College of Accountancy, Business, Economics and International Hospitality Management

Market Equilibrium and the

Perfect Competition Model: A
Narrative Report on Managerial
Economics

Submitted by:
Dimaandal, Bea Mari B.
Dimaano, Nica Mae M.
Dongon, Almira Eunice A.
Ebreo, Ronalyn Angel A.
Fajilan, Kimberly Mae M.
Ramirez, Lovely Raisa D.
Veran, Claudine Joy E.

BSA-3101

2024
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6.1 Assumptions of the Perfect Competition Model

What is a Perfect Competition Model?

Perfect competition or pure competition is an idealized market condition where many sellers
compete to offer the best prices and large sellers have no advantages over smaller ones.
(Hayes, 2024)

It is only a theoretical market structure in which there are no monopolies. Meaning, it is only a
representation of a perfect market condition where no single firm is dominating the market. We
should know that this condition rarely occurs in real-world markets and we are only using it as a
model to give us an idea how supply and demand affect prices and behavior in a market
economy.

Assumptions of the Perfect Competition Model

1. The market consists of many buyers.

Buyer acts as a price taker. The buyer takes the price as given and decides the amount
to purchase that best serves the utility of her household.

In this type of market, there are lots of buyers, and each one makes up only a tiny part of
the total demand. Since each buyer’s purchases are so small compared to the whole
market, no single buyer can affect the price of the product. They have to accept the
market price as it is and decide how much to buy based on that price. Consumer
behavior is insignificant to the pricing of the market.

2. The market consists of many sellers.

Seller acts as a price taker. The seller takes the price as given and decides the amount
to produce that will generate the greatest profit.

Just like with buyers, there are also many sellers in the market, and each one
contributes only a small portion to the overall supply. This means that no single seller
can influence the market price either. Sellers accept the market price and choose how
much they want to produce and sell to maximize their profit.
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3. Firms that sell in the market are free to either enter or exit the market.

New sellers are free to enter the market if they think they can make a profit, and existing
sellers can leave the market if it’s no longer profitable for them.

This assumption provides minimal or even non-existent barriers to entry and exit. Free
entry and exit prevent any single firm from dominating the market. If one firm makes
abnormally high profits, other firms will be enticed to also enter the market, increasing
the supply and demand, and driving the prices down until the profits of the firm return to
a normal level. This cycle keeps prices competitive and prevents monopolies or
excessive profits.

4. The goods sold by all sellers in the market are assumed to be homogeneous.

This means every seller sells the same good, or stated another way, the buyer does not
care which seller he uses if all sellers charge the same price.

This assumption provides that there is no differentiation in a perfectly competitive

market. If the same commodity is sold for the same price, the buyer does not care as to
which seller they are going to buy from. In the same manner, if a firm sells the same
commodity for a higher price, the buyers will shift to the firm with a lower price because
there is no quality differentiation to justify the higher price. Product homogeneity in a
perfectly competitive market eliminates the ability for firms to gain an advantage through
branding or differentiation. Instead, firms must operate efficiently to compete on price
alone, which promotes lower prices and maximizes consumer benefit.

5. Buyers and sellers in the market are assumed to have perfect information.

Both buyers and sellers know everything about the market. Sellers know what other
sellers can do and the resources they use, and both buyers and sellers are aware of the
prices everyone else is charging.

In this assumption, a perfectly competitive market prevents price manipulation. With no

information gaps, price changes will immediately be known to sellers and buyers, which
makes it hard for sellers to manipulate prices and charge unreasonably higher prices
than the market price. This cycle helps maintain competitiveness and stable price in the
market.
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6.2 Operation of a Perfectly Competitive Market in the Short Run

The consequence of the preceding assumptions is that all exchanges in a perfectly competitive
market will quickly converge to a single price.

Flat Demand Curve as Seen by an Individual Seller in a Perfectly Competitive Market

Any amount the firm offers for sale during

a production period (up to its maximum
possible production level) will sell at the
market price.

In the case of the perfect competition

model, since sellers are price takers and
their presence in the market is of small
consequence, the demand curve they see
is a flat curve, such that they can produce
and sell any quantity between zero and
their production limit for the next period,
but the price will remain constant.

Demand Curve as Seen for All Sellers in a Market

Although one seller sees a fixed price for

its supply, if all sellers were to increase
production, the maximum price that
customers would pay to buy all the units
offered would drop.

As the production level of all sellers

increases, the quantity demanded
increases as well while the price
decreases. When the supply increases,
the competition in the market intensifies
which drives the prices down, which
furthermore leads to increased demand.

In a competitive market, this process

helps achieve equilibrium where supply meets demand at a certain price level. The price
decrease adjusts to balance the increased supply with higher demand, stabilizing the market.
College of Accountancy, Business, Economics and International Hospitality Management

What is its implication on firms’ profitability in the short run?

We should know na even though all firms charge the same price, they might not earn the same
profit because not all have the same costs.

For example, Firm 1 uses machinery while Firm 2 uses manual labor in producing a 10-peso
product. Obviously, Firm 2 will cost more to produce than Firm 1. Let’s say Firm 2’s cost was 8
pesos while Firm 1’s is 5 pesos. Firm 1 will derive to a profit of 5 pesos while Firm 2 will only
have 2 pesos even though they both sold the product for 10 pesos.

