PERFECT COMPETITION

SYBA
PROFIT IN PC IN THE SHORT-RUN

- A perfectly competitive firm has to decide what quantity to produce

- Profit: π=TR−TC
- Since firm is a price-taker, it can only decide the quantity to be sold
- If the firm sells a higher quantity of output, then total revenue will increase (TR-TC
approach)
CONDITIONS FOR EQUILIBRIUM

- MR-MC approach (marginal variables used)

1. MR = MC (Necessary condition)
2. MC curve should cut the MR curve from below
(Sufficient condition)
SHORT- RUN EQUILIBRIUM OF A FIRM

▪ In the short-run there can be two cost conditions

1. Identical cost conditions: Means all firms are facing same cost-conditions, that is,
their average and marginal cost curves are of the same level and shapes. This
would be so if the entrepreneurs of all firms are of equal efficiency and also the
other factors of production used by them are perfectly homogeneous and are
available to all of them at the same prices
2. Differentiated cost conditions: all firms face different costs. Thus, cost curves of
all firms will be different
 SUPER NORMAL PROFIT
(IDENTICAL COST CONDITIONS)

• Firm will make super normal profit, if at equilibrium, AR >

AC
• Equilibrium at e where MR=MC
• Profit = TR – TC
• TR = AR x output
= (eXe) x (OXe) = OPeXe
• TC = AC x Output
= (BXe) X (OXe) = OABXe
• Profit = TR – TC
= OPeXe – OABXe
= APeB
 NORMAL PROFIT

• At equilibrium, AR = AC
• Firm is at equilibrium at point A where
MR=MC
• TR= AQ x OQ = OPAQ
• TC = AQ x OQ = OPAQ
• Since, TR = TC we have normal profit
LOSS

▪ e is the point of equilibrium

▪ Loss = TC – TR
▪ TR = (eXe) x (OXe) = OPeXe
▪ TC = (CXe) x (OXe) = OFCXe
▪ Loss = OFCXe – OPeXe
▪ AR < AC, thus firm is making losses
▪ If the firm is able to cover the AVC, it
continues its operations
 SHUT-DOWN POINT

• AR < AVC
• The firm can minimize its losses up to fixed
costs only by not producing
• E is point of equilibrium
• TR = EX * OX = OPEX
• TC = BX * OX = OABX
• Loss = OABX – OPEX
= PABE
= Shaded area + PDCE
= TFC + part of TVC
LONG-RUN EQUILIBRIUM OF FIRMS UNDER
IDENTICAL COST CONDITIONS
▪ All factors of production are variable in the long run
▪ Firms enter and exit the industry
▪ When some firms are earning super-normal profit in the long-run, i.e. AR > AC,
new firms are lured to enter the industry
▪ Thus, output increases and prices fall
▪ When firms face losses, AR < AC, some firms exit the industry
▪ Output reduces and prices rise
▪ Normal profits
LONG RUN EQUILIBRIUM OF FIRMS UNDER
DIFFERENTIAL COST CONDITIONS

▪ Intra-marginal firms: Managed and controlled by the most efficient entrepreneurs so

that their cost of production is low. They earn super-normal profits in the long run
▪ Marginal firms: Managed and controlled by less efficient entrepreneurs and they
manage to get normal profits
 LMC

LAC

D=LAR=LM
R

Equilibrium position of Intra-marginal and marginal firms

 DIFFERENCE BETWEEN A FIRM AND
INDUSTRY
▪ A firm is a commercial enterprise, a company that buys and sells products and/or
services with the aim of making a profit.

