Perfect Competition

Topic 5

Characteristics
Pure Competition large number of sellers & buyers homogenous (identical) products low barriers to entry (free entry and exit from the industry) Perfect Competition large number of sellers & buyers homogenous (identical) products low barriers to entry perfect market knowledge perfect mobility of FoPs

Lead to faster adjustment

Price takers & Price makers

Demand curve for a Price taker

Demand curve for a Price maker

Demand curve for a Price taker

The demand curve facing a perfectly competitive firm is perfectly elastic, meaning that the firm can sell as many units as it wants at the market price, but cannot sell any quantity if it charges more than the market price. The firm has no market power, no pricing power at all. It is just a small player in a large market.. It is a price taker.

Demand curve for a Price maker

Downward sloping. It is just matter of how steep the curve is. The more market power a firm has, the steeper is the demand curve. The characteristic of a downward sloping demand curve is that, normally, if a firm raises the price of its product, it needs not lose all its customers, and if it wants to sell more, it has to cut price.

Demand curve for Individual firm under PC

Market D curve Firms D curve

P = AR = MR

Revenue Concepts under PC

Total revenue (TR): Total number of dollars (or dong) received by a firm from the sale of a product. TR = P x Q Average revenue (AR): Total revenue per unit of a product sold AR = TR/Q = (P x Q) / Q = P Marginal Revenue (MR): Additional revenue received resulting from the sale of an extra unit of output P. Q TR MR = = =P Q Q

Product Price (Average Revenue)

$131 131 131 131 131 131 131 131 131 131 131

Quantity Demanded (Sold) 0 1 2 3 4 5 6 7 8 9 10

Total Revenue
$ 0 131 262 393 524 655 786 917 1048 1179 1310 ] ] ] ] ] ] ] ]

Marginal Revenue $131 131 131 131 131 131 131 131 131 131

] ]

Price, average and marginal revenue, total revenue (dollars)

TR
917
786 655

524
393 262

P = AR = MR
1 2 3 4 5 6 7 8 9 10

131
0

D = MR

Quantity demanded (sold)

Profit Maximisation in the Short Run

Two approaches to profit maximisation:
Total Revenue minus Total Cost Approach Marginal Revenue, Marginal Cost Approach

IMPORTANT! Rules for Profit Maximisation

Optimum output where: TR TC = largest or Optimum output where: MR = MC
or MR closest to MC but MR > MC MC cuts MR curve from below

Total Revenue Total Cost Approach (Price = $131)

Total Total Total Fixed Product Revenue Cost 0 1 2 3 4 5 6 7 8 9 10 $ 0 131 262 393 524 655 786 917 1048 1179 1310 $ 100 100 100 100 100 100 100 100 100 100 100 Total Variable Cost $ 0 90 170 240 300 370 450 540 650 780 930 Total Cost $ 100 190 270 340 400 470 550 640 750 880 1030 Profit $100 59 8 + 53 + 124 + 185 + 236 + 277 + 298 + 299 + 280

Profit Maximisation: MR, MC Approach

Total Total Fixed Product Cost 0 1 2 3 4 5 6 7 8 9 10 100 100 100 100 100 100 100 100 100 100 100 Total Variable Cost 0 90 170 240 300 370 450 540 650 780 930

Total Cost
100 ] 190 ] 270 ] 340 ] 400 ] 470 ] 550 ] 640 ] 750 ] 880 ] 1030

Price = Total MarginalMarginal Economic Cost Revenue Prof./Loss 90 80 70 60 70 80 90 110 13 0 15 0 $ 131 131 131 131 131 131 131 131 131 131
$100 59 8 + 53 + 124 + 185 + 236 + 277 + 298 + 299 + 280

Short-run equilibrium of industry and firm under Perfect Competition

P
S

MC

Pe

AR

D = AR = MR

O
Q (millions)

Qe Q (thousands)

(a) Industry

fig

(b) Firm
Copyright 2001 Pearson Education Australia

IMPORTANT! Rules for Profit Maximisation

Optimal output is where MR = MC
or MR closest to MC but MR > MC MC cuts MR curve from below

IMPORTANT ! Rules for Profit maximization

Short Run
P AVC In the short run, fixed costs will be incurred whether or not the firm produces. So this means that total revenue must be at least equal to total variable cost for the firm to continue producing. If P < AVC, firm should shut down

IMPORTANT ! Rules for Profit maximization

Long Run
P ATC In the long run, firms have the option of closing down and going out of business, so total revenue must at least cover total costs ( all costs ). If P < ATC, firm should shut down

SR Profit maximisation under Perfect Competition

P
S

MC

ATC

Pe

AR AC

D = AR = MR

O
Q (millions)

Qe Q (thousands)

(a) Industry

fig

(b) Firm
Copyright 2001 Pearson Education Australia

SR Profit maximisation under Perfect Competition

P
S

MC

ATC

Pe

AR AC

D = AR = MR

O
Q (millions)

Qe Q (thousands)

(a) Industry

fig

(b) Firm
Copyright 2001 Pearson Education Australia

SR Loss minimisation under Perfect Competition

P
S

MC

ATC

AVC

AC P1 AR1

D1 = AR1 = MR1

O
Q (millions)

Qe Q (thousands)

(a) Industry

fig

(b) Firm
Copyright 2001 Pearson Education Australia

Short-run shut-down point

P
S

MC

ATC

AVC

P2 D2

AR2

D2 = AR2 = MR2
Q1

O
Q (millions)

(a) Industry

fig

(b) Firm
Copyright 2001 Pearson Education Australia

Long run Equilibrium under PC

Under PC P = min. ATC = MR = MC why?

Long-run equilibrium under PC

P
S1 ATC P1 AR1 D1

Q (millions)

(a) Industry
fig

Q (thousands)

(b) Firm
Copyright 2001 Pearson Education Australia

Long-run equilibrium under PC

P
S1 Se ATC P1 PL AR1 D1 DL

ARL

Q (millions)
(a) Industry: As firms making supernormal profits , new firms will enter the industry. S curve shifts to right. Price falls.

QL Q (thousands) (b) Firm

fig
Copyright 2001 Pearson Education Australia

Long-run equilibrium under PC

P
Se S1 PL P1 D ATC

ARL
AR1

DL D
1

Q (millions)
(a) Industry: As firms making losses , some firms will leave the industry. S curve shifts to left. Price rises.

QL Q (thousands) (b) Firm

fig
Copyright 2001 Pearson Education Australia

Long run Equilibrium

.

Long run Equilibrium

Key characteristics of PC:
large number of sellers & buyers identical products freedom of entry & exit

Implication (or conclusion)

Firms in PC cannot earn economic profits in the long run

Efficiency
Allocative efficiency: Resources are allocated among firms and industries to obtain a mix of products most desired by society (consumers) Productive efficiency: The least costly methods of production are used (ie. goods are produced at the lowest possible costs)

Efficiency and Perfect Competition

Price of product X = the relative worth of product X to the society (or the marginal benefit/satisfaction the society gets from an additional unit of X) .
Marginal Cost of product X is the cost of producing an additional unit of X (MC measures the sacrifice of other goods in using resources to produce more of X)

Efficiency and Perfect Competition

Allocative efficiency:
P > MC : resources are under allocated P < MC : resources are over allocated P = MC : resources are best allocated/utilised

Productive efficiency:
P = min ATC
(For more details, read Jackson pp. 276 77)

Assessment of Perfect Competition

Pros
Productive efficiency: min AC (ie. firms produce at the least-cost output) Allocative efficiency: P = MC Consumer gains from low prices (ie. maximum consumer surplus) Speed of resource reallocation No power groups

Cons
Less scope for R&D Almost no product variety

Short-Run Supply Curve

For the individual firm: the SR supply curve is the MC curve above the AVC curve For the entire industry: horizontal sum of firms MC curves above AVC

P = MC: Short-Run Supply Curve

P
Costs and revenues (dollars)

ATC

MC

AVC
At every price, the MR = MC point changes the quantity being exchanged...

P = MC: Short-Run Supply Curve

P
Costs and revenues (dollars)

ATC

MC

P3

AVC
Record the quantity being supplied for each price Q3

MR3

P = MC: Short-Run Supply Curve

P
Costs and revenues (dollars)

ATC

MC

P3 P2

AVC

MR3 MR2

At a lower price a lower quantity will be supplied

Q2 Q3

P = MC: Short-Run Supply Curve

P
Costs and revenues (dollars)

ATC

Break-even (normal profit) point

MC

P4 P3 P2

MR4 AVC MR 3 MR2

At a higher price a greater quantity will be supplied

Q2 Q3 Q 4

P = MC: Short-Run Supply Curve

P
Costs and revenues (dollars)

ATC

Break-even (normal profit) point

MC

P5 P4 P3 P2

MR5 MR4 AVC MR 3 MR2

Q2 Q3 Q 4 Q5

P = MC: Short-Run Supply Curve

P
Costs and revenues (dollars)

ATC

Break-even (normal profit) point

MC

P5 P4 P3 P2 P1

Firm should not produce unless revenue is at least able to meet AVC

MR5 MR4 AVC MR 3 MR2 MR1

Q2 Q3 Q 4 Q5

P = MC: Short-Run Supply Curve

P
Costs and revenues (dollars)

ATC

Break-even (normal profit) point

MC

P5 P4 P3 P2 P1

The Marginal Cost Curve at points above AVC represents the short-run supply curve

MR5 MR4 AVC MR 3 MR2 MR1

Q2 Q3 Q 4 Q5

P = MC: Short-Run Supply Curve

P
Costs and revenues (dollars)

ATC

Short-run supply curve (red)

MC

P5 P4 P3 P2 P1

MR5 MR4 AVC MR 3 MR2 MR1

Q2 Q3 Q 4 Q5

P = MC: Short-Run Supply Curve

P
If costs increase... the supply curve effectively shifts to the left

MC2 MC1

AVC2 AVC1

P = MC: Short-Run Supply Curve

P
If costs decrease... the supply curve effectively shifts to the right

MC1

MC2

AVC1 AVC2