This shows that, in the short run, not all firms earn the same profit, even though they all charge
the same market price. Consequently, not all the firms would be able to justify remaining in the
market if the market price were to remain the same, unless they were able to adapt their
production to match the more successful operators.

6.3 Perfect Competition in the Long Run

In a long-run perfect competition market scenario, firms experience conditions vastly different
from those in the short-run. In the short-run, firms face certain fixed or "sunk" costs and have
limited flexibility in adjusting all aspects of their production. However, the long run allows firms to
fully adjust their operations, scale, and strategies to achieve optimal efficiency, affecting
economic profits, pricing strategies, and overall market dynamics.

To better understand the Perfect Competition in the Long Run, here's the Key Points to
remember:

1. Economic Profits Disappear

In the long run, firms operating under perfect competition cannot sustain economic profits due to
the high degree of transparency and competition. A small advancement of the production
method of a firm can be eventually replicated or mimicked by the competitors, specifically on the
successful firms wherein their efficient practices became known and widespread. As a result of
this perfect competition, firms are forced to lower prices to remain in the competitive side. As
firms cut prices to match or exceed competitors, this results in diminishing economic profits, and
they'll eventually operate just enough to cover opportunity costs, eliminating excess economic
profits in the market.

2. Price Matching and Undercutting

With perfect competition, there is an assumption that firms sell homogeneous products, with
this, they must constantly monitor competitor prices to attract and retain customers. As they aim
to secure market share, firms keep offering lower prices that leads to price matching and even
undercutting between competitors. Each price cut by one firm forces competitors to respond
similarly, resulting in a downward trend in prices. This dynamic continues until firms reach a
College of Accountancy, Business, Economics and International Hospitality Management
break-even point, where prices stabilize and firms earn zero economic profit, covering only
production costs.

3. Minimum Efficient Scale (MES)

To maintain profitability in the long run, firms must achieve the minimum efficient scale (MES),
where production costs are minimized at a particular output level. Only firms that operate at this
scale can maintain profitability in the long-term competitive market. Infact, the larger firms are
usually the ones that can meet this scale as they can compete effectively despite lowering
prices. On the other hand, the smaller firms that struggle to achieve the MES don't have any
other choice but to scale up or exit the market.

4. Zero Economic Profit

The final equilibrium in a perfectly competitive market results in firms earning zero economic
profit. Firms earn just enough to cover opportunity costs but do not make excess profits. For
example, in an agricultural market like corn farming, numerous sellers offer similar quality
products, and buyers have perfect information about prices. This transparency forces sellers to
continuously match competitor prices, preventing any one farmer from raising prices
significantly. Over time, the market reaches a state of zero economic profit, where firms neither
gain excessive profit nor incur losses.

Therefore, only the most cost-effective firms survive since the long-run equilibrium in perfect
competition drives the firms to operate at a minimum efficient scale that matches production
cost with prices and results in earning at only normal profits.

Advantages and Disadvantages of Perfect Competition in the Long Run

One of the notable advantages of perfect competition in the long run is that it creates efficiency
in resource allocation since the firms operate at the level where price equals marginal cost.
Additionally, due to the competitive environment, firms try to innovate by improving their
processes or introducing new ideas to gain temporary advantage. While in the consumer
perspective, high competition drives to lower prices, benefiting them as the product becomes
more affordable. However, since perfect competition in the long run makes firms to only make
normal profits, this discourages the firms to invest in innovation since the profitability is limited,
and despite innovating, the competitors can quickly imitate any advancements they make that
results in diminishing the incentive to invest for the costly innovation. Moreover, on the
consumer side, they have limited choices as the variety of goods are homogeneous due to the
lack of product differentiation in the perfect competitive market. Thus, while perfect competition
fosters efficiency and low prices, it also limits profitability and product variety, creating
challenges for firms striving to grow and innovate.
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6.4 Firm Supply Curves and Market Supply Curves

In a competitive market, both firm and market supply curves help explain how producers
respond to changes in price. The firm supply curve shows the production decisions of a single
firm, while the market supply curve aggregates the responses of all firms in the market.

1. Firm Supply Curve

It reflects how much a single firm is willing to produce at various price levels. In perfect
competition, a firm’s goal is to produce at the level where the price equals marginal cost,
ensuring it maximizes profits or minimizes losses in the short run. When prices are high enough
to cover production costs, the firm will produce up to the point where price equals marginal cost.
If prices drop too low to cover costs, however, the firm will shut down temporarily, as it would
incur losses at any production level.

2. Operating Decisions Based on Marginal Cost

- Shut Down: If the price is too low to cover costs, the firm stops production temporarily to avoid
losses.
- Operate at Maximum: When prices are high enough to cover all costs, firms operate at full
capacity.
- Operate Where Price Equals Marginal Cost: For intermediate price levels, firms adjust
production to match marginal cost with the price, aiming to maximize short-run profits.

