Chapter Five

Price and output Determination

under perfect competition

Perfect Competition Short Run

Chapter 10-1
Definition and Basic Assumptions

 Perfect competition is a market structure

characterized by a complete absence of rivalry
among the individual firms.

 Perfect competition is characterized by the

following assumptions

i. Large number of sellers and buyers

 Since there are many buyers & sellers in the market, the
market share of each firm or buyer is too small to have a
perceptible effect on the price of the commodity.
 ii. Homogeneous products
 The product of each seller (the technical characteristics of the product
as well as the service associated with its sale) in a perfectly competitive
market must be identical to the product of every other seller.
 The assumption of large number of seller and of product homogeneity
implies that the individual firm in pure competition is a price taker.
 Since the share of the firm from the market is too small to affect the
market price, the only thing that the firm can do is to sell any quantity
at the ongoing market price. Thus, the demand curve that an
individual firm faces is a horizontal line (perfectly elastic demand
curve).
- Moreover, the demand curve is also the average revenue (AR) and
marginal revenue (MR) curve.
 Price

P P=AR=MR=DD

Output
III. The goal of all firms is profit maximization
oIn this model, it is assumed that the goal of all firms is to
maximize their profit and no other goal is pursued.
iv. No government regulation
ono tariffs, no subsidies, no reforming of production
v. Free Entry and exist of firms
o There is no legal or market barrier on entry of new firms to the
industry.
o The market structure in which the above assumptions are fulfilled
is called pure competition. It is different from perfect
competition, which requires the fulfilment of the following
additional assumptions.
vi. Perfect Knowledge
 All buyers and sellers have complete information about
o Price of the product
o Quality of the product

vii- Perfect mobility of factors of production

This implies that all factors of production, such as labor and raw
materials, are free to move from one sector to another or from one
firm to another.
 Given the horizontal demand function at the ongoing market price, the total
revenue of a firm operating under perfect competition is given by the product of
the market price and the quantity of sales, i.e.,
TR = P*Q
 Since the market price is constant at P*, the total revenue function is linear and the
amount of total revenue depends on the quantity of sales. To increase his total
revenue, the firm should sell large quantity.
Graphically, the TR curve is as shown below.

TR

TR =P.Q

Q
 The marginal revenue (MR) and average revenue (AR)
of a firm operating under perfect competition are
equal to the market price. To see this, let’s find the
MR and AR functions from TR functions.
TR= PQ
 By definition, MR is the change in total revenue
that occurs when one more unit of the out put is
sold

Average revenue is the TR divided by the quantity of sales.

TR P.Q
AR   P
Q Q
Short run equilibrium of the firm and
the Industry
 A firm is said to be in equilibrium when it maximizes its
profit (). Profit is defined as the difference between total
cost and total revenue of the firm:  = TR-TC

A) Equilibrium of the firm in the short run

There are two approaches to determine the level of output at

which the firm will realize maximum profits or minimum
losses.

1. Total Approach

2. Marginal Approach
 A. TR-TC approach
Under this approach the firm is in equilibrium when it produces
the output that maximizes the difference between the total
receipts and total cost curves of a perfectly competitive firm.
The profit maximizing level of output is that level of output at
which the vertical distance between TR & TC curves is
maximum (provided that TR lies above TC).

TC,TR TC TR

Qe Output
 B. MR -MC Approach
The firm will maximize profits or minimizes losses by producing that level of
output where MR equals MC and MC is rising.

SMC

SAC

F E
P=AR=MR=DD

The firm is in equilibrium (maximizes profit) at the level of output

defined by the intersection of the MC and MR curves (point E) i.e.
MC=MR where Q levels of output is supplied at price P. ( FOC)
The 2nd order condition for equilibrium requires that the MC be rising
at the point of its intersection to the MR curve.
The fact that a firm is in the short run equilibrium does not necessarily
mean that the firm gets positive profit. Whether the firm gets positive or
zero or negative profit depends on the level of ATC at equilibrium thus;
 If the ATC is below the market price at equilibrium, the firm earns a
positive profit
MC

AC

P MR
PROFIT
C

Q
Qe

 If the ATC is equal to the market price at

equilibrium, the firm gets zero profit.
 If the ATC is above the market price at equilibrium, the firm earns
a negative profit (incurs a loss)
o The question is what would be the output decision of the firm
in the short run if the prevailing market price makes it to
incur loss?
 In fact, the firm will continue to produce
irrespective of the existing loss as far as the price is
sufficient to cover the average variable costs. In
other words, the firm should continue producing as
far as the TR sufficiently covers the total variable
costs.
 This is so because if the firm stops production he
will incur a loss which equals the total fixed cost.
But, if it continues to produce the loss is less than
the total fixed costs because the TR will cover some
portion of the fixed costs in addition to the whole
variable costs as far as it is greater than TVC.
However, if the market price falls below the AVC or
alternatively, if the TR of the firm is not sufficient
to cover at least the total variable cost, the firm
should close (shut down) its factory (business). It
will only lose the fixed costs; but if it continues
operation while the TR is unable to cover even the
variable costs, the loss is greater than the fixed
costs since part of the variable cost is also not
covered by the existing revenue.
 Figure 5.5-profit gain
 Figure 5.6 profit loss
 Figure 5.7 closing down
Or shut-down point
Figure 5.8 normal/zero profit