▪ An industry consists of several different firms selling similar products

 SHORT- RUN EQUILIBRIUM OF THE
INDUSTRY
▪ Industry is in equilibrium at the price at which the quantity demanded is equal to the
quantity supplied
▪ This is a short-run equilibrium because at this price, firms are making either excess
profits or losses
 LONG-RUN EQUILIBRIUM OF THE
INDUSTRY
▪ Firms that make losses and cannot readjust their plant will close down
▪ Those that make excess profits will expand their capacity
▪ excess profits will attract new firms
▪ Entry, exit and readjustment of the remaining firms in the industry will lead to a
long-run equilibrium in which firms will just be earning normal profits
 PERFECT COMPETITION

How Perfectly Competitive Firms Make Output Decisions

A perfectly competitive firm has only one major decision to make—namely, what quantity to
produce. To understand this, consider a different way of writing out the basic definition of
profit:
Profit = Total revenue − Total cost
= (Price)(Quantity produced) − (Average cost)(Quantity produced)
Since a perfectly competitive firm must accept the price for its output as determined by the
product’s market demand and supply, it cannot choose the price it charges. This is already
determined in the profit equation, and so the perfectly competitive firm can sell any number
of units at exactly the same price. It implies that the firm faces a perfectly elastic demand
curve for its product: buyers are willing to buy any number of units of output from the firm at
the market price. When the perfectly competitive firm chooses what quantity to produce, then
this quantity—along with the prices prevailing in the market for output and inputs—will
determine the firm’s total revenue, total costs, and ultimately, level of profits.
Determining the Highest Profit by Comparing Total Revenue and Total Cost
A perfectly competitive firm can sell as large a quantity as it wishes, as long as it accepts the
prevailing market price. The formula above shows that total revenue depends on the quantity
sold and the price charged. If the firm sells a higher quantity of output, then total revenue will
increase. If the market price of the product increases, then total revenue also increases
whatever the quantity of output sold. As an example of how a perfectly competitive firm
decides what quantity to produce, consider the case of a small farmer who produces
raspberries and sells them frozenfor $4 per pack. Sales of one pack of raspberries will bring
in $4, two packs will be $8, three packs will be $12, and so on. If, for example, the price of
frozen raspberries doubles to $8 per pack, then sales of one pack of raspberries will be $8,
two packs will be $16, three packs will be $24, and so on.
Comparing Marginal Revenue and Marginal Costs
The approach that we described in the previous section, using total revenue and total cost, is
not the only approach to determining the profit maximizing level of output. In this section,
we provide an alternative approach which uses marginal revenue and marginal cost.
Firms often do not have the necessary data they need to draw a complete total cost curve for
all levels of production.They cannot be sure of what total costs would look like if they, say,
doubled production or cut production in half, because they have not tried it. Instead, firms
experiment. They produce a slightly greater or lower quantity and observe how it affects
profits. In economic terms, this practical approach to maximizing profits means examining
how changes in production affect marginal revenue and marginal cost.
Conditions of Equilibrium:
A firm would be in equilibrium when the following two conditions are fulfilled:
A firm is in equilibrium when it has no tendency to change its level of output. It needs neither
expansion nor contraction. It wants to earn maximum profits in by equating its marginal cost
with its marginal revenue, i.e. MC = MR.
Diagrammatically, the conditions of equilibrium of the firm are:
(1) The MC curve must equal the MR curve. This is the first order and necessary condition.
But this is not a sufficient condition which may be fulfilled yet the firm may not be in
equilibrium.