3. Shape of the Firm Supply Curve

In a perfectly competitive market, the firm’s supply curve corresponds to the upward-sloping
portion of its marginal cost curve above the shutdown point, representing the positive
relationship between price and quantity supplied.
. As prices increase, firms are motivated to produce more because each additional unit
becomes profitable.
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4. Formation of the Market Supply Curve

It reflects the aggregate individual supply curves of all firms in the market. It represents the total
quantity of a product that all firms combined are willing to supply at various price levels. Like the
firm supply curve, the market supply curve slopes upward, as rising prices incentivize firms to
increase production and may encourage firms that temporarily shut down to resume production.

In essence, the firm supply curve captures the price-quantity relationship for individual firms,
however , it may vary in size, production technology, and cost structure, causing individual
supply curves to differ slightly. While the market supply curve aggregates the responses of all
firms in the market, and regardless of differences of firms, the overall market supply curve
typically slopes upward as price and quantity supplied increase in response to potential
profitability.

To better understand the difference between the two curves, suppose there is a market for
apples.

Market Supply Curve

- At a price of $1 per pound, each farmer is willing to supply 100 pounds of apples.
- At a price of $2 per pound, each farmer is willing to supply 200 pounds of apples.
- At a price of $3 per pound, each farmer is willing to supply 300 pounds of apples.

In the market for apples, the market supply curve represents the combined supply from all apple
farmers. If each farmer is willing to supply a certain amount of apples at various price points, the
total market supply is the sum of these individual quantities. For instance, at $1 per pound, each
farmer supplies 100 pounds, leading to a market supply of 10,000 pounds if there are 100
farmers. As prices increase, so does the quantity supplied by the collective market.

Firm Supply Curve Example

- At a price of $1 per pound, the farm will produce 100 pounds of apples.
- At a price of $2 per pound, the farm will produce 150 pounds of apples.
- At a price of $3 per pound, the farm will produce 200 pounds of apples.

For an individual apple farm, the firm supply curve shows how many apples this single farm will
supply at different price levels. If prices are low, the farm may only supply a smaller amount. As
prices increase, the farm can cover higher production costs and thus increase its supply,
forming an upward-sloping supply curve.
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6.5 Market Equilibrium

In any marketplace, interactions between buyers and sellers determine the dynamics of supply
and demand. To understand this interaction, it's essential to define the following key terms:
● Market: The environment where buyers and sellers engage in the exchange of goods
and services, influenced by varying levels of supply and demand.
● Equilibrium: A state of balance where opposing forces are equal, resulting in stability.
● Market Equilibrium: The specific point at which buyers and sellers reach a state of
balance. Here, the quantity of goods demanded by consumers equals the quantity
supplied by producers.

Determining Market Equilibrium

● In order to have buyers and sellers agree on the quantity that would be provided and
purchased, the price needs to be at the right level. This is called the equilibrium price
where at this price, the sellers are able to sell exactly the quantity they want to sell and
the buyers are able to buy exactly the quantity that they want to buy. Basically, the
market equilibrium is the quantity and associated price at which there is concurrence
between sellers and buyers.
● If the market demand curve and market supply curve are displayed on the same graph,
the market equilibrium occurs at the point where the two curves intersect. The market
demand curve indicates the maximum price that buyers will pay to purchase a given
quantity of the market product. The market supply curve indicates the minimum price
that suppliers would accept to be willing to provide a given supply of the market product.

Suppose that in the market for pencils the market demand is given by the linear demand
function QD = 10 - p and the market supply is equal to QS = 2p - 2. In equilibrium, the number of
pencils that the sellers want to sell has to be equal to the number of pencils that the buyers want
to buy, i.e., quantity supplied has to be equal to the quantity demanded, or QD = QS. For the
demand and supply function of our example this means
College of Accountancy, Business, Economics and International Hospitality Management
10 - p = 2p - 2.
Now we only have to solve p to find the equilibrium price.
10 - p = 2p - 2
10 + 2 = 2p + p
12 = 3p
12 3𝑝
3
= 3
p=4

To find the corresponding equilibrium quantity, we substitute p back into either the demand or
supply function:
Demand: QD = 10 - p Supply: QS = 2p - 2
= 10 - 4 = 2(4) - 2
QD = 6 =8-2
QS = 6

Thus, in our market for pencils the equilibrium price is equal to 4, and at this price the quantity
exchanged is equal to 6 units.

The Invisible Hand in a Perfectly Competitive Market

Recall that the perfect competition model assumes all buyers and sellers in the market are price
takers. This raises an interesting question: If all the actors in the market take the price as a
given condition, how does the market get to an equilibrium price?

One answer to this question was provided by the person who is often described as the first
economist, Adam Smith. Smith ascribed the mechanism that moves a market to equilibrium as
a force he called the invisible hand. This metaphor describes how self-interested individuals
unknowingly contribute to the economic equilibrium through their actions. Even though they aim
to maximize their own gains, they help allocate resources efficiently in response to market
signals, leading the market towards equilibrium.

