Perfect

Competition

1
FOUR MARKET STRUCTURES
Perfect Monopolistic Pure
Competition Competition Oligopoly Monopoly
Imperfect Competition

Characteristics of Perfect Competition:

Examples of Perfect Competition: potato farmers

Many small firms

Identical products (perfect substitutes)
Easy for firms to enter and exit the industry
Seller has no need to advertise
Firms are Price Takers
The seller has NO control over price.
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Assumptions of the model
Perfect competition is considered as the ideal or the standard against which everything is judged.
Perfect competition is characterised as having:
Many buyers and sellers. Nobody has power over the market.
Perfect knowledge by all parties. Customers are aware of all the products on offer and their
prices.
Firms can sell as much as they want, but only at the current price. Thus sellers have no
control over market price. They are price takers, not price makers.
All firms produce the same product, and all products are perfect substitutes for each other,
i.e. goods produced are homogenous.
There is no advertising nor brand loyalty
There is freedom of entry and exit from the market. Firms can, and will come and go as
they wish.
Companies in perfect competition in the long-run are both productively and allocatively
efficient.
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 Perfectly Competitive Firms
Example:
Say you are in Thailand and go to buy a hammock.
After visiting at few different shops you find that the
buyers and sellers always agree on $15.
This is the market price (where demand and supply meet)
1. Is it likely that any shop can sell hammocks for $20?
2. Is it likely that any shop will sell hammocks for $10?
3. What happens if a shop prices hammocks too high?
4. Do you think that these firms make a large profit off of
hammocks? Why?
These firms are price takers because the sell their products
at a price set by the market.

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 Demand for Perfectly Competitive Firms
Why are they Price Takers?
If a firm charges above the market price, NO ONE
will buy. They will go to other firms
There is no reason to offer a lower price because
consumers will buy just as much at the market price.

Since the price is the same at all quantities demanded,

the demand curve for each firm is
Perfectly Elastic
(A Horizontal straight line)
5
 The Competitive Firm is a Price Taker
Price is set by the Industry

P S P

$15 $15 Demand

D
5000 Q Q
Industry Firm
6
(price taker)
 The Competitive Firm is a Price Taker
Price is set by the Industry
What is the additional
revenue for selling an P
additional unit?
1st unit earns $15
2nd unit earns $15
Marginal revenue is $15 Demand
constant at $15 MR=D=AR=P
Notice:
Total revenue increases
at a constant rate
MR equal Average Q
Revenue Firm
7
(price taker)
 The Competitive Firm is a Price Taker
Price is set by the Industry
What is the additional
revenue for selling an P
For Perfect
additional unit? Competition:
1st unit earns $15
2nd unit earnsDemand
$15 = MR
Marginal revenue is $15 Demand
constant at(Marginal
$15 Revenue)MR=D=AR=P
Notice:
Total revenue increases
at a constant rate
MR equal Average Q
Revenue Firm
8
(price taker)
 REVIEW - Perfect Competition
In perfect competition, the market is the sum of all of the individual firms.
The market is modelled by the standard market diagram (demand and supply) and the firm is modelled by the
cost model (standard average and marginal cost curves).
The firm as a price taker simply 'takes' and charges the market price (P* in Figure 1).

Figure 1 Equilibrium of the firm and industry in perfect competition

This price represents their average and marginal revenue curve.

Onto this we superimpose the marginal and average cost curves and this gives us the equilibrium of the firm.
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 REVIEW - Perfect Competition
Firms in equilibrium in perfect competition will make just normal profit.
This level of profit is just enough to keep them in the industry and since profits are adequate they have no
incentive to leave.

Normal profits
Normal profit is the level of profit that is required for a firm to keep the resources they are using in their
current use.
In other words it is enough profit to keep them in the industry.
Anything in excess of normal profits is called abnormal or supernormal profits.

Any profit above normal profit is a 'bonus' for the firms, as it is more than they need to keep them in the
industry.
We call this supernormal (or abnormal) profit.
However, this supernormal profit will be a signal to other firms and will attract more firms into the
industry.
If firms are making consistently below normal profits then they will choose to leave the industry.
of the firm.
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What does this mean for prices and competition?
Consider the following case.
A firm enters a perfectly competitive market with a product.
It sells Q1 units of its product at price P1.
Figure 2 Firm in perfect competition making supernormal profit
It is able to make supernormal profits at this stage.
It sells at P1 but has a cost of only C.
It makes SNP's of P1 to C per unit sold.
Competition is perfect.
New firms enter the market.
Supply increases (the supply curve shifts to the right - S2) and prices fall.
The original firm has to lower its price or it will sell nothing.
It charges P2 (the same as the market price) and so now sells Q2.
The market size expands from Q1 to Q2.