(2) The MC curve must cut the MR curve from below and after the point of equilibrium it
must be above the MR. This is the second order condition.’ 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 1(A), the MC curve cuts the MR curve first at point A. It satisfies the condition of
MC = MR, but it is not a point of maximum profits because after point A, 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 В is of maximum profits where both the conditions are satisfied. Between points A and
B. 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 B. The same conclusions hold
good in the case of a straight line MC curve as shown in Figure 1. (B)
Short-run equilibrium
Short run means period of time within which the firms can alter their level of output only by
increasing or decreasing the amount of variable factors such as labour and raw material,
while fixed factors, like capital equipment remain unchanged. Moreover, in the short run,
new firms can neither enter the industry nor the existing firms can leave it.
For the sake of simplicity of study, let us suppose that in an industry all factors of production,
are homogenous. All the firms are equally efficient such as they have identical cost curve.
Under the circumstances each firm of a given industry, in equilibrium may get either:
(i) Super normal profit.
(ii) Normal profit.
(iii) Suffer losses
All the three situations depend upon the price determined by the industry.
1. Short-Run Equilibrium of a Competitive Firm (Maximising Profits)
The case of a perfectly competitive firm earning supernormal profits in the short run is shown
in Fig. 13.2, where the average cost curve of the efficient firm lies below its average revenue
curve. The firm is in equilibrium at point 'E', where the MC curve cuts the MR curve from
below. Corresponding to the equilibrium point, the equilibrium output is OQ, which is sold at
the equilibrium price OP. Since this price (OP or EQ) exceeds the average cost (BQ), the firm
will earn super normal or excess profits in this situation (shown by shaded area in Fig. 13.2).
Total profits from the sale of equilibrium output are 'profit per unit of output x quantity', i.e..
(EQ-BQ) OQ = Area (APEB). Alternatively,
Super normal Profits = Total Revenue - Total Cost
= Price x Equilibrium Quantity - Average Cost x Quantity Equilibrium
= (OP x OQ)- (BQ x OQ)=Area (OPEQ-OABQ)
=Area (APEB)
2. Short-Run Equilibrium of a Competitive Firm (Earning Normal Profits)
In the short-run, there are some firms of average efficiency earning only normal profits just
sufficient to induce them to continue to operate in the short-run. These normal profits are
included in the costs. Fig. 13.4 illustrates such a case for a competitive firm, which is just
able to break-even (no profit-no loss situation) at point ‘E'. Here, the AC curve is tangent to
the AR curve at the minimum point 'E' of the former. This means that the price of the product
is equal to its average cost. In other words, total cost is equal to total revenue. Such a
competitive firm, which neither makes excess profits nor suffers losses in the short-run is
called a marginal firm.

3. Short-Run Equilibrium of a Competitive Firm (Minimising Losses)

If the average cost curve of the firm lies above the average revenue (price) curve, the firm
suffers losses, as shown by the shaded area in Fig. 13.3. Here, the equilibrium point is below
the break-even point. In this case, the average cost of the firm corresponding to its
equilibrium output OQ is equal to BQ, which is greater than the equilibrium price EQ. The
loss per unit of output incurred by the firm is Q-EQ=EB. The overall losses suffered by the
competitive firm under consideration from the sale of equilibrium output are 'loss per unit of
output x equilibrium quantity', i.e., EB × 0Q = Area (APEB). Alternatively,
Total Losses = Total Cost - Total Revenue
= Average Cost x Equilibrium Quantity - Price x Equilibrium Quantity
= (BQ x OQ) - (OP x OQ)
=Area (OABQ-OPEQ)
= Area (APEB)
The competitive firm suffers losses in the short-run, when it cannot cover the full average
cost (AC). In such situations, the firm tries to minimise the losses. The competitive firm will
be willing to bear the loss, provided price (or total revenue) at least covers the average
variable cost (or total variable cost). In the present case, the competitive firm will continue to
produce, since, it is able to cover the entire average variable cost (AVC) and a part of fixed
cost (EC per unit of output). Here, price is less than AC, but greater than AVC. If the firm
ceases production, it will continue to incur full fixed cost (indicated by the gap between AC
and AVC) though variable costs will be avoidable. In that situation, the losses of the firm
would be much higher (loss per unit of output quantity, i.e., BC0Q Area (PABC)), since,
otherwise by continuing to produce, the firm was able to cover a part of the fixed cost. Thus,
in the present case, the firm is minimising its losses by choosing to produce and sell. So long
as these losses are less than the fixed cost (ie., when equilibrium price is greater than AVC,
but, less than AC), a prudent firm will continue to operate the business rather than to stop
production. In other words, if the firm is incurring losses in the short-run, the maximum
losses it can bear do not exceed total fixed costs. However, the firm cannot bear losses on the
variable costs in the short-run.