Excess Demand (Shortage) and Excess Supply (Surplus)

In effect, if the price is not at the equilibrium level, sellers will detect an imbalance between
supply and demand and some will be motivated to test other prices. If the existing market price
is below the equilibrium price, the provided supply will be insufficient to meet the demand. This
implies that the quantity demanded exceeds the quantity supplied and we call this situation
excess demand or shortage. We can illustrate this situation using our example demand and
supply equations. If the pencil price is set at 2 instead of 4, the quantity demanded is equal to 8,
but the quantity supplied is only equal to 2.
Demand: QD = 10 - p Supply: QS = 2p - 2
= 10 - 2 = 2(2) - 2
QD = 8 =4-2
QS = 2
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The price is so low that it is not profitable for the sellers to sell more than 2 units. This implies
that some customers who want to buy the good cannot, because there is no seller who wants to
sell to them at the market price. Sensing this, some suppliers will try a slightly higher price and
learn that, despite perfect information among buyers, some buyers will be willing to pay the
higher price if an additional amount would be supplied. Other sellers will see that the higher
price has enough demand and raise their prices as well. The new price may still be below
equilibrium, so a few sellers will test a higher price again, and the process will repeat until there
is no longer a perception of excess demand beyond the amount buyers want at the current
price.

If the market price is higher than the equilibrium price, sellers will initially respond with increased
rates of production but will realize that buyers are not willing to purchase all the goods available.
This means that the quantity supplied exceeds the quantity demanded - a situation called
excess supply or surplus. Coming back to our example: if the price p = 6 per pencil, the
quantity that sellers want to sell is equal to 10, while the quantity demanded is equal to 4 and
there is an excess supply of 10 - 4 = 6 units.
Demand: QD = 10 - p Supply: QS = 2p - 2
= 10 - 6 = 2(6) - 2
QD = 4 = 12 - 2
QS = 10
The price is considered so high for the buyers to purchase the product. This implies that there
are many sellers who would like to sell at the market price of 6, but are unable to find a buyer.
This causes some sellers to consider lowering the price slightly to make a sale of goods that
would otherwise go unsold. Seeing this is successful in encouraging more demand, and due to
buyers being able to shift their consumption to the lower priced sellers, all sellers will be forced
to accept the lower price. As a result, some sellers will produce less based on the change in
their firm supply curve and other sellers may shut down entirely, so the total market supply will
contract. This process may be repeated until the price lowers to the level where the quantity
supplied is in equilibrium with the quantity demanded.

These situations implies that whenever the market is not in equilibrium, either because the
market price is too high (excess supply) or too low (excess demand), the forces of supply and
demand will cause prices to adjust and the market price will move towards the equilibrium price.

6.6 Shifts in Supply and Demand Curves

There are five shifters of demand and supply

Five shifters of Demand are:

1. Tastes/Preferences: Changes in consumer interests or trends. For example, if a
celebrity promotes a certain sneaker brand, more people want it.
2. Number of Consumers: More buyers increase demand, fewer buyers decrease it. For
example, a town's population grows, increasing demand for housing.
College of Accountancy, Business, Economics and International Hospitality Management

3. Price of Related Goods: Substitutes and complements affect demand.For example, if

the price of coffee increases, demand for tea (a substitute) might rise.
4. Income: Higher income increases demand for normal goods, decreases it for inferior
goods. For example, when people earn more, they buy more luxury cars (normal goods)
and fewer instant noodles (inferior goods).
5. Future Expectations: Anticipated changes in price or availability influence current
demand. For example, if people expect gas prices to rise next week, they fill up their
tanks today.

Five shifters of Supply are:

1. Price of Resources: Higher costs reduce supply; lower costs increase it. Example: If the
cost of wheat rises, bakeries may produce less bread.
2. Number of Producers: More producers increase supply, fewer reduce it. Ex: More
farmers start growing apples, increasing the apple supply.
3. Technology: Better technology lowers costs, increasing supply. Ex: A new machine
makes producing smartphones faster and cheaper, increasing supply.
4. Taxes & Subsidies: Taxes decrease supply; subsidies increase it. Ex: A tax on
cigarettes reduces their supply, while a government subsidy for solar panels increases
supply.
5. Future Profit Expectations: If higher profits are expected, supply may decrease now to
save resources. Ex: If farmers expect higher grain prices next season, they might store
their current harvest instead of selling it now.

For the illustration of graphs regarding shifts in supply and demand curves, let us assume that
we have a hamburger business. Based on the 5 scenarios, let's assess how the curve will
change with the increase or decrease in demand and supply and how it will affect the price and
quantity.

1. New grilling technology cuts production time in

half

This graph shows the supply and demand for a

product (represented by quantity on the x-axis and
price on the y-axis). When a new technology reduces
production time, it increases the supply of the product.
This causes the supply curve to shift to the right (to the
new, bolder SS line). As a result, the equilibrium point
moves down, leading to a lower price and a higher
quantity of the product in the market.
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2. Price of chicken sandwiches (a substitute) increases.

In this graph, the demand for hamburgers has

increased because the price of chicken
sandwiches, a substitute, went up. This causes the
demand curve to shift to the right.

As a result:

● The equilibrium price increases.

● The equilibrium quantity also increases.

This shows that higher demand leads to higher

prices and quantities when the supply curve
remains the same.