Figure 3 The impact on a market of supernormal profit

The presence of SNP's has attracted more firms to the market and this has led to the price falling.
The supernormal profits were competed away and equilibrium was reached where only normal profit was earned.
Each of the firms will now be in long run equilibrium earning only normal profit.
The long run equilibrium is where MC = MR = AC = AR.

Figure 4 Long run equilibrium in perfect competition

The falling prices put pressure on the less efficient firms.

They may be forced to close and transfer their assets elsewhere.
Break-even price
The break-even price in perfect competition is where normal profits are made and AR = P = ATC = MC = MR.

Figure 7 Perfect competition - break-even price

Shut down price
A firm may make a loss in the short run, providing
AVC is being covered and some contribution is
being made to the fixed costs.

If a firm is unable to cover its AVCs,

i.e. its day-to-day running costs,
it will shut down immediately.

Figure 8 Shut down point

Here output is OQ*, where MC = MR. A loss of PBCE is being made, as ATC is greater than AR.
The fixed costs are given by the area ABCD.

Thus if the firm receives a price of OP it will not cover all its costs but will contribute the area APED towards its
fixed costs which have to be met even if output is zero.
It will therefore be worth remaining in the business at least in the short run.

However, if the price were to fall to OP1 (the lowest point on the AVC curve, where AVC = MC), the firm would
shut down immediately as it would be covering neither its fixed nor its variable costs.
Do perfectly competitively industries exist?
No 'perfect' perfectly competitive industries exist.

One of the closest today is probably the market for shares.

However, as we mentioned before, it is still an important model as it provides a benchmark

against which other markets can be judged.

It can help in formulating appropriate policies to improve uncompetitive markets.

Efficient allocation of resources
Economists are concerned about the efficiency of markets, and ensuring that resources are allocated efficiently.

Perfect competition is considered to be efficient because:

Supernormal profits are not made by any firm in perfect competition in the long-run.

MC = price, so both parties, suppliers and customers, get exactly what they want.

No wasteful advertising.

Firms are allocatively and productively efficient.

The major assumption behind this analysis and evaluation is that firms cannot produce products cheaper if they
were bigger.
It assumes that there are no economies of scale available in the market.
Allocative efficiency
Allocative efficiency occurs when the value consumers put on the good or service equals the cost of producing the
product or service.

In other words, when price = marginal cost.

Productive efficiency

Productive efficiency occurs when output is achieved at the minimum average cost.
When perfect competition is in long-run equilibrium, it achieves allocative and productive
efficiency as MC = MR = AC = AR.

This means that they are maximising profits (MC = MR) but only making normal profit (AC = AR).

Figure 1 Long-run equilibrium - perfect competition

So, perfect competition looks good, but is it always so?

Problems with perfect competition are:

There are no reasons to do anything better, or research new products. As soon as you do,
everybody else would step in and copy. Better to wait and let somebody else do it.

Consumer has no choice. There is just one unbranded product on the market.

Some economies of scale always exist.

Perfect competition is not really competitive!

Barriers to entry will always exist.

Perfect competition may well operate efficiently, as far as economists are concerned.
The consumer, however, may get an ordinary product or service at a high price.
Is it worth it?
Maximizing
PROFIT!

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 Short-Run Profit Maximization
What is the goal of every business?
To Maximize Profit!!!!!!

To maximum profit firms must make the right output

Firms should continue to produce until the additional
revenue from each new output equals the additional cost.

Example (Assume the price is $10)

Should you produce
if the additional cost of another unit is $5
if the additional cost of another unit is $9
if the additional cost of another unit is $11 22
 Short-Run Profit Maximization
What is the goal of every business?
To Maximize Profit!!!!!!
To maximum profit firms must make the right
output
Firms should continue to produce until the
Profit Maximizing Rule
additional revenue from each new output

MR=MC
equals the additional cost.
Example (Assume the price is $10)
Should you produce
if the additional cost of another unit is $5
if the additional cost of another unit is $9
if the additional cost of another unit is $11 23
How much output should be produced?
How much is Total Revenue? How much is Total Cost?
Is there profit or loss? How much?
P
$9 MC
8
7 MR=D=AR=P
6 Profit = $18 ATC
5 AVC
4
3 Dont forget
2 that averages
1 Total Cost=$45 show PER
Total Revenue =$63 UNIT COSTS
1 2 3 4 5 6 7 8 9 10 Q
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Suppose the market demand falls. What
would happen if the price is lowered from
$7 to $5?