4. Shut-down point
So far, we have been analyzing the question of how much a competitive firm will produce. In
certain circumstances, however, the firm will decide to shut down and not produce anything
at all.
Here we need to distinguish between a temporary shutdown of a firm and the permanent exit
of a firm from the market. A shutdown refers to a short-run decision not to produce anything
during a specific period of time because of current market conditions. Exit refers to a long-
run decision to leave the market. The short-run and long-run decisions differ because most
firms cannot avoid their fixed costs in the short run but can do so in the long run. That is, a
firm that shuts down temporarily still has to pay its fixed costs, whereas a firm that exits the
market does not have to pay any costs at all, fixed or variable. For example, consider the
production decision that a farmer faces. The cost of the land is one of the farmer’s fixed
costs. If the farmer decides not to produce any crops one season, the land lies fallow, and he
cannot recover this cost. When making the short-run decision of whether to shut down for a
season, the fixed cost of land is said to be a sunk cost. By contrast, if the farmer decides to
leave farming altogether, he can sell the land. When making the long-run decision of whether
to exit the market, the cost of land is not sunk. (We return to the issue of sunk costs shortly.)
Now let’s consider what determines a firm’s shutdown decision. If the firm shuts down, it
loses all revenue from the sale of its product. At the same time, it saves the variable costs of
making its product (but must still pay the fixed costs).
Thus, the firm shuts down if the revenue that it would earn from producing is less than its
variable costs of production.
A bit of mathematics can make this shutdown rule more useful. If TR stands for total revenue
and VC stands for variable cost, then the firm’s decision can be written as
Shut down if TR < VC.
The firm shuts down if total revenue is less than variable cost. By dividing both sides of this
inequality by the quantity Q, we can write it as
Shut down if TR/Q < VC/Q.
The left side of the inequality, TR/Q, is total revenue P 3 Q divided by quantity Q, which is
average revenue, most simply expressed as the good’s price, P. The right side of the
inequality, VC/Q, is average variable cost, AVC. Therefore, the firm’s shutdown rule can be
restated as
Shut down if P < AVC.
That is, a firm chooses to shut down if the price of the good is less than the average variable
cost of production. This rule is intuitive: When choosing to produce, the firm compares the
price it receives for the typical unit to the average variable cost that it must incur to produce
the typical unit. If the price doesn’t cover the average variable cost, the firm is better off
stopping production altogether. The firm still loses money (because it has to pay fixed costs),
but it would lose even more money by staying open. The firm can reopen in the future if
conditions change so that price exceeds average variable cost.
Diagrammatically, it is explained below. The firm shuts down as losses are more than the
fixed costs. The firms will not be able to cover even AVC. This fact is clear from figure 14.
In figure 14, when price falls to OP, below the shut-down point, Equilibrium takes place at
point E. Losses which are incurred are equal to BE per point.
Total loss = Total Rectangle (ABEP)
= Shaded Rectangle ABCD + rectangle DCEP
= TFC + some part of TVC.
Since, losses are more than TFC, the firm shuts down its unit.