3. Price of ground beef triples.

This graph shows that the supply of hamburgers

has decreased. When the supply curve shifts to
the left, it leads to:

● An increase in the equilibrium price.

● A decrease in the equilibrium quantity.

This means there’s less of the product available,

causing prices to rise and the quantity in the
market to fall, assuming demand remains the
same.
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4. Consumers became health conscious.

This graph shows the effect of a decrease in

demand on the equilibrium price and quantity in a
market.

When consumers become health conscious, they

may reduce their demand for hamburgers. This
decrease in demand shifts the demand curve.

As a result:

1. Equilibrium Price (P) decreases, shown

by the lower point on the vertical axis.
2. Equilibrium Quantity (Q) also decreases, shown by the lower point on the horizontal
axis.

So, in response to consumers becoming more health-conscious, the price and quantity of the
product decrease in this market.

In short, demand and supply shift to the right when it increases and move to the left when it
decreases. Also, demand has a direct relationship to price and quantity, while supply is inversely
affecting price and has a direct relationship to quantity.
College of Accountancy, Business, Economics and International Hospitality Management

5. Price of hamburgers decreases

Change in price of a product does not change the

curve of the graph. What happens is when the price
of the product decreases, the quantity demanded
increases because hamburgers are now cheaper,
and the quantity supply decreases because at a
lower price the producers are less willing to supply.
In this case, a shortage arises as quantity
demanded exceeds supply.

Now, what happens when supply and demand both change? Well, double shifting happens,
wherein when two curves shift at the same time, either the price or the quantity will be
indeterminate.

When both supply and demand increase, it

obviously increases the quantity while the price
is indeterminate. In this case, there are three
results that can happen in price.
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Huge Demand Increase, Small Supply

Increase:

● Demand shifts far right, supply shifts

slightly right.
● Quantity increases, price increases
significantly.
● Since the demand effect on price is
larger than supply, there's an overall rise in
price.

Equal Increases in Demand and Supply:

● Both demand and supply shift right by the

same amount.
● Quantity increases, but price stays the
same.
● Price increase from demand is canceled
out by the price decrease from supply.

Small Demand Increase, Huge Supply

Increase:

● Demand shifts slightly right, supply shifts

far right.
● Quantity increases, but price decreases.
● Small demand effect on price is
outweighed by the large supply effect, resulting in
a slight price drop.
College of Accountancy, Business, Economics and International Hospitality Management

When demand increases and supply decreases, it

obviously increases the price while the quantity is
indeterminate. In this case, there are three results that
can happen in quantity.

Huge
Demand Increase, Small Supply Decrease:

● Demand shifts far right; supply shifts

slightly left.
● Result: Both price and quantity increase.

Equal Increase in Demand and Decrease in

Supply:

● Demand and supply change equally in

opposite directions.
● Result: Price increases, but quantity stays
the same.
College of Accountancy, Business, Economics and International Hospitality Management

Small Demand Increase, Huge Supply Decrease:

● Demand shifts slightly right; supply shifts far

left.
● Result: Price increases, but quantity
decreases.

When demand decreases and supply increases, it

obviously decreases the price while the quantity is
indeterminate. In this case, there are three results that
can happen in quantity.

Huge Demand Decrease, Small Supply

Increase:

● Demand drops a lot; supply increases

a little.
● Result: Both price and quantity
decrease.
College of Accountancy, Business, Economics and International Hospitality Management

Equal Decrease in Demand and Increase in

Supply:

● Demand and supply change equally in

opposite directions.
● Result: Price decreases, but quantity stays
the same.

Small Demand Decrease, Huge Supply

Increase:

● Demand drops a little; supply increases

a lot.
● Result: Price decreases, but quantity
increases.

When demand decreases and supply decreases, it

obviously decreases the quantity while the price is
indeterminate. In this case, there are three results
that can happen in price.
College of Accountancy, Business, Economics and International Hospitality Management

Huge Demand Decrease, Small Supply

Decrease:

● Demand drops a lot; supply drops a little.

● Result: Both price and quantity decrease.

Equal Decrease in Demand and Supply:

● Demand and supply decrease by the

same amount.
● Result: Quantity decreases, but price
stays the same.

Small Demand Decrease, Huge Supply

Decrease:

● Demand drops a little; supply drops a

lot.
● Result: Quantity decreases, but price
increases.
College of Accountancy, Business, Economics and International Hospitality Management
Here’s a simple summary:

1. When demand or supply changes by different amounts:

○ Price or quantity change may be indeterminate because it depends on how
much each curve shifts.
2. When demand and supply shift equally:
○ Price often stays the same, while quantity either increases or decreases
depending on the direction of the shift.
3. When one shift is much larger than the other:
○ The larger shift usually determines the overall change in price and quantity.

6.7 Why Perfect Competition Is Desirable

Perfect competition represents an economic concept for market structure. Economists utilize it
to study behavior and outcomes in highly competitive marketplaces, implying that neither buyer
nor seller has any sort of advantage over other customers or sellers. In perfect competition,
every market participant engages on an equal playing field. It's an idealized market state in
which numerous vendors battle to offer the best costs, with significant sellers having no
advantage over smaller suppliers. Perfect competition is uncommon in real-world markets, but it
provides a valuable model for illustrating how supply and demand influence pricing and behavior
in a market economy.

