Micro

McEachern 2010-
2011

Perfect Competition
.
 LEARNING OBJECTIVES
• To understand different kinds of market
structures.
• To understand the characteristics of a perfect
competition
• To understand short-run and long-run
equilibrium in a perfect competition.
Market is a place where buyers and sellers appear to conduct
exchange transactions.

The only requirement of a market is that all potential buyers and

sellers should be in close contact with each other to conduct
exchange transaction.

Basic Features :
• Buyers
• Sellers
• Interaction
• Existence of a commodity
• Price
 Market
Marketstructures
structures

The
Thefirm
firminincompetitive
competitivemarkets
markets Non-perfect
Non-perfectcompetition
competition

Perfect
Perfectcompetition
competition Monopoly
Monopoly

Oligopoly
Oligopoly

Monopolistic
Monopolisticcompetition
competition
 IMPERFECT COMPETITION

All the assumptions of perfect competition are not met

Increase in market power

Perfect Monopolistic Oligopoly Pure

competition competition monopoly

Many small Firms with Few but One firm

and similar brands powerful firms
firms
 PERFECT COMPETITION

• A market in which there are many small firms, all producing

homogeneous goods.
• No single firm has influence on the price of the product it
sells.
 PERFECT COMPETITION
• Feature of Perfect competition
– Many buyers / Many sellers
– Homogeneous Products
– Low-entry / exit barriers
– Perfect information – For both consumers and producers
 PERFECT COMPETITION

For a market to be perfectly competitive, following conditions

must be met:

1. Both buyers and sellers are price takers – a price taker

is a firm or individual who takes the price determined
by market supply and demand as given
2. The number of firms is large – any one firm’s output
compared to the market output is imperceptible and
any one firm has no influence on other firms
 PERFECT COMPETITION
3. There are no barriers to entry – barriers to entry are social,
political, or economic impediments that prevent firms from
entering a market
4. Firms’ products are identical – this requirement means that
each firm’s output is indistinguishable from any other firm’s
output .
5. There is complete information – all consumers know all
about the market such as prices, products.
 PERFECT COMPETITION
• As a result of its characteristics, the perfectly competitive
market has the following outcomes:
– The actions of any single buyer or seller in the market have
a negligible impact on the market price.
– Each buyer and seller takes the market price as given i.e
price taker
 PERFECT COMPETITION
• No individual firm can affect the market price
• Firm faces a flat demand curve at the market price
 PERFECT COMPETITION
• For competitive firms,

Price (P)= Average Revenue (AR)

= Marginal Revenue (MR)
P = MR
Short-Run Profit Maximization

 Maximize economic profit

 Quantity at which TR exceeds TC by the
greatest amount
 Total revenue TR
 Total cost TC
 Profit = TR – TC
 If TR > TC: economic profit
 If TC > TR: economic loss
 Short-Run Profit Maximization

 Marginal revenue MR = P = AR
(perfect competition)
 Marginal cost MC
 Maximize economic profit:
 Increase production as long as each
additional unit adds more to TR
than TC
 Golden rule
 Expand output: MR>MC
 Stop before MC>MR
Profit-maximizing level of output
Economic Profits > 0

Economic profit
 Minimizing
Short-Run Losses

• TC = FC+VC
– Shut down in short run: pay fixed cost
– If TC<TR: economic profit
• Produce if TR>VC (P>AVC)
– Revenue covers variable costs and a
portion of fixed cost
– Loss < fixed cost
• Shut down if TR<VC (P<AVC)
– Loss = FC
Economic loss (AVC<P< ATC)
Loss if shut down
P < AVC
 The Shutdown Decision
• The shutdown point is the P
point below which the firm MC
will be better off if it shuts
down than it will if it stays in
business ATC
• If P>min of AVC, then the
firm will still produce, but
earn a loss AVC
• If P<min of AVC, the firm will PShutdo P = D = MR
shut down wn

• If a firm shuts down, it still

has to pay its fixed costs Q
Qprofit max
 CLASS TASK-14
• Suppose a firm is operating under perfectly
competitive conditions in the market in short-
run. It faces the following revenue and cost
conditions
P= 405-4Q
TC= 40 + 5Q + Q 2

Determine the equilibrium level of output and

total profit made.
 CLASS TASK -15
• At a price of Rs 32,should a perfectly
competitive firm continue to produce in the
short-run if total cost is given by