Long-run equilibrium of a firm under identical cost conditions

No perfectly competitive firm acting alone can affect the market price. However, the
combination of many firms entering or exiting the market will affect overall supply in the
market. In turn, a shift in supply for the market as a whole will affect the market price. Entry
and exit to and from the market are the driving forces behind a process that, in the long run,
pushes the price down to minimum average total costs so that all firms are earning a zero
profit.
To understand how short-run profits for a perfectly competitive firm will evaporate in the
long run, imagine the following situation. The market is in long-run equilibrium, where all
firms earn zero economic profits producing the output level where P = MR = MC and P =
AC. No firm has the incentive to enter or leave the market. Let’s say that the product’s
demand increases, and with that, the market price goes up. The existing firms in the industry
are now facing a higher price than before, so they will increase production to the new output
level where P = MR = MC.
This will temporarily make the market price rise above the minimum point on the average
cost curve, and therefore, the existing firms in the market will now be earning economic
profits. However, these economic profits attract other firms to enter the market. Entry of
many new firms causes the market supply curve to shift to the right. As the supply curve
shifts to the right, the market price starts decreasing, and with that, economic profits fall for
new and existing firms. As long as there are still profits in the market, entry will continue to
shift supply to the right. This will stop whenever the market price is driven down to the zero-
profit level, where no firm is earning economic profits.
Short-run losses will fade away by reversing this process. Say that the market is in long-run
equilibrium. This time, instead, demand decreases, and with that, the market price starts
falling. The existing firms in the industry are now facing a lower price than before, and as it
will be below the average cost curve, they will now be making economic losses. Some firms
will continue producing where the new P = MR = MC, as long as they are able to cover their
average variable costs. Some firms will have to shut down immediately as they will not be
able to cover their average variable costs, and will then only incur their fixed costs,
minimizing their losses. Exit of many firms causes the market supply curve to shift to the left.
As the supply curve shifts to the left, the market price starts rising, and economic losses start
to be lower. This process ends whenever the market price rises to the zero-profit level, where
the existing firms are no longer losing money and are at zero profits again. Thus, while a
perfectly competitive firm can earn profits in the short run, in the long run the process of
entry will push down prices until they reach the zero-profit level. Conversely, while a
perfectly competitive firm may earn losses in the short run, firms will not continually lose
money. In the long run, firms making losses are able to escape from their fixed costs, and
their exit from the market will push the price back up to the zero-profit level. In the long run,
this process of entry and exit will drive the price in perfectly competitive markets to the zero-
profit point at the bottom of the AC curve, where marginal cost crosses average cost.
MONOPOLISTIC
COMPETITION
FEATURES

• LARGE NUMBER OF SELLERS

• PRODUCT DIFFERENTIATION
• SELLING COSTS
• FREEDOM OF ENTRY AND EXIT
• LACK OF PERFECT KNOWLEDGE
• NON-PRICE COMPETITION
 SHORT RUN EQUILIBRIUM

• SUPER NORMAL PROFIT

NORMAL PROFIT
LOSSES
LONG-RUN EQUILIBRIUM – NORMAL PROFIT
 SELLING COSTS

• SELLING COSTS REFER TO THOSE EXPENSES WHICH ARE INCURRED FOR

POPULARIZING THE DIFFERENTIATED PRODUCT AND INCREASING THE DEMAND
FOR IT
• SELLING COSTS ARE COSTS INCURRED IN ORDER TO ALTER THE POSITION OR
SHAPE OF DEMAND CURVE FOR A PRODUCT
• SUCH SELLING COSTS MAY BE INCURRED IN ANY FORM SUCH AS
ADVERTISING, SALES PROMOTION, SAMPLES TO POTENTIAL CUSTOMERS
• AIM AT RAISING THE DEMAND FOR THE PRODUCT
 INEFFICIENCY

• FIRST, AT ITS OPTIMUM OUTPUT THE FIRM CHARGES A PRICE THAT EXCEEDS
MARGINAL COSTS, THE MC FIRM MAXIMIZES PROFITS WHERE MARGINAL
REVENUE = MARGINAL COST. SINCE THE MC FIRM'S DEMAND CURVE IS
DOWNWARD SLOPING THIS MEANS THAT THE FIRM WILL BE CHARGING A PRICE
THAT EXCEEDS MARGINAL COSTS
• EXCESS CAPACITY : FIRM'S PROFIT MAXIMIZING OUTPUT IS LESS THAN THE
OUTPUT ASSOCIATED WITH MINIMUM AVERAGE COST
 REFERENCES

• HTTPS://MSBRIJUNIVERSITY.AC.IN/ASSETS/UPLOADS/NEWSUPDATE/MONOPOLISTI
C.PDF
• GREGORY MANKIW
MONOPOLY
 INTRODUCTION
• The term monopoly means a single seller (mono = single and poly = seller)

• A monopoly refers to a firm which has a product without any substitute in the market