Main Assumptions of the Perfect Competition Model

Markets in the ideal competition model exhibit the following characteristics:

➢ Many buyers and sellers are present.

➢ An identical product or service is bought and sold.
➢ Low barriers to entry and exit are present.
➢ All participants in the market have perfect information about the product or
service being sold.

1. In perfect competition, equilibrium occurs at the intersection of supply and demand.

In economics, equilibrium refers to the outcome that quantities in the model tend to gravitate
towards. In perfect competition, equilibrium occurs when supply equals demand. This is where
the supply and demand curves cross on the graph.

2. A perfectly competitive market brings itself into equilibrium without any outside
intervention.
If a market is perfectly competitive, it will eventually move toward market equilibrium without any
involvement of the government or other external pressures. Assume that the market price
exceeds the equilibrium. In such instance, surplus supply will exert downward pressure on
prices, causing supply to decline and demand to rise until they reach equilibrium. If the market
price is below equilibrium, surplus demand will exert upward pressure on the price, causing
supply to increase and demand to decrease until they reach equilibrium.
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3. Equilibrium in the perfect competition model is Pareto efficient.
The equilibrium in perfect competition is a desirable conclusion since it results in a Pareto
efficient allocation of the product being sold. Pareto efficiency implies that no one can be made
better off without making someone else worse off.

Pareto efficiency is a key implication of perfect competition. It suggests that any market
manipulation, such as setting price limits, floors, quotas, or taxes, may only benefit certain
groups of market players while harming others.

4. All businesses are price takers and will generate no profits in the long run.
A completely competitive company is a price taker, which means it must accept the equilibrium
price as given. Due to the amount of competition, sellers in perfect competition do not have the
ability to set prices. If a seller attempts to raise their price over the market-clearing price,
competitors will undercut them, causing purchasers to search elsewhere. The vendor has no
motivation to charge less than the market price because they may earn more by charging it. As
an extension of this principle, perfect competition implies that no vendor in the market will make
a profit over time. Sellers can only break even.

PRODUCER SURPLUS
The producer surplus is the gap between the price a seller obtains and their willingness to sell
for each quantity. Each price on a supply curve indicates a seller's marginal cost of producing
one unit of goods. As a result, the difference between the seller's price for each unit and the
cost of producing the final unit is the seller's gain from the price they get.

This refers to the benefit enjoyed by producers who sell at a greater price than they would have
been willing to sell for. Graphically, the area above the supply curve and below the market price.

CONSUMER SURPLUS
The price customers are willing to pay for a specific quantity of product indicates the consumers'
marginal benefit at that quantity. The marginal benefit is the amount of extra satisfaction that
customers gain from a product for the final unit they consume.

This refers to the advantage gained by paying a lower price than one's willingness to pay.
Graphically, the area below the demand curve and above the market price.

ALLOCATIVE EFFICIENCY
This refers to market production occurring at a quantity and price where MB=MC. There is
neither overproduction nor underproduction, and resources are allocated efficiently.

ALLOCATIVE INEFFICIENCY
MB is not equal to MC with the current price and quantity combination. There is either too much
or too little of the goods being produced.
College of Accountancy, Business, Economics and International Hospitality Management

DEADWEIGHT LOSS
A deadweight loss is the cost to society that results from market inefficiency, which arises when
supply and demand are out of balance. Deadweight loss, which is commonly used in
economics, refers to any shortfall produced by weak resource allocation.

This is the loss in total welfare caused by a market producing at an allocatively inefficient price
and quantity combination.

EXAMPLES

Problem:
In a perfectly competitive market for apples, the market supply and market demand curves are
given by the following equations:

Demand curve: P=20−0.5Q

Supply curve: P=5+0.5Q

Where:
P is the price per apple
Q is the quantity of apples in pounds

Determine the equilibrium price and equilibrium quantity in this market, and calculate the
consumer surplus and producer surplus.

Solution:
1. Find the equilibrium quantity and price:

At equilibrium, the quantity supplied equals the quantity demanded, so we set the demand curve
equal to the supply curve:

20−0.5Q = 5+0.5Q

Now, solve for Q:

20−5 = 0.5Q + 0.5Q
15 = 1Q
15 = Q

So, the equilibrium quantity is

Q=15 pounds.
College of Accountancy, Business, Economics and International Hospitality Management
Next, substitute this quantity into either the demand or supply curve to find the equilibrium price.
Using the demand curve:
P = 20−0.5(15)
P =20−7.5
P =12.5

So, the equilibrium price is

P = 12.5 per pound.

2. Calculate the Consumer Surplus (CS):

Consumer surplus is the area between the demand curve and the price line, up to the
equilibrium quantity.

The formula for consumer surplus is the area of the triangle:

Consumer Surplus = ½ x ×Base×Height

*Base: The equilibrium quantity Q=15 pounds.

*Height:The difference between the price consumers are willing to pay at Q=0 (which is the
y-intercept of the demand curve, P=20) and the equilibrium price P=12.5.

