Perfect Competition

Chavi Asrani
Market Structure: Perfect Competition

§ The impact of the product market on firms’ prices and output choices is determined
by the nature of the product and the market structure in which they operate.
§ In perfect competition firms produce a homogeneous product and are price-takers in
their output markets.
§ All profit-maximising firms choose their output to equate marginal cost with marginal
revenue.
Perfect Competition
Market Structure and Firm Behaviour
§ Competitive behaviour refers to the extent to which individual firms compete with each
other to sell their products.
§ Competitive market structure refers to the power that individual firms have over the market
- perfect competition occurring where firms have no market power and hence no need to
react to each other.

Perfectly Competitive Markets

§ The theory of perfect competition is based on the following assumptions
§ Firms sell a homogenous product
§ Customers are well informed
§ Each firm is a price-taker
§ Industry can support many firms
§ Firms are free to enter or leave the industry.
Assumptions of perfect competition
§ All the firms in the industry sell an identical or homogeneous product.
§ Buyers of the product are well informed about the characteristics of the product being
sold and the prices charged by each firm- customers are well informed
§ When each firm is operating at its normal capacity, its output is a small fraction of the
industry’s total output.
§ Each firm is a price taker.
§ There is freedom of entry and exit
§ The industry can support many firms
§ The implications of these conditions are:
§ A single market price is determined by the interaction of demand and supply
§ Firms earn zero economic profits in the long run.
Perfect Competitive Markets
PRICE TAKING

Each individual firm sells a sufficiently small proportion of total market output.

PRODUCT HOMOGENEITY

When products of all of the firms in a market are perfectly substitutable with one another

No firm can raise the price of its product above the price of other firms without losing most
or all of its business.

In contrast, when products are heterogeneous, each firm has the opportunity to raise its price
above that of its competitors without losing all of its sales.

Assumption of product homogeneity is important because it ensures that there is a single market price,
consistent with supply-demand analysis.
Free Entry and Exit
§ Condition under which there are no special costs that make it difficult for a firm to enter (or exit)
an industry.
§ With free entry & exit, buyers can easily switch from one supplier to another, and suppliers can
easily enter or exit a market.
§ Markets are highly competitive in the sense that firms face highly elastic demand curves with
relatively easy entry & exit.
§ There is no simple rule of thumb to describe whether a market is close to being perfectly
competitive.
§ Because firms can implicitly or explicitly collude in setting prices, the presence of many firms is
not sufficient for an industry to approximate perfect competition.
Profit Maximization
For smaller firms managed by their owners, profit is likely to dominate almost all decisions.

In larger firms, however, managers who make day-to-day decisions usually have little contact
with the owners.

Firms that do not come close to maximizing profit are not likely to survive.

Firms that do survive make long-run profit maximization one of their highest priorities.

Alternative Forms of Organization

Cooperative : Association of businesses or people jointly owned and operated by members for
mutual benefit.
Condominium A housing unit that is individually owned but provides access to common
facilities that are paid for and controlled jointly by an association of owners.
A major distinction between firms operating in perfectly competitive markets and firms
operating in any other type of market is the shape of the firm’s own demand curve.

In perfect competition each firm faces a demand curve that is horizontal, because
variations in the firm’s output have no noticeable effect on price so that the firm can
sell all it wishes to sell at that price.
Demand at the market & firm levels under perfect competition
Price Price
Market Firm
S

𝑃! 𝐷 " = 𝑃!

0 Market Firm’s
output output
Demand and Marginal Revenue for a Competitive Firm

A competitive firm supplies only a small portion of the total output of all the firms in an industry.
Therefore, the firm takes the market price of the product as given, choosing its output on the
assumption that the price will be unaffected by the output choice.
(a) demand curve facing the firm is perfectly elastic: AR=MR=Price
(b) is downward sloping. even though the market demand curve in
Competitive Firm’s Demand
The demand curve for a competitive firm’s product is a
horizontal line at the market price.

This price is the competitive firm’s marginal revenue.

