PERFECT COMPETITION

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 PERFECT COMPETITON
• A Perfect Competition market is that type of market in
which the number of buyers and sellers is very large, all are
engaged in buying and selling a homogeneous product
without any artificial restrictions and possessing perfect
knowledge of the market at a time.
• ”Perfect Competition prevails when the demand for the
output of each producer is perfectly elastic.” - Joan
Robinson
 PERFECT COMPETITON
• Characteristics of Perfect Competition:
1.Large Number of Buyers and Sellers
2. Homogeneity of the Product
3. Free Entry and Exit of Firms
4. Perfect Knowledge of the Market
5. Perfect Mobility of the Factors of Production and Goods
6. Absence of Price Control:
7. Perfect Competition among Buyers and Sellers
8. Absence of Transport Cost
One Price of the Commodity
10. Independent Relationship between Buyers and Sellers
PERFECT COMPETITON-Conditions of Equilibrium
First order condition – MR = MC
Second order condition - The MC curve must cut the
MR curve from below and after the point of
equilibrium it must be above the MR.
Under conditions of perfect competition, the MR curve
of a firm coincides with the AR curve. The MR curve is
horizontal to the X- axis. Therefore, the firm is in
equilibrium when MC=MR=AR (Price).
In Figure, the MC curve cuts the MR curve first at point
F. It satisfies the condition of MC = MR, but it is not a
point of maximum profits because after point F, the MC
curve is below the MR curve. It does not pay the firm
to produce the minimum output OM when it can earn
larger profits by producing beyond OM.
• Point E is of maximum profits where both the conditions are satisfied. Between
points F and E, it pays the firm to expand its output because it’s MR > MC. It will,
however, stop further production when it reaches the OM1 level of output where
the firm satisfies both the conditions of equilibrium.
• If it has any plans to produce more than OM1 it will be incurring losses, for its
marginal cost exceeds its marginal revenue beyond the equilibrium point E.
 PERFECT COMPETITON
Equilibrium of the Firm and Industry
“Firm is the unit that employs factors of production to produce
commodities that it sells to other firms, to households, or to
the government.
“Industry is a group of firms that sells a well-defined product or
closely related set of products.”
Short-Run Equilibrium of the Firm
• Short-Run Equilibrium of the Firm:
• The short-run is a period of time in which the firm can vary its
output by changing the variable factors of production.
• The number of firms in the industry is fixed because neither
the existing firms can leave nor new firms can enter it.
• A firm is in equilibrium in the short-run when it has no
tendency to expand or contract its output and wants to earn
maximum profit or to incur minimum losses.
 PERFECT COMPETITON
• Assumptions:
• This analysis is based on the following assumptions:
• 1. All firms use homogeneous factors of production.
• 2. Firms are of different efficiency.
• 3. Cost curves of firms vary from each other.
• 4. All firms sell their products at the same price determined by
demand and supply of the industry so that the price of each firm, P
(Price) = AR = MR.
• 5. Firms produce and sell different quantities.
•
PERFECT COMPETITON
 PERFECT COMPETITON
• Short-Run Equilibrium of the Industry:
• An industry is in equilibrium in the short-run when its total
output remains steady, there being no tendency to expand or
contract its output.
• If all firms are in equilibrium, the industry is also in equilibrium.
• For full equilibrium of the industry in the short-run, all firms
must be earning only normal profits.
• The condition for this is SMC = MR = AR = SAC. But full
equilibrium of the industry is by sheer accident because in the
short- run some firms may he earning supernormal profits and
some incurring losses. Even then, the industry is in short-run
equilibrium when its quantity demanded and quantities
supplied are equal at the price which clears the market.
 PERFECT COMPETITON
• Short-Run Equilibrium of the Industry:
•

In Figure above, where in Panel (A), the industry is in equilibrium at

point E where its demand curve D and supply curve S intersect which
determine OP price at which its total output OQ is cleared. But at the
prevailing price OP, some firms are earning supernormal profits PE1ST,
as shown in Panel (B), while some other firms are incurring FGE2P
losses, as shown in Panel (C) of the figure.
 PERFECT COMPETITON
• Long-Run Equilibrium of the Firm and Industry:
• Long-Run Equilibrium of the Firm:
• The long run is a period of time in which the firm can change its plant and
scale of operations. Thus in the long-run all costs are variable and there are
no fixed costs.
• The firm is in the long-run equilibrium under perfect competition when it
does not want to change its equilibrium output.
• It is earning normal profits. If some firms are earning supernormal profits,
new firms will enter the industry and supernormal profits will be competed
away. If some firms are incurring losses, some of the firms will leave the
industry till all earn normal profits.
• Thus there is no tendency for firms to enter or leave the industry because
every firm must earn normal profits.
• “In the long-run, firms are in equilibrium when they have adjusted their
plant so as to produce at the minimum point of their long-run AC curve,
which is tangent (at this point) to the demand (AR) curve defined by the
market price” so that they earn normal profits.
•
 PERFECT COMPETITON
• Each firm of the industry will be in long-run
equilibrium when it fulfils the following two
conditions.
• (1) In equilibrium, its short-run marginal cost
(SMC) must equal to its long-run marginal cost
(LMC) as well as its short-run average cost (SAC)
and its long-run average cost (LAC) and both
should equal MR=AR=P.
• Thus the first equilibrium condition is:
• SMC = LMC = MR = AR = P = SAC = LAC at its
minimum point, and
• (2) LMC curve must cut MR curve from below:
Both these conditions of equilibrium are satisfied
at point E in Figure 5 where SMC and LMC curves
cut from below SAC and LAC curves at their
minimum point E and SMC and LMC curves cut
AR = MR curve from below. All curves meet at
this point E and the firm produces OQ optimum
output and sells it at OP price.
 PERFECT COMPETITON
• Long-Run Equilibrium of the Industry:
• The industry is in equilibrium in the
long-run when all firms earn normal
profits. There is no incentive for firms
to leave the industry or for new firms
to enter it. With all factors
homogeneous and given their prices
and the same technology, each firm
and industry as a whole are in full
equilibrium where LMC = MR = AR (-P)
= LAC at its minimum.
• Such an equilibrium position is
attained when the long-run price for
the industry is determined by the
equality of total demand and supply of
the industry.