1- PERFECTLY COMPETITIVE MARKET

Perfect competition is said to prevail where there is a large number of

firms producing a homogeneous product. It is a market structure
characterized by a complete absence of rivalry among the individual
firms.

The maximum output which an individual firm can produce is very

small as compared to the total demand of the industry's product so
that a firm cannot affect the price by varying its supply of output. No
individual firm in it is in a position to influence the price of the product.
So firm is a price taker.

“The perfect competition is characterized by the

presence of many firms. They all sell identically
same product. The seller is a price taker.”
 Features of Perfect Competition Market

Large number of buyers and sellers :

Free entry and exit of firms :
This market includes a large number of firms so
that each individual firm, however large, supplies There is no barrier to entry or exit from
only a small part of the total quantity offered in the the industry. Entry or exit may take
market. The buyers are also numerous, so that no time, but firms have freedom of
one can influence the price. movement in and out of the industry.

Product homogeneity : Profit Maximization :

The industry is defined as a group of firms The goal of all firms is
producing a homogeneous product. The technical profit maximization.
characteristics of the product as well as services
associated with its sale and deliveries are
identical. There is no way in which a buyer could
differentiate among the products of different firms.
 No Govt. Regulation : Perfect knowledge :

There is no govt. regulation or intervention in the It is assumed that all

market in the form of tariffs, subsidies, rationing sellers and buyers have
of production etc. complete knowledge of
the conditions of the
Perfect mobility of factors of production : market. Information is
free and costless.
The factors of production are free to move from
one firm to another throughout the economy. No transport cost :
• A price-taking producer is a producer whose In this market structure,
actions have no effect on the market price of transport cost is ignored.
the good or service it sells.
• A price-taking consumer is a consumer whose
actions have no effect on the market price of
the good or service he or she buys.
• A perfectly competitive market is a market in
which all market participants are price-takers.
Assumptions

a)Large number of buyers and sellers

b)Product homogeneity
c) Free entry and exit of firms.
d)Profit maximization.
e) No Govt. Regulation

The market structure in which the above assumptions are fulfilled is

called pure competition. It is different from perfect competition,
which requires the fulfillment of the following additional assumptions.

f) Perfect mobility of factors of production

g) Perfect knowledge
h) No transport cost.
 EQUILIBRIUM OF THE FIRM IN THE SHORT RUN

Short run means a 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 materials, while fixed factors like capital equipment remain
unchanged. Under perfect competition, an individual firm has to accept the
prevailing price as given. As a result, demand curve or average revenue curve of
the firm is a horizontal straight line. Since perfectly competitive firms sell
additional units of output at the same price, marginal revenue curve coincides
with average revenue curve. Marginal cost curve as usual is U-shaped.
P Q TR AR MR
3 1 3 3 3
3 2 6 3 3
3 3 9 3 3
3 4 12 3 3
3 5 15 3 3
Profit maximization under perfect competition. When price equals marginal
cost, a competitive firm will maximize profit. If price is greater than marginal
cost, the firm can increase profit by increasing output and adding more to total
revenue than to total cost. Alternatively, if price is less than marginal cost, the
firm can increase profit by reducing output and subtracting more from total
cost than from total revenue.

• It’s important to understand clearly that a firm’s decision to produce or not,

to stay in business or to close down permanently, should be based on
economic profit, not accounting profit.

• In the calculation of economic profit, a firm’s total cost incorporates the

implicit cost—the benefits for gone in the next best use of the firm’s
resources—as well as the explicit cost in the form of actual cash outlays.

• This means that economic profit incorporates the opportunity cost of

resources owned by the firm and used in the production of output, while
accounting profit does not.
To see how curves can be used to decide whether TR/Q is average revenue, which is the
production is profitable or unprofitable, recall that market price. TC/Q is average total cost.
profit is equal to total revenue minus total cost, TR — So a firm is profitable if the market price for
TC. This means: its product is more than the average total
■ If the firm produces a quantity at which TR > TC, cost of the quantity the firm produces; a
the firm is profitable. firm loses money if the market price is less
■ If the firm produces a quantity at which TR = TC, than average total cost of the quantity the
the firm breaks even. firm produces. This means:
■ If the firm produces a quantity at which TR < TC, ■ If the firm produces a quantity at which P
the firm incurs a loss. We can also express this idea > ATC, the firm is profitable.
in terms of revenue and cost per unit of output. If we ■ If the firm produces a quantity at which P
divide profit by the number of units of output, Q, we = ATC, the firm breaks even.
obtain the following expression for profit per unit of ■ If the firm produces a quantity at which P
output: < ATC, the firm incurs a loss.
Profit/Q = TR/Q − TC/Q

Profit = TR − TC = (TR/Q − TC/Q) × Q Profit = (P − ATC) × Q

The total-revenue curve is a straight line through the SHORT-RUN EQUILIBRIUM
origin, showing that the price is constant at all levels of
output. The firm is a price-taker and can sell any
amount of output at the going market price, with its TR
increasing proportionately with its sales. The slope of
the TR curve is the marginal revenue. It is constant
and equal to the prevailing market price, since all units
are sold at the same price. Thus in pure competition
MR = AR = P.