The MR=MC rule still applies but now the

firm will make an economic loss.
The profit maximizing rule is also the
loss minimizing rule!!!

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How much output should be produced?
How much is Total Revenue? How much is Total Cost?
Is there profit or loss? How much?

MC
Cost and Revenue
$9
8
7 ATC
6 AVC
Loss =$7
5
4 MR=D=AR=P
3
2 Total Cost = $42
Total Revenue=$35
1
1 2 3 4 5 6 7 8 9 10 Q
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 Assume the market demand falls even
more. If the price is lowered from $5 to $4
the firm should stop producing.
Shut Down Rule:
A firm should continue to produce as long
as the price is above the AVC
When the price falls below AVC then the
firm should minimize its losses by shutting
down
Why? If the price is below AVC the firm is
losing more money by producing than the
they would have to pay to shut down.
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 SHUT DOWN! Produce Zero

MC
Cost and Revenue
$9
8 ATC
7
6 AVC
5
4
Minimum AVC
3
is shut down
2
point
1
1 2 3 4 5 6 7 8 9 10 Q
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 P<AVC. They should shut down
Producing nothing is cheaper than staying open.

MC
Cost and Revenue
$9
8
7 ATC
Fixed Costs=$10
6 AVC
5
TC=$35
4 MR=D=AR=P
3
2
TR=$20
1
1 2 3 4 5 6 7 8 9 10 Q
29
 Profit Maximizing Rule
MR = MC
Three Characteristics of MR=MC Rule:
1. Rule applies to ALL markets
structures (PC, Monopolies, etc.)
2. The rule applies only if price is
above AVC
3. Rule can be restated P = MC for
perfectly competitive firms (because
MR = P) 30
Side-by-side graph for perfectly completive
industry and firm.
Is the firm making a profit or a loss? Why?
P S P
MC

ATC
$15 $15 MR=D
AVC

D
5000 Q 8 Q
Industry Firm
31
(price taker)
Where is the profit maximization point? How do you know?
What output should be produced? What is TR? What is TC?
How much is the profit or loss? Where is the Shutdown Point?

$25
MC
Cost and Revenue
20
MR=P
Profit
ATC
15 AVC

10
Total Revenue Total Cost

0
32
1 2 3 4 5 6 7 8 9 10
Supply Revisited

33
 Marginal Cost and Supply
As price increases, the quantity
increases
$5
MC
0
Cost and Revenue

45 ATC
40 MR5
35 AVC MR4
30
MR3
25
MR2
20
15 MR1
10
5 Q
0 1 2 3 4 5 6 7 9
34
 Marginal Cost and Supply
When price increases, quantity increases
When price decrease, quantity decreases
$5
MC = Supply
0
Cost and Revenue

45 ATC
MC above AVC is the
40
35 AVC
30 supply curve
25
20
15
10
5 Q
0 1 2 3 4 5 6 7 9
35
 Marginal Cost and Supply
What if variable costs increase (ex: tax)?
MC2=Supply2
$5
0
Cost and Revenue

45 MC1=Supply1
40
AVC
35
30
AVC
25
20
15
When MC increases, SUPPLY decrease
10
5 Q
0 1 2 3 4 5 6 7 9
36
 Marginal Cost and Supply
What if variable costs decrease (ex: subsidy)?
$5 MC1=Supply1
0
Cost and Revenue

45 MC2=Supply2
40
AVC
35
30
AVC
25
20
15
When MC decreases, SUPPLY increases
10
5 Q
0 1 2 3 4 5 6 7 9
37
Perfect Competition in
the Long-Run
You are a wheat farmer. You learn that
there is a more profit in making corn.
What do you do in the long run?

38
In the Long-run
Firms will enter if there is profit
Firms will leave if there is loss
So, ALL firms break even, they make
NO economic profit
(No Economic Profit=Normal Profit)
In long run equilibrium a perfectly
competitive firm is EXTREMELY
efficient.