So, the consumer surplus is:

𝐶𝑆 = ½ × 15 × (20−12.5)
= ½ × 15 × 7.5
= 56.25
So, consumer surplus = 56.25.

3. Calculate the Producer Surplus (PS):

Producer surplus is the area between the price line and the supply curve, up to the equilibrium
quantity.

The formula for producer surplus is also the area of a triangle:

PRODUCER SURPLUS = ½ × Base × Height

*Base: The equilibrium quantity Q=15 pounds.

*Height: The difference between the equilibrium price P=12.5 and the price producers
are willing to accept at Q=0 (which is the y-intercept of the supply curve, P=5).
College of Accountancy, Business, Economics and International Hospitality Management
So, the producer surplus is:

PS= ½ × 15 × (12.5−5)
= ½ × 15 × 7.5
= 56.25

So, producer surplus = 56.25.

● The demand curve (blue line) shows how consumers' willingness to pay decreases as
the quantity increases.
● The supply curve (red line) shows the price producers are willing to accept for each
additional unit produced.
● The equilibrium point is where the two curves intersect, at Q = 15 and P = 12.5.
● The consumer surplus (shaded blue area) is the area between the demand curve and
the equilibrium price, up to the equilibrium quantity.
● The producer surplus (shaded red area) is the area between the supply curve and the
equilibrium price, up to the equilibrium quantity.

DEADWEIGHT LOSS
Problem: Consider a perfectly competitive market for a good where the demand and
supply are given by the following equations:
College of Accountancy, Business, Economics and International Hospitality Management
Demand Curve:
𝑄𝐷=100−2𝑃
Supply Curve: 𝑄𝑆=2𝑃−20

Where:

● Q is the quantity of the good.

● P is the price of the goods.

Now, the government imposes a tax of $10 per unit on producers. We need to calculate the new
equilibrium price and quantity after the tax and determine the deadweight loss.

Step 1: Find the original equilibrium (before the tax).

To find the equilibrium without the tax, set 𝑄𝐷=𝑄𝑆:

100−2𝑃=2𝑃−20

Solve for P:
100+20 = 4𝑃
⇒ 120 = 4𝑃
⇒ 𝑃=30

Now, substitute P=30 into either the demand or supply equation to find the equilibrium quantity
Q:
𝑄𝐷 =100−2(30)
=40
​
So, the equilibrium price is $30, and the equilibrium quantity is 40.

Step 2: Find the new equilibrium after the tax.

With a tax of $10 per unit, the supply curve shifts upward by $10. The new supply equation is:

𝑄𝑆=2(𝑃−10)−20=2𝑃−40

Now, set the new supply equal to the demand:

100−2𝑃 = 2P−40
College of Accountancy, Business, Economics and International Hospitality Management
Solve for P:

100+40=4P
⇒140=4P
⇒P=35

This is the price the consumers pay, but the producers receive 35−10=25

Now, substitute P=35P = 35P=35 into the demand equation to find the new quantity:
QD=100−2(35)
=30
So, the new equilibrium price paid by consumers is $35, the price received by producers is $25,
and the new quantity traded is 30.

Step 3: Calculate the Deadweight Loss.

The deadweight loss is the reduction in total surplus due to the tax. It is the area of the triangle
formed between the original equilibrium quantity (40), the new quantity (30), and the prices
consumers and producers receive.

The base of the triangle is the difference in quantity: 40−30=10.

The height of the triangle is the tax per unit: $10.

So, the deadweight loss (DWL) is:

DWL= ½ × base × height

= ½ ×10 × 10
=50

6.8 Monopolistic Competition

Monopolistic competition refers to a market structure that entails many companies (i.e. sellers)
offering a differentiated product but with a virtually identical utility to the end-user. This means
that while all sellers in the market sell a similar good that serves the same basic need of the
consumer, some sellers can make slight variations in their version of the good sold in the
market.

One example of monopolistic competition is the smartphone brands in the market. Samsung,
Oppo, and Vivo are the top smartphone brands in the market today. They all offer android
smartphones but with different variations. Samsung provides timely software updates, ensuring
that its devices remain secure and up-to-date with the latest features. Meanwhile, Oppo has
consistently pushed the boundaries of smartphone photography, introducing innovative features
like AI-powered image processing and advanced camera systems. On the otherhand, Vivo
College of Accountancy, Business, Economics and International Hospitality Management
offers devices with powerful processors and smooth performance, ensuring a seamless user
experience. These variations on the product only make sense if consumers are responsive to
these differences and are willing to pay a slightly higher price for the variation they prefer.

Unfortunately, even under monopolistic competition, firms can expect to do no better than a zero
economic profit in the long run. The rationale for this is as follows: Suppose a firm has
discovered a niche variation that is able to sustain a premium price and earn a positive
economic profit. Another firm selling in the market or a new entrant in the market will be
attracted to mimic the successful firm. Due to free entry and perfect information, the successful
firm will not be able to stop the copycats. Once the copycats are selling a copy of this product
variation, a process of price undercutting will commence as was described for perfect
information, and prices will continue to drop until the price equals average cost and firms are
earning only a zero economic profit.