The shape of the total-cost curve reflects the U

shape of the average-cost curve, that is, the law of
variable proportions. The firm maximizes its profit at EQUILIBRIUM
the output Xe, where the distance between the TR OF THE FIRM
and TC curves is the greatest. At lower and higher IN THE SHORT RUN
levels of output total profit is not maximized: at
levels smaller than XA and larger than XB the firm
has losses.
The total-revenue-total-cost approach is awkward to
use when firms are combined together in the study
of the industry. The alternative approach, which is
based on marginal cost and marginal revenue, uses
price as an explicit variable, and shows clearly the
behavioural rule that leads to profit maximisation.

The average- and marginal-cost curves of the firm together with

its demand curve. We said that the demand curve is also the
average revenue curve and the marginal revenue curve of the
firm in a perfectly competitive market. The marginal cost cuts
the SATC at its minimum point. Both curves are U-shaped,
reflecting the law of variable proportions which is operative in
the short run during which the plant is constant.
The firm is in equilibrium (maximises its profit) at the level of output
defined by the intersection of the MC and the MR curves. To the
left of e profit has not reached its maximum level because each
unit of output to the left of Xe brings to the firm a revenue which is
greater than its marginal cost. To the right of Xe each additional
unit of output costs more than the revenue earned by its sale, so
that a loss is made and total profit is reduced.
(a) If MC < MR total profit has not been maximised and it pays
the firm to expand its output. (b) If MC > MR the level of total
profit is being reduced and it pays the firm to cut its
production. (c) If MC = MR short-run profits are maximised.
Thus the first condition for the equilibrium of the firm is that
marginal cost be equal to marginal revenue. However, this
condition is not sufficient, since it may be fulfilled and yet the
firm may not be in equilibrium.

The condition MC = MR is satisfied at point e', yet clearly

the firm is not in equilibrium, since profit is maximized at
Xe > X’e· The second condition for equilibrium requires (i) MC = MR and (ii) (slope of MC) >
that the MC be rising at the point of its intersection with the (slope of MR). It should be noted that
MR curve. This means that the MC must cut the MR curve the MC is always positive, because
from below, i.e. the slope of the MC must be steeper than the firm must spend some money in
the slope of the MR curve. The slope of MC is positive at order to produce an additional unit of
e, while the slope of the M R curve is zero at all levels of output. Thus at equilibrium the MR is
output. Thus at e both conditions for equilibrium are also positive.
satisfied
The fact that a firm is in (short-run) equilibrium does
not necessarily mean that it makes excess profits.
Whether the firm makes excess profits or losses
depends on the level of the ATC at the short-run
equilibrium if the ATC is below the price at
equilibrium. The firm earns excess profits (equal to
the area PABe). If, however, the ATC is above the
price the firm makes a loss (equal to the area
FPeC). In the latter case the firm will continue to
produce only if it covers its variable costs. Otherwise
it will close down, since by discontinuing its
operations the firm is better off: it mimimises its
losses. The point at which the firm covers its
variable costs is called 'the closing-down point.’ The
closing-down point of the firm is denoted by point w.
If price falls below P,. the firm does not cover its
variable costs and is better off if it closes down.
 Mathematical derivation of the equilibrium of the firm
The firm aims at the maximization of its profit where
π = profit, R = total revenue, C = total cost, π=R-C
Clearly R = f1(X) and C = f2(X) given the price P.

(a) The first-order condition for the maximisation of a function is that its first derivative (with
respect to X in our case) be equal to zero. Differentiating the total-profit function and equating
to zero we obtain

OR

The term ∂R/ ∂ x is the slope of the total revenue curve, that is, the marginal revenue. The term
∂ c/ ∂ x is the slope of the total cost curve, or the marginal cost. Thus the first-order condition
for profit maximisation is MR=MC. Given that MC > 0, MR must also be positive at equilibrium.
Since MR = P the first-order condition may be written as MC = P.
 (b) The second-order condition for a maximum requires that the second derivative of the
function be negative (implying that after its highest point the curve turns downwards).
The second derivative of the total-profit function is