𝐷 ! = 𝑃 = 𝑀𝑅
Profit Maximization under Perfect Competition
$
𝑴𝑪 𝑨𝑻𝑪

𝑷𝒆 𝑫𝒇 = 𝑷𝒆 = 𝑴𝑹
Profits
𝑨𝑻𝑪 𝑸∗

0 𝑸∗ Firm’s output
Short-run output decisions
§ The short run is a period of time over which some factors of production
are fixed and some variable.
§ To maximize short-run profits, managers must take the fixed inputs as
given, and determine how much output to produce by changing the
variable inputs.
Because each firm in a competitive industry sells only a small fraction of the
entire industry output, how much output the firm decides to sell will have no
effect on the market price of the product. Firm is a price taker, demand curve
facing a competitive firm is given by a horizontal line.
Demand curve facing an individual firm in a competitive market is both its
average revenue curve and its marginal revenue curve. Along this demand curve,
marginal revenue, average revenue, and price are all equal.
Profit Maximization by a Competitive Firm
A perfectly competitive firm should choose its output so that marginal cost equals
price: MC(q) = MR = P
To maximize profits, a perfectly competitive firm produces the output at which price
equals marginal cost in the range over which marginal cost is increasing.
𝑷 = 𝑴𝑪 𝑸
Revenue, Costs, and Profits for a Perfectly Competitive Firm
Costs
$
𝐶 𝑄
Revenue
𝑅 = 𝑃×𝑄
B
Maximum
profits
Slope of 𝐶 𝑄 = 𝑀𝐶
Slope of 𝑅 = 𝑀𝑅 = 𝑃
A E

0 𝑄∗ Firm’s output
Marginal Revenue, Marginal Cost, and Profit Maximization
Profit Difference between total revenue and total cost.
Marginal revenue Change in revenue resulting from a one-unit increase in output.

PROFIT MAXIMIZATON IN
THE SHORT RUN

A firm chooses output q*, so that

profit, the difference AB between
revenue R and cost C, is maximized.

At that output, marginal revenue (the

slope of the revenue curve) is equal to
marginal cost (the slope of the cost
curve).
MR(q) = MC(q)
Competitive Output Rule In Action
§ The cost function for a firm is 𝐶 𝑄 = 5 + 𝑄 ! .
§ If the firm sells output in a perfectly competitive market and other firms
in the industry sell output at a price of $20, what price should the
manager of this firm charge? What level of output should be produced
to maximize profits? How much profit will be earned?
§ Answer:
§ Charge $20.
§ Since marginal cost is 2𝑄, equating price and marginal cost yields: $20 = 2𝑄 ⟹
𝑄 = 10 units.
§ Maximum profits are: 𝜋 = 20×10 − 5 + 10! = $95.
When Should the Firm Shut Down?
IF A COMPETITIVE FIRM IS
INCURRING LOSSES

A competitive firm should

shut down if price is below
AVC.

Firm may produce in the

short run if price is greater
than average variable cost.
Equilibrium in the short run
Producer Surplus in the Short Run
Sum over all units produced by a firm of differences between the market price of a good and
the marginal cost of production.

Measured by the yellow area below the

market price and above the marginal cost
curve, between outputs 0 and q*, the profit-
maximizing output.

Alternatively, it is equal to rectangle ABCD

because the sum of all marginal costs up to
q* is equal to the variable costs of
producing q*.

Fixed cost does not change in the short run

Choosing Output in the Long Run
OUTPUT CHOICE IN THE LONG RUN Long-Run Profit Maximization

Firm maximizes its profit by

choosing the output at which
price = long-run marginal cost

Long-run output of a profit-maximizing competitive firm is the point at which long-run marginal cost equals price.
Effects of a Tax
EFFECT OF AN OUTPUT TAX ON A COMPETITIVE FIRM’S OUTPUT

An output tax raises the firm’s marginal cost

curve by the amount of the tax.

Firm will reduce its output to the point at

which the marginal cost plus the tax is equal
to the price of the product.
Effect of an output tax on industry output

An output tax placed on all

firms in a competitive market
shifts the supply curve for the
industry upward by the amount
of the tax.

This shift raises the market

price of the product and lowers
the total output of the industry.