39
Side-by-side graph for perfectly completive
industry and firm in the LONG RUN
Is the firm making a profit or a loss? Why?
P S P
MC
ATC

$15 $15 MR=D

D
5000 Q 8 Q
Industry Firm
40
(price taker)
Firm in Long-Run Equilibrium
Price = MC = Minimum ATC
Firm making a normal profit
P
MC
ATC

$15 MR=D
There is no incentive
to enter or leave the
TC = TR industry
8 Q 41
Going from Long-Run to
Short-Run

42
 1. Is this the short or the long run? Why?
2. What will firms do in the long run?
3. What happens to P and Q in the industry?
4. What happens to P and Q in the firm?
P S P
MC

ATC
$15 $15 MR=D

D
5000 6000 Q 8 Q
Industry Firm 43
Firms enter to earn profit so supply
increases in the industry
Price decreases and quantity increases
P S P
MC
S1

ATC
$15 $15 MR=D
$10
D
5000 6000 Q 8 Q
Industry Firm 44
Price falls for the firm because they are
price takers.
Price decreases and quantity decreases
P S P
MC
S1

ATC
$15 $15 MR=D
$10 $10 MR1=D1
D
5000 6000 Q 5 8 Q
Industry Firm 45
New Long Run Equilibrium at $10 Price
Zero Economic Profit

P P
MC
S1

ATC

$10 $10 MR1=D1

D
5000 6000 Q 5 Q
Industry Firm 46
 1. Is this the short or the long run? Why?
2. What will firms do in the long run?
3. What happens to P and Q in the industry?
4. What happens to P and Q in the firm?
P S P
MC
ATC

$15 $15 MR=D

D
4000 5000 Q 8 Q
Industry Firm 47
Firms leave to avoid losses so supply
decreases in the industry
Price increases and quantity decreases
S1
P S P
MC
ATC

$20
$15 $15 MR=D

D
4000 5000 Q 8 Q
Industry Firm 48
Price increase for the firm because they
are price takers.
Price increases and quantity increases
S1
P S P
MC
ATC

$20 $20 MR1=D1

$15 $15 MR=D

D
4000 5000 Q 89 Q
Industry Firm 49
New Long Run Equilibrium at $20 Price
Zero Economic Profit

S1
P P
MC
ATC

$20 $20 MR1=D1

D
4000 Q 9 Q
Industry Firm 50
Going from Long-Run to
Long-Run

51
 Currently in Long-Run Equilibrium
If demand increases, what happens in the short-run
and how does it return to the long run?

P S P
MC
ATC
MR1=D1
$15 $15 MR=D

D
5000 Q 8 Q
Industry Firm 52
 Demand Increases
The price increases and quantity increases
Profit is made in the short-run
P S P
MC
ATC
$20 $20 MR1=D1
$15 $15 MR=D
D1
D
5000 Q 8 9 Q
Industry Firm 53
 Firms enter to earn profit so supply
increases in the industry
Price Returns to $15
P S S1 P
MC
ATC
$20 $20 MR1=D1
$15 $15 MR=D
D1
D
5000 7000 Q 8 9 Q
Industry Firm 54
 Back to Long-Run Equilibrium
The only thing that changed from long-run to
long-run is quantity in the industry
P S1 P
MC
ATC

$15 $15 MR=D

D1
D
7000 Q 8 Q
Industry Firm 55
Efficiency

56
 PURE COMPETITION AND EFFICIENCY

In general, efficiency is the optimal use

of societies scarce resources
Perfect Competition forces producers to use
limited resources to their fullest.
Inefficient firms have higher costs and are
the first to leave the industry.
Perfectly competitive industries are
extremely efficient
There are two kinds of efficiency:
1. Productive Efficiency
2. Allocative Efficiency 57
 Efficiency Revisited
Which points are productively efficient?
Which are allocatively efficient?
Productive Efficient
A
14 combinations are A through D
B G
12 (they are produced at the
lowest cost)
Bikes

10

8
C
Allocative Efficient
E
6
combinations depend on
4
F
the wants of society
2
D
0
0 2 4 6 8 10
Computers 58
 Productive Efficiency
The production of a good in a least
costly way. (Minimum amount of
resources are being used)
Graphically it is where
Price = Minimum ATC

59
 Short-Run
MC
ATC
D=MR
Price Profit

Notice that the product is NOT being made

at the lowest possible cost
(ATC not at lowest point).
Q
Quantity
60
 Short-Run
MC
ATC
Price

P Loss
D=MR

Notice that the product is NOT being made at the

lowest possible cost (ATC not at lowest point).

Q
Quantity
61
 Long-Run Equilibrium
MC