This must be negative if the function has been maximised, that is

which yields the condition

 THE SUPPLY CURVE OF THE FIRM AND THE INDUSTRY
The supply curve of the firm may be derived
by the points of intersection of its MC curve
with successive demand curves. Assume
that the market price increases gradually.
This causes an upward shift of the demand
curve of the firm. Given the positive slope of
the MC curve, each higher demand curve
cuts the (given) MC curve to a point which
lies to the right of the previous intersection.
This implies that the quantity supplied by
the firm increases as price rises. The firm,
given its cost structure, will not supply any
quantity (will close down) if the price falls If we plot the successive points of intersection of MC
below pw, because at a lower price the firm and the demand curves on a separate graph we
does not cover its variable costs. observe that the supply curve of the individual firm is
identical to its MC curve to the right of the closing-down
point w. Below Pw the quantity supplied by the firm is
zero. As price rises above Pw the quantity supplied
increases.
 SHORT-RUN EQUILIBRIUM OF THE INDUSTRY

Given the market demand and the

market supply the industry is in
equilibrium at that price which
clears the market, that is at the
price at which the quantity
demanded is equal to the quantity
supplied. the industry is in
equilibrium at price P, at which the
quantity demanded and supplied Short-run equilibrium
Short-run industry Short-run equilibrium
is Q. of a firm (excess
equilibrium of a firm (losses)
profits)

However, this will be a short-run equilibrium, if at the

prevailing price firms are making excess profits or
losses. In the long run, firms that make losses and
cannot readjust their plant will close down.
So the rule for determining whether a producer of a good
is profitable depends on a comparison of the market
price of the good to the producer’s break-even price—its
minimum average total cost:
■ Whenever the market price exceeds minimum average
total cost, the producer is profitable.
■ Whenever the market price equals minimum average
total cost, the producer breaks even.
■ Whenever the market price is less than minimum
average total cost, the producer is unprofitable.
In the short run, sometimes the firm For example, if Jennifer and Jason have
should produce even if price falls rented a tractor for the year, they have to
below minimum average total cost. pay the rent on the tractor regardless of
The reason is that total cost whether they produce any tomatoes.
includes fixed cost—cost that does Although fixed cost should play no role in
not depend on the amount of output the decision about whether to produce in
produced and can only be altered in the short run, other costs—variable
the long run. In the short run, fixed costs—do matter. An example of variable
cost must still be paid, regardless of costs is the wages of workers who must be
whether or not a firm produces. hired to help with planting and harvesting.
Since it cannot be changed in the Variable costs can be saved by not
short run, their fixed cost is producing; so they should play a role in
irrelevant to their decision about determining whether or not to produce in
whether to produce or shut down in the short run.
the short run.
We are now prepared to fully analyze the optimal When price is greater than
production decision in the short run. We need to minimum average variable cost,
consider two cases: however, the firm should
■ When the market price is below minimum average produce in the short run. In this
variable cost case, the firm maximizes
■ When the market price is greater than or equal to profit—or minimizes loss— by
minimum average variable cost When the market price is choosing the output quantity at
below minimum average variable cost, which its marginal cost is equal
the price the firm receives per unit is not covering its to the market price.
variable cost per unit. A firm in this situation should
cease production immediately. Why? Because there is
no level of output at which the firm’s total revenue
covers its variable costs—the costs it can avoid by not
operating. In this case the firm maximizes its profits by
not producing at all—by, in effect, minimizing its losses.
It will still incur a fixed cost in the short run, but it will no
longer incur any variable cost. This means that the
minimum average variable cost is equal to the shut-
down price, the price at which the firm ceases
production in the short run.
 But what if the market price lies between the shut-down price and the break-even
price—that is, between minimum average variable cost and minimum average total
cost? farm is not profitable; since the market price is below minimum average total
cost, the farm is losing the difference between price and average total cost per unit
produced. Yet even if it isn’t covering its total cost per unit, it is covering its variable
cost per unit and some—but not all—of the fixed cost per unit. If a firm in this situation
shuts down, it would incur no variable cost but would incur the full fixed cost. As a
result, shutting down generates an even greater loss than continuing to operate.

This means that whenever price falls between minimum In the short-run
average total cost and minimum average variable cost, the firm production decision,
is better off producing some output in the short run. The reason fixed cost is, in
is that by producing, it can cover its variable cost per unit and at effect, like a sunk
least some of its fixed cost, even though it is incurring a loss. In cost—it has been
this case, the firm maximizes profit—that is, minimizes loss—by spent, and it can’t
choosing the quantity of output at which its marginal cost is be recovered in the
equal to the market price. It’s worth noting that the decision to short run.
produce when the firm is covering its variable costs but not all
of its fixed cost is similar to the decision to ignore sunk costs,
 LONG-RUN EQUILIBRIUM
• 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 curve defined by the market price.

