 600
The
total fixed costs of
B
Rs. 200 and total 3 400
Break-even Point
variable costs of 200-
Rs. 5 (Q) (the slope of
the TC curve). This is
X
often the case for many 20 40 60 80 100
firms for small
sin outputs. The firm
breaks even at Q
changes

=
Output

40. Fig. 10.100

The firm incurs a loss at smaller
outputs and earns a profit at
higher output level.
6) An increase in the price of the
commodity can be shown by
increasing the slope of the TR curve; an increase in the TFC of the
firm can be shown by an increase in the vertical interceptof the
TC curve, and an increase in AVC
can be shown by an increase
in the
slope of the TC curve. The break-even point of the firm will
also
change.
A
8easidehotel has fixed cost of Rs. 10,000. During the winter it
makes
a loss, since in addition to its fixed costs it has variable
s. B0,000 per month whereas costs ot
revenue from guests is only Rs. 51,000
per month.
Should the hotel close down during the winter? Give
reasons.
Solution:

Keeping open the hotel, the firm recovers Rs. 1,000 of the TF
feough it continues to incur a loss of Rs. 9,000 per month.However
he hotel is closed down will incur a toial
during the winters, thefirm
 10.12 Essentials of Managerial Economics

loss of Rs. 10,000 per month. Therefore, it is in the interest

interest of the
tha s
to keep open the hotel.
firm
PE 3. You arethe owner ofa firm thatis currently losing Rs. 1,000
per me
with fixed costs per month of Rs. 800. A management month,
nt consul,
advises you to cease production. Should you accept the advice?consultan
Wh
why not? hyor
Solution:
Yes. Because you will lose less money (Rs. 800 rather than Rs. 1.000
if you stop production than if you continue to 00)
produce.

4. LONG-RUN EQUILIBRIUM
The key to long-run equilibrium in a perfectlycompetitive industry is entry and
exit of firms.
In the short-run we have admitted three possibilities as below:
1. AR AC, i.e., firms make abnormal profits.
2. AR< AC, ie., firms suffer losses, but continues production as long as
AR AVC.
3. AR =AC, i.e., firms are in a position to cover all of their costs,
including
the opportunity cost of capital.
Let us look at these situationsmore closely from the perspective of the long.
run.
1. An Entry-attracting Price
In a situation where firms earn abnormal profits (i.e.,AR> AC), new firms will
enter the industry. The supply curve of the industry will shift rightwards. With
an unchanged market demand curve, the equilibrium price will fall. Both new
and old firms will have to adjust their output to the new price. New firmswill
continue to enter, and the equilibrium price will continue to fall, until all firms
in the industry are just covering their total costs. All the firms will be earning
zero profits. The competitive industry will be in a zero-profitequilibrium.
2. An Exrit-inducingPrice
In a situation where firms are incurring losses (i.e., AC > AR), this is a signal
for the exit of firms. Old plants and equipment notbe replaced as they wear
will

out. As a result, the industry'ssupply curve leftwards; the market

will shift

price will rise. Firms will continue to exit, and the market price will continue
to rise, until the remaining firms can cover their total costs, that is, until they

are all in the zero-profit equilibrium.

3. The Break-even Price

This occurs for a firm which only recovers its total costs at the existing prie
i.e., for it AR =AC. There is neither an attraction for new firms to enter tn
industry, nor for existing firms to exit. The industry demand and industy
 Defee.Output Determination under Perfect Competition 10.13

will be in
remain unchanged. The industry zero-profit
nditions
supp
of a perfectly competitive industry obtains
equilibrium. equilibrium
long-run
are in zero-prof equilibrium. This is shown in Fig. 10.11.
the
Thus,
all
the firms
when from Fig. 10.11 that when the industry is in equilibrium,
be observed
It may
earns zero profits but produces at the lowest point on its
firm not only
each
Thus,
LAC curve. to the goods and servicesdesired
are used most eficiently produce
resources
at the minimum cost;
by society consumers purchase the commodity at the
also earn zero profits,
firms
since
price.
lowest possible
the situation under imperfect competition (discussed
be contrastedto
mLie is to

inthe following chapters),where we will see that producers seldom, if ever,

nroduce at
the lowest point on their LAC curve.

LONG-RUN
Firm's equilibriumn
Industry equilibrium

MC LAC ,SS

P MR

DD

Quantity Quantity
(a) (b)

Fig. 10.11
wil all the
firms have identicalcost
curves
the long-run equilibrium, all the firms need not have identical cost curves.
D,the minimum point on their IAC curves must occur at.thesame cost per
unit.

If
iher s had more productive inputs, and, thus, lower average costs than
froms 1nthe industry,the more productive inputs would be able to extract their
ot employer higher rewards commensurate to higher
uctivity, under the threat of leaving to work for others.
result, their
LAC curve LAC curves would shift upward until the lowest point on the
of all
the firms is the same.
Thus,
will
com eitionin the input markets as well as in the commodity market
costs and zero
economic al firms having identical (minimum) average
proits when the industry is in long-run equilibrium.
 10.14 Essentials of Managerial conomics

5.SOMERELATED ASPECTS OF COMPETITIVE INDUSTRY

1. Technological Change and Competitive Industry

We will examine the effects ot two types of technological chane
These are: on
competitive industry.
(a) a one-point technological change
(b) a continuous technological change.