• Therefore, for all practical purposes, it is a single-firm industry

 FEATURES
1. Single seller, many buyers
2. Price maker
3. No close substitutes
4. Barriers to entry and exit
5. Relatively inelastic demand curve
6. No selling costs
7. Price discrimination
 WHY MONOPOLIES ARISE?
• Monopoly resources

• Government created monopolies

• Natural Monopolies : When a firm’s average-total-cost curve continually declines, the firm
has what is called a natural monopoly.
 CONDITIONS FOR EQUILIBRIUM
• MR = MC

• MC curve should cut the MR curve from below

 SHORT- RUN EQUILIBRIUM
Super Normal Profit

TR = AR x output
= AQ x OQ
= OPAQ

TC = AC x output
= BQ x OQ
= OP’BQ

Profit = TR – TC
= OPAQ – OP’AQ o
= P’PAB
 NORMAL PROFIT
• TR = AR x Output
= AQ x OQ
= OPAQ
• TC = AC x Output A

= AQ x OQ
= OPAQ

O
 LOSSES
• TC = AC x Output
= BQ x OQ
= OP’BQ
• TR = AR x Output
= AQ x OQ
= OPAQ
• Losses = TC - TR
= OP’BQ – OPAQ
= PP’BA Q
 LONG-RUN EQUILIBRIUM
• E : point of equilibrium
• QP: equilibrium price
• OQ: Equilibrium output
• Super normal profit: KPHN
• At the equilibrium output OQ, the plant is
not being fully utilized
• LAC is not minimum at this point
INEFFICIENCY IN MONOPOLY
 REFERENCES
• https://www.toppr.com/guides/business-economics-cs/analysis-of-market/equilibrium-in-mo
nopoly/
• http://www.economicsconcepts.com/long_run_equilibrium_under_monopoly.htm
• https://courses.lumenlearning.com/wmopen-microeconomics/chapter/the-inefficiency-of-mo
nopoly/
• Principles of Microeconomics, Gregory Mankiw
OLIGOPOLY
FEATURES
• Few firms/sellers
• Interdependence
• Non-Price competition
• High entry and exit barriers
• Role of selling costs
• Group behavior
• Indeterminate demand curve
Types of oligopoly
1. Pure or perfect oligopoly

2. Imperfect or differentiated oligopoly

3. Collusive oligopoly

4. Non-collusive oligopoly
Non-collusive oligopoly- KINKED DEMAND
CURVE
• Paul Sweezy, 1939
• Price rigidity
• Demand curve has two parts- relatively
elastic and relatively inelastic
• MR curve has two segments, there is
discontinuity
Equilibrium in cartel
PRICE LEADERSHIP
Low cost firm
Dominant firm
• Refers to a type of leadership in which only one organization dominates the entire industry.
• Under dominant price leadership, other organizations in the industry cannot influence prices.
• The dominant organization uses its power of monopoly to maximize its profits and other organizations
have to adjust their output with the set price.
Barometric price leadership
• Usually it is a firm which from past behaviour has established the reputation of a good forecaster of
economic changes
• Barometric price leadership may be established for various reasons:
1. Rivalry between several large firms in an industry may make it impossible to accept one among them as
the leader
2. Followers avoid the continuous recalculation of costs, as economic conditions change
3. The barometric firm usually has proved itself as a ‘reasonably’ good forecaster of changes in cost and
demand conditions in the particular industry and the economy as a whole, and by following it the other
firms can be ‘reasonably’ sure that they choose the correct price policy.
References
• https://www.yourarticlelibrary.com/oligopoly-market/the-oligopoly-market-example-types-and-features-
micro-economics/9140
• https://www.economicsdiscussion.net/wp-content/uploads/2016/01/clip_image002-49.jpg
• https://www.economicsdiscussion.net/oligopoly/cartels-types-joint-profit-maximisation-and-market-shari
ng-cartel/7370
• https://www.economicsdiscussion.net/collusive-oligopoly/price-leadership-with-3-forms-and-diagrams/5
492