TC = 35 + 40Q – 0.4Q 2
 CLASS TASK-16
• A perfect competitive firm has the following
output and cost data
output TFC TVC
0 100 0
1 100 50
2 100 90
3 100 140
4 100 200
5 100 280
6 100 380
 CLASS TASK-16
• If price =Rs 60,how many units will the firm
produce?
• What will be level of profits/losses at this level
of production?
• Will the firm operate in short-run?
 Firm and Industry
Short-Run S Curves

 Short-run firm supply curve

– Upward sloping portion of MC curve
– Above minimum AVC curve
 Short-run industry supply curve
– Horizontal sum of
all firms’ short-run
supply curves
 Summary of Short-Run Output Decisions
Break-even
Marginal cost Firm’s short-run S curve
point
5
p5 d5 p5>ATC, q5, economic profit
Average total cost
4
Price per unit

p4 d4 p4=ATC, q4, normal profit

Average variable cost
3
p3 d3 ATC>p3>AVC, q3, loss <FC
2
p2 d2 p2=AVC, q2 or 0, loss=FC
p1 1 d1 p1<AVC, shut down,
Shutdown
q1=0,loss=FC
0 point
q1 q2 q3 q4 q5 Quantity per period
 Perfect Competition
in the Long Run

 Long run
 Firms enter/exit the market
 Firms adjust scale of operations
 Until average cost is minimized
 All resources are variable
 Perfect Competition
in the Long Run

 Economic profit in short run

 New firms enter market in long run
 Existing firms expand in long run
 Market Supply increases
 Price decreases
 Economic profit disappears
 Firms break even
 Perfect Competition
in the Long Run
 Economic loss in short run
 Some firms exit the market in long run
 Some firms reduce scale in long run
 Market Supply decreases
 Price increases
 Economic loss disappears
 Firms break even
Zero Economic Profit
in the Long Run
 Firms enter, leave, change scale
 Market:
 Supply shifts; Price changes
 Firm
 d(P=MR=AR) shifts
 Long run equilibrium
 MR=MC =ATC=LRAC
 Normal profit
 Zero economic profit
Long-Run Equilibrium for a Firm and the Industry
(a) Firm (b) Industry or market

MC S
Price per unit

Price per unit

ATC
LRAC
e
p d p

Quantity Quantity
0 q per period 0 Q
per period
Long run equilibrium: P=MC=MR=ATC=LRAC. No reason for new firms to enter the market
or for existing firms to leave. As long as the market demand and supply curves remain
unchanged, the industry will continue to produce a total of Q units of output at price p.
Long-Run Adjustment
to a Change in D
 Effects of an Increase in Demand
 Short run
 Price increases; demand increases
 Firms increase quantity supplied
 Economic profit
 Long run
 New firms enter the market
 Supply increases, Price decreases
 Firm’s demand curve decreases
 Normal profit
Long-Run Adjustment to an Increase in Demand
(a) Firm (b) Industry or market

MC S S’
Price per unit

d’ b

Price per unit

p’ p’
Profit ATC
LRAC
a
p d p c S*
D’

D
Quantity Quantity
0 q q’ per period 0 Qa Qb Qc
per period
Increase in D to D’ moves the market equilibrium Long run: new firms enter the industry;
point from a to b; firm’s demand increases to d’; supply increases to S’; price drops back
economic profit in short run. to p; firm’s demand drops back to d.
Long-Run Adjustment
to a Change in D
 Effects of a Decrease in Demand
 Short run
 Price decreases; demand decreases
 Firms decrease quantity supplied
 Economic loss
 Long run
 Firms exit the market
 Supply decreases, Price increases
 Firm’s demand curve increases
 Normal profit
Long-Run Adjustment to a Decrease in Demand
(a) Firm (b) Industry or market

MC S’’ S
Price per unit

Price per unit

ATC
LRAC g a
p d p S*
Loss
p’’ d’’ p’’ f
D’’ D
Quantity Quantity
0 q’’ q per period 0 Qg Qf Qa
per period
Decrease in D to D’’ moves the market equilibrium Long run: firms exit the industry; supply
point from a to f; firm’s demand decreases to d’’; decreases to S’’; price increases back to
economic loss in short run. p; firm’s demand rises back to d.