Figure 5.8
Example
Suppose a firm has a TFC of $2,000, a TVC of $ 5,000 and a TR of $6,000 at
equilibrium. Should the firm stop its operation? Why?
In fact the firm is incurring a loss of $ 1,000 because TC (2,000 + 5,000=7,000) is greater
than the total revenue. But the firm should continue production because the TR is
greater than TVC. If the firm stops operation, it will lose the fixed cost ($ 2,000). But if
it continues production the loss is only $ 1,000 (TR-TC). Thus, the firm requires a
minimum TR of $ 5,000 to continue operation. If the TR is equal to $ 5,000, the firm is
indifferent in between choosing to continue or to discontinue its operations because
in both cases the loss is equal to fixed costs. Thus the level output at which TR and
TVCs are equal is called shut down point. In other words, shut down point is the
point at which AVC equals the market price. (AVC = P) OR TR = TVC

Equally important point is the point of break-even. Break-even

point is the output level at which market price is equal to the
average cost of production so that the firm obtains only normal
profit (zero profit).
 Summary
If Then

P > AC Positive ( economic) profit

P = AC ( zero ) profit, i.e., break-even point

AVC < P < AC Loss, but the firm continues to

produce
P = AVC Shut-down point

P < AVC Loss or no operation

Numerical example

Suppose that the firm operates in a perfectly competitive

market. The market price of his product is $10. The firm
estimates its cost of production with the following cost
function:

TC=10q-4q2+q3
A. What level of output should the firm produce to
maximize its profit?

B. Determine the level of profit at equilibrium.

C. What minimum price is required by the firm to stay in the market?

 Short Run Equilibrium of the
Industry
 Given the market demand and the market supply the
industry is in equilibrium at the price at which the
quantity supplied is equal to the quantity demanded.

 Thus in order to determine the equilibrium of the

industry we need to derive the market supply.(why?)
[P=MR=DD=AR] This requires the determination of the
supply of the individual firms since the industry's output
is the sum of the quantities supplied by all the individual
firms
The supply curve of the firm and
the Industry
The short run supply curve of a firm in perfect competition

is precisely its short run marginal cost curve for all levels

of output equal to or greater than the output associated

with minimum average variable cost.

The supply curve of the individual firm is identical to its

MC curve of the individual firm.

The figure shows, the short run supply curve of a
perfectly competitive firm is obtained by connecting
different equilibrium points E1, E2, E3 that occurs at
successive price levels p1, p2 and p3 respectively.
When the market price is $6, the firm supplies 50
units to maximize its profit. As the price increases to
$7, the equilibrium quantity supplied increases to 140
units and so on.
Thus, the short run supply curve of a perfectly
competitive firm is that part of MC curve which lies
above the minimum average variable cost (Shut
down point)
Short - run supply curve of the competitive Industry

The supply curve of the industry is obtained by horizontal

summation of short run supply curves of all individual
firms in the industry. Having derived the industry supply
curve indicated by the positively sloped line SS and demand
curve DD, the industry is in equilibrium at the intersection
point of the two curves (point E) where qe level of output is
demanded and supplied.
SS

E
P

DD
qe
Long Run Equilibrium of the firm
and Industry
Equilibrium of the firm
The firm is in the long run equilibrium when the market price is equal to
the minimum of long run AC. Thus, firms will be earning just
normal profits (zero profits), which are included in the LAC.

Firms get only normal profit in the long run due to two reasons.

First, if the firms existing in the market are making

excess profits new firms will be attracted to the
industry seeking for this excess profit. The entry of
new firms results in two consequences:
A. The entry of new firms will lead to a fall in market price of the
commodity. This happens because entry of new firms will increase the
market supply of the commodity (which is shown by the right ward
shift of the industry supply), resulting in the lower market price.
B. Moreover, the entry of new firms results in an upward shift of the
cost curves. This happens because, when new firms enter into the
market the demand for factors of production increases which exerts an
upward pressure on the prices of factors of production. An increase in
the price of factors of production in turn shifts the cost curves up
ward. These changes (decrease in the market price and upward shift
of the cost curves) will continue until the LAC becomes tangent to the
demand curve defined by the market price. At this time, entry of new
firms will stop since there is no positive profit (since P = LAC) which in
turn attracts new firms in to the market.
Second, if the firms are incurring losses in the long run (P < LAC) they
will leave the industry (shut down). This will result in higher market
price (because market supply of the commodity decreases) and lower
costs (because the market demand for inputs decreases as the number
of firms in the market decreases). These changes will continue until
the remaining firms in the industry cover their total costs inclusive of
the normal rate of profit.
It is therefore follows that for a perfectly competitive firm to be in
long run equilibrium, the following two conditions must be fulfilled
1. Price (AR) = LMC =MR
2. Price = Average cost
Hence in the long run the firm will be in equilibrium if price = AR =
LMC= LAC =MR
This can be illustrated with the help of graph as follows.
 LMC LAC

R
P1
E
P2
T
P3

Q3 Q2 Q1
At price P1, the firm is in equilibrium at point R at output Q1. The
firm earn per unit abnormal profit, as a result new firms enter the
industry & increase production. The increase in production lowers down
the price to P2 level and equates it to the average cost at its minimum.
If the price is P3, which is below LAC, the firm will be in equilibrium at
point T where Q3 level of out is produced and P3 <LAC. The firm will
incur losses. In consequence, to avoid losses the firm will leave the
industry in the long run. This reduces supply in the market raising the
price to P2 to equal average cost; where the firm will be making normal
profits and the LAC is tangent to the demand curve (P2 = MR2=AR2
=D2).