(a) A one-point technological change

We beginwith a situation where the industry is in long-run equilibrium
firm is earning zero profit. Let us assume that some technological develoDm
occurs. velopment

This new technology will be used only by new plants; the technology Can:
annot
be used by old plants. Because of the new technology, the cost of produeti
with the help of the new plants will be lower than the cost of production wia
with
the help of old plants. These producers would be in a position to earn abnormal
profits (i.e., for them AR> AC), Since the market price would be equal to th.
the
AC of the old plants.

MC MC
AC
AVC
AVC

P AR MR AR MR

-x -X
Quantity Quantity
(a) (b)

otd tperarol
AC

AR-MRa is
AVC golon

Quantity
(c)

Fig. 10.12
 Determination under Perfect Competition
10.15
Price-Output

en abnormal this wil be an invitationfor new firms

profits,
This would result in a
with new technology.
plants
ls thenew rightward
the
the industry
curve, and the market price will come down.
to entertheindustry supply
of the
shift ice falls, in wake of increased supppl many old firms may not
prio be
the market their AVCs, and they forced to shut down. Other
will
As the
As ecoverthe
to recover
ease out of the industry. The new firms
be in position also slowly and gradually
niants will
take their place, and ultimately in the long-run the
new plants will
ith
with be in zero profit long-run equilibrium.
will once again
industry
change
(6)
A continuous technologicalsituation where the technology in use is kept
now look at a related
Let us basis. The cOstof production with the help of the plants
raded on continuous
will be more than the cost of production
sed on new technology next yearon
of the plants based existing technology this year. This cost
with the help
itself from year to year.
will reinforce
reduction

Consequence
there would be in use at anv
As a result of continuous technologicalprogress
point of time, machinery and equipment with varying levels of efficiency and
cost of production.

The market price would be determined by the lowest average cost of the firm
with the most efficient plant. In consequence,
(a) Those firms which are not in a position to recover their AVC will close

down;
(6) Those firmswhich are in a position to recover their AVC will continue to
be in production as long as this situation lasts.

situationcan be depicted graphically in Fig. 10.12.

The
t would beseen in Fig. 10.12 that it is only the firm depicted in panel ()that
in a position to
15 break-even. Firms in panel (a) and (b) will continue to be
n production till they are in a
position to recover their AVC.
As
further technological progress occurs, firms in panel (a) and (6) would be
gradually eased out from the industry. The process would keep on repeating
Self. More efficient firms will keep entering the industry; less efficient firms
will be
forced to
quit.
2.
Effect of Increaseand Decrease in
Demand
analyse the effects of an increase in demand on (a)
prices, (6) quantity
upplied, and (e)
profits in a perfectly market structure in
) short-run competitive
)
long-run.
e a
1.
Short-run, rise in demand in a competitive industry will cause:
price to
rise;

. ncrease
industry;
each firm
to earn
in the quantitv supplied by each firm and nence Dy

profits.
 10.16 Essentialsof Managerial Econonmics

In the long-run, profits will attract neW investment. New entry will causo
the
increase in supply that will force price below the previously establishod
short-run equilibrium. This wll continue until profits have returned t
zero. Thus, in the long-run, a rise in demand in a competitive industry
will
cause
1. the scale of industry to
expand;
2. profits to to zero;
return
3. thenew equilibrium price to be above, below, or equal to the original Dricer
ice,
but (i) constant factorprices and (i7) identical and unchanged, cost curva
ves
for new and old firms ensure that price returns to its original level.

Similarly, we will analyse the ettects of a fall in demand on (a) prices.

(6) quantity supplied and (c) profits
in a perfectly competitive market
structure
ce
in

) short-run
(i) long-run.
In the short-run, a fall in demand in a competitive industry will cause:
1. price to fall;
2. a decrease in the quantity supplied by each firm and hence by theindustry
3. each firm to make losses;
4. firms to stop production immediately if they are unable to cover their
variable costs of production.
In the long-run, losses make the industry an unattractive place in which to
invest.No new capital will enter; as old plant and equipment wear out, it wil
not be replaced.As the supply diminishes, the price of the product will rise until
the remaining firms cover their total costs. Thus, in the long-run, a fall in
demand will cause
1. the scale of the industry to contract;
2 losses to be eliminated eventually;
3. price to be above, below or equal to its originallevel; but (i) constant factor
prices, and (ii) identical and unchanged, cost curves for all firms ensure
that price returns to its original level.

3. Effects of Change in Cost of Production

the a fall in the costs of production, and (6) a rise
We can costs
analyse effects of (a)
of in a competitive industry during () shortrun,
in the production
(ii) long-run, on prices, output and profits.

Intheshortrun under perfectcompetition, a fall in variable cost causes prices

but less than the reduction in marginal cost. The benefit of the reduction
fall
to
in is
cost thus shared between consumers, in terms of lower prices, and
producers, in terms of higher profits. scsa arA
This is illustrated in Fig. 10.13,
In Fig. 10.13 it would be seen as follows;a fall in costs in a
competitive industry
leads to () a fall in price,
(i) an increase in and
output, the emergenee
(iii)
of profit.