6.9 Contestable Market Model

In the contestable market model, there can be a modest number of sellers, each of which
represents a sizeable portion of overall market sales. However, the assumptions of free entry
and exit and perfect information need to be retained and play a key role in the theory underlying
this model. If buyers in the market know which seller has the lowest price and will promptly
transfer their business to the lowest price seller, once again any firm trying to sell at a higher
price will lose all its customers or will need to match the lowest price.

It may be argued that the selling firms, by virtue of their size and being of limited number, could
all agree to keep prices above their average cost so they can sustain positive economic profits.
However, here is where the assumption of free entry spoils the party. Because if the company
charges too much or offers poor service, new companies can quickly swoop in, grab customers,
and undercut prices. This threat of competition keeps the original company in check, making it
act more like a competitive market, even if it's technically a monopoly. A new entrant could see
the positive economic profits of the existing sellers, enter the market at a slightly lower price,
and still earn an economic profit. Once it is clear that firms are unable to sustain a pact to
maintain above cost prices, price competition will drive the price to where firms will get zero
economic profits.

6.10 Firm Strategies in Highly Competitive Markets

In markets resembling perfect competition, consumers benefit from increased social
surplus. However, individual businesses struggle because they have to carefully control costs
and adjust to changing market conditions, hence yielding limited profits. Though long-term
profits are limited, well-executed strategies can help firms survive and occasionally generate
returns above average costs.

In Competitive Strategy, Michael Porter of Harvard University outlines a road map for
firms to prevail in these competitive markets. He outlined two main strategies:
College of Accountancy, Business, Economics and International Hospitality Management

1. Cost Leadership strategy

It is a strategy where firms keep their costs below the costs of other sellers. This
approach may encompass the pursuit of economies of scale, proprietary technology, preferential
access to raw materials, and other factors. A low-cost producer needs to identify and take
advantage of every area of cost advantage. If a firm can attain and sustain overall cost
leadership, then it will be an above-average performer in its industry, given that it can command
prices at or near the industry average.

Examples of firms/companies that uses cost leadership strategy:

● Walmart - the most well-known cost leader that employs effective supply management,
capitalizes on economies of scale, and strikes advantageous deals with suppliers
● IKEA - lowers costs while providing customers with fashionable and reasonably priced
furniture by using flat packaging for convenient transportation, producing items for
effective manufacture, and introducing self-service in-store operations
● McDonald’s - has effective supply chain management and employs standardized menus

In a perfect competition model, some firms achieve short-term success by producing

goods at a reduced cost with the help of better technology, management, or economies of scale.
However, because competitors can access the same information, these cost advantages are
soon copied. Firms that use a cost leadership strategy must constantly look for ways to cut
costs to stay ahead of the competition. In this manner, the leader will have already lowered its
average cost by the time competitors catch up. This necessitates a continuous dedication to
cost reduction.

2. Product Differentiation strategy

It is a strategy that allows firms to make their products distinguishable from the
competition. This strategy chooses one or more qualities that many buyers in an industry value
and uniquely positions itself to meet those needs. It commands a premium price in recognition
of its originality.

Examples of firms/companies that uses product differentiation strategy:

● Apple - their iPhone product
● Tesla - focuses on electric vehicles and sustainable energy solutions
● Coca-Cola - their brand image and emotional connection with consumers

In monopolistic competition, firms are able to charge more for unique products
because consumers are willing to pay more for distinctive products. However, the original firm's
advantage is diminished when competitors start to provide comparable items after noticing
successful innovations. In order to maintain above-average revenues, Porter's product
differentiation strategy entails continuously creating new product variations that consumers
value. Consistent investment in market research and innovation is essential for success here.
College of Accountancy, Business, Economics and International Hospitality Management
Porter also proposed the focus strategy where each of his two approaches may be
tailored to a certain market niche or aimed at market participation in general. This strategy
capitalizes on market segmentation. By focusing on the specific needs of this market, the firm
can either provide more affordable prices or unique products that appeal to this demographic,
which will postpone competition and increase profitability. Businesses must choose if a focused
or broader approach is more appropriate for their market and available resources because
concentrating on a single segment can limit potential revenues in other areas.
Additionally, the focus strategy has two variants:
a. Cost Focus - where firm seeks a cost advantage in its target segment; and
b. Differentiation Focus - where a firm seeks differentiation in its target segment.

The risk of being “stuck in the middle”

Despite the apparent benefits, Porter cautions against pursuing both cost leadership and
product differentiation strategies at the same time because doing so could leave a firm "stuck in
the middle." The situation arises when a firm attempts to deliver distinctive product features at a
large cost reduction, effectively trying to simultaneously appeal to consumers who are
quality-focused and price-sensitive. It should be noted that each strategy has different goals. For
example, the cost leadership strategy seeks to draw in price-conscious consumers by lowering
production costs, while the product differentiation strategy aims to attract consumers who are
prepared to pay more for distinctive or superior products, necessitating greater investment in
branding, development, and innovation.
College of Accountancy, Business, Economics and International Hospitality Management

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Action, I. (2016). Successful Examples Of Product Differentiation In Action - FasterCapital.
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