• In the long run the firms will be earning just normal profits, which are included in
the LAC. If they are making excess profits new firms will be attracted in the
industry; this will lead to a fall in price (a down ward shift in the individual demand
curves) and an upward shift of the cost curves due to the increase of the prices of
factors as the industry expands.

• These changes will continue until the LAC is tangent to the demand curve defined
by the market price. If the firms make losses in the long run they will leave the
industry, price will rise and costs may fall as the industry contracts, until the
remaining firms in the industry cover their total costs inclusive of the normal rate of
profit.
How firms adjust to their long-run EQUILIBRIUM OF THE FIRM IN THE LONG RUN
equilibrium position. If the price is P, the
firm is making excess profits working with
the plant whose cost is denoted by SAC1.
It will therefore have an incentive to build
new capacity and it will move along its
LAC. At the same time new firms will be
entering the industry attracted by the
excess profits. As the quantity supplied in
the market increases (by the increased
production of expanding old firms and by
the newly established ones) the supply
curve in the market will shift to the right and
price will fall until it reaches the level of P1
at which the firms and the industry are in
long-run equilibrium. The LAC is the final-
cost curve including any increase in the
prices of factors that may have taken place
as the industry expanded.
The condition for the long-run equilibrium of the firm is that the marginal cost
be equal to the price and to the long-run average cost

LMC =LAC= P

The firm adjusts its plant size so as to produce that level of output at which
the LAC is the minimum possible, given the technology and the prices of
factors of production. At equilibrium the short-run marginal cost is equal to
the long-run marginal cost and the short-run average cost is equal to the long-
run average cost. Thus, given the above equilibrium condition, we have

SMC = LMC = LAC = LMC = P = MR

This implies that at the minimum point of the LAC the corresponding (short-
run) plant is worked at its optimal capacity, so that the minima of the LAC and
SAC coincide. On the other hand, the LMC cuts the LAC at its minimum point
and the SMC cuts the SAC at its minimum point. Thus at the minimum point of
the LAC the above equality between short-run and long-run costs is satisfied.
The industry is in long-run equilibrium when a price is reached
at which all firms are in equilibrium (producing at the minimum EQUILIBRIUM OF THE INDUSTRY
point of their LAC curve and making just normal profits). Under IN THE LONG RUN
these conditions there is no further entry or exit of firms in the
industry, given the technology ;md factor prices. The long-run
equilibrium of the industry. At the market price, P, the firms
produce at their minimum cost, earning just normal profits. The
firm is in equilibrium because at the level of output X.
LMC = SMC = P = MR
This equality ensures that the firm maximizes its profit. At the
price P the. industry is in equilibrium because profits are normal
and all costs are covered so that there is no incentive for entry
or exit. That the firms earn just normal profit (neither excess
profits nor losses) is shown by the equality
LAC= SAC= P
which is observed at the minimum point of the LAC curve. With
all firms in the industry being in equilibrium and with no entry or
exit, the industry supply remains stable, and, given the market
demand (DD’), the price P is a long-run equilibrium price.
Thus the more efficient firms will be in
equilibrium, producing that output at which
the redrawn LAC is at its minimum (at which
point the LAC is cut by the initial LMC given
that factor prices remain constant). Under
these conditions, with the superior, more
productive resources properly costed at their
opportunity cost, all firms have the same unit
cost in their long-run equilibrium. At the initial
price P0 the second firm was not in the
industry as it could not cover its costs at that
price. However, at the new price, P1, firm B
enters the industry, making just normal
profits. The established firm A earns rents
which are imputed costs, so that its LAC
shifts upwards and it reaches a new long-run
equilibrium producing a higher level of output
(X’A).
 The Cost of Production and Efficiency in Long-Run Equilibrium
First, in a perfectly competitive
industry in equilibrium, the value of
marginal cost is the same for all
firms. That’s because all firms Moreover, this condition tends to persist over time
produce the quantity of output at as the environment changes: the force of
which marginal cost equals the competition makes producers responsive to
market price, and as price-takers changes in consumers’ desires and to changes in
they all face the same market technology.
price. Second, in a perfectly competitive
industry with free entry and exit,
each firm will have zero economic
profit in long-run equilibrium. Each
firm produces the quantity of output
that minimizes its average total cost. The third and final conclusion is that the
So the total cost of production of the long-run market equilibrium of a perfectly
industry’s output is minimized in a competitive industry is efficient: no mutually
perfectly competitive industry. beneficial transactions go unexploited.