Perfect Competition

The nature of the competition that a firm’s

products face is the most important factor
governing the price of that product.

Different combinations of characteristics create

different types of market structure.
 Perfect Competition
Perfect competition is a market situation in which
there is large number of buyers and sellers of a
homogeneous product.

Price of such a product is determined by the market

forces of demand and supply.

All sellers and buyers accept that price.

 Perfect Competition
• Features
– Very large number of buyers and sellers
– Homogenous products
– Freedom of entry and exit to the industry
– Perfect knowledge of market
Total, Average, and Marginal Revenue for a Competitive
Firm

Copyright©2004 South-Western
 The Marginal Revenue Curve of a Perfectly
Competitive Curve is the Same as its Demand Curve

• The firm’s marginal revenue is the change in total

revenue that results from selling one additional unit of
output.

• Notice that marginal revenue at any output level is

always equal to the equilibrium price. For a perfectly
competitive firm, price is equal to marginal revenue.

• The marginal revenue curve for the perfectly

competitive firm is the same as its demand curve.
 Shape of the AR and MR Curves of a firm
Horizontal curves
Parallel to x- axis

Revenue
S
Price

Pe D = AR
AR
= MR

D
O O
Quantity (millions) Quantity (thousands)

(a) Industry (b) Firm

 Demand curve facing a single firm
• Demand curve facing each firm is perfectly elastic
 Very Large Number of Buyers & Sellers
Firm is the price taker

– Each firm forms an insignificant part of the market

– No firm can influence the market price

– Firm is a price taker

– Industry is the price maker

 Price Taking
A price taker is a seller that does not have the ability
to control the price of the product it sells; it takes the
price determined in the market.
Why?...
If the firm tried to charge a higher price, it would
lose all its business. Customers could go elsewhere
to buy the same product for less.

Since the firm is very small, it can sell as much as it

wants at the market price. So there’s no reason to
charge a lower price.
 Firm is a Price Taker under perfect competition

Revenue
S
Price

D
O O
Quantity (millions) Quantity (thousands)

(a) Industry
 Firm is a Price Taker under perfect competition

Revenue
S
Price

Pe

D
O O
Quantity (millions) Quantity (thousands)

(a) Industry (b) Firm

 Firm is a Price Taker under perfect competition

Revenue
S
Price

Price Line

Pe D = AR
AR
= MR

D
O O
Quantity (millions) Quantity (thousands)

(a) Industry (b) Firm

 Homogenous Product
• Product sold by different firms are identical
• Product of one firm is exactly the same as product
of another firm
• Products are perfect substitutes
• Demand is perfectly elastic

• Homogenous products are those that are identical in all

aspects i.e. there is no difference in packaging, quality
colors etc.
 Freedom to Entry & Exit
• No costs attached to enter or exit industry
• No barriers to enter the market
• No barriers leave from the market
Very easy entry into a market means that a new firm faces
no barriers to entry. Barriers can be financial, technical or
government imposed barriers such as Licenses, Permits
and Patents.

The implication of this feature of Perfect Competition is in

the short run firms can make either supernormal profits
or losses, in the long run all firms in market earn only
normal profits.
 Perfect Knowledge

• Perfect knowledge exists between buyers and

sellers

• Buyers and sellers have all relevant information

about prices, product quality, sources of supply,
and so on.

• Ensures uniform market price

 Perfect Competition in the Short Run
• The firm will continue to increase its quantity of
output as long as marginal revenue is greater than
marginal cost.

• The firm will stop increasing its quantity of output

when marginal revenue and marginal cost are equal

• The Profit – Maximization Rule: Produce the

quantity of output at which MR=MC
The Quantity of Output the Perfectly Competitive
Firm Produces

The firm’s demand

curve is horizontal
at the equilibrium
price. Its demand
curve is its
marginal revenue
curve. The firm
produces that
quantity of output
at which MR=MC
 The Perfectly Competitive Firm and Resource
Allocative Efficiency
For the perfectly Because P=MR and MR=MC, it follows that
P=MC, that is the perfectly competitive
competitive firm, firm exhibits resource allocative efficiency.
P=MR.
Also, the firm
maximizes profits
or minimizes
losses by
producing that
quantity of output
at which MR=MC.
 Equilibrium of the Firm in Short-run

In short-run a firm under perfect competition may earn

 Abnormal or supper normal profit

 Losses

 Normal profit
 Equilibrium of the Firm in Short-run
Abnormal or supper normal profit:- Revenue >
Costs [AR >AC]

If AC is below the P = MR = AR, the firm

earns super normal profit.

In this case existing firms will stay in the

market and new firms will enter the market.
Short-run equilibrium of industry and firm under perfect
competition

Revenue / Costs
S MC
Price

Pe D = AR
AR
= MR

D
O O Qe
Quantity (millions) Quantity (thousands)

(a) Industry (b) Firm

Short-run equilibrium of industry and firm under perfect
competition

Revenue / Costs
S MC AC
Price

Pe D = AR
AR
AC = MR

D
O O Qe
Quantity (millions) Quantity (thousands)

(a) Industry (b) Firm

Short-run equilibrium of industry and firm under perfect
competition – Super Normal Profits

Revenue/ Costs
Supernormal MC AC
S
Price

Profits

Pe D = AR
AR
AC = MR

D
O O Qe
Quantity (millions) Quantity (thousands)

(a) Industry (b) Firm

 Equilibrium of the Firm in Short-run

Losses :- Revenue < Cost [AR < AC]

AC curves above the price the firm may losses.

Short-run equilibrium of industry and firm under perfect
competition

Revenue / Costs
S
Price

D
O O
Quantity (millions) Quantity (thousands)

(a) Industry
Short-run equilibrium of industry and firm under perfect
competition

Revenue / Costs
S
Price

Pe

D
O O
Quantity (millions) Quantity (thousands)

(a) Industry
Short-run equilibrium of industry and firm under perfect
competition

Revenue/ Costs
S
Price

Pe D = AR
AR
= MR

D
O O
Quantity (millions) Quantity (thousands)

(a) Industry (b) Firm

Short-run equilibrium of industry and firm under perfect
competition

Revenue / Costs
S MC
Price

Pe D = AR
AR
= MR

D
O O Qe
Quantity (millions) Quantity (thousands)

(a) Industry (b) Firm

Short-run equilibrium of industry and firm under perfect
competition

Revenue / Costs
MC AC
S
Price

AC
Pe D = AR
AR
= MR

D
O O Qe
Quantity (millions) Quantity (thousands)

(a) Industry (b) Firm

Short-run equilibrium of industry and firm under perfect
competition – Abnormal Losses

Revenue/ Costs
Abnormal
Losses MC AC
S
Price

AC
Pe D = AR
AR
= MR

D
O O Qe
Quantity (millions) Quantity (thousands)

(a) Industry (b) Firm

 Equilibrium of the Firm in Short-run

In short-run a firm under perfect competition may earn

Normal profit/Economic Profit

Revenue = Cost [AR =AC]

Normal Profit/Economic Profit
• If price = minimum
point on ATC curve,
economic profit = 0.

• Owners receive
normal profit.

• No incentive for
firms to either enter
or leave the market.
 Profit Maximization and Loss Minimization for
Perfect Competition
• A firm produces in the short run as long as price is above
average variable cost.

• A firm shuts down in the short run if price is less than

average variable cost.

• A firm produces in the short run as long as total revenue

is greater than total variable costs.

• A firm shuts down in the short run if total revenue is less

than total variable costs.
Loss if shut down
P < AVC
Profit Maximization and Loss Minimization for the
Perfectly Competitive Firm: Three Cases
 Supply Curve of the Firm
Supply curve of the firm shows various quantities of a
commodity a firm is willing to supply at different
prices.

The quantity which a firm is willing to supply at a

particular point (equilibrium output) is determined by
the equality of MC and MR (=P).

By finding out equilibrium output at different prices

and by joining different equilibrium points, it will be
able to derive the supply curve of the firm.
Short-run supply curve
• A perfectly
competitive
firm will
produce at the
level of output
at which P =
MC, as long as
P > AVC.
Part of the short run MC curve which
lies above the minimum point of AVC
represents the firm’s supply curve.
 Perfectly Competitive Firm’s Short-
Run Supply Curve

• Only a price above average

variable cost will induce
the firm to supply output.

• The Short-Run supply

curve is that portion of the
firm’s marginal cost curve
that lies above the average
variable cost curve.
 The market short run supply curve
Market supply equals the sum of the
quantities supplied by all firms in the market.
 SR Market Supply with a Fixed Number of Firms

(a) Individual Firm Supply (b) Short Run Market Supply

Price Price

SR
MC Supply

Rs.2.00 Rs2.00

1.00 1.00

0 100 200 Quantity (firm) 0 100,000 200,000 Quantity (market)

Copyright © 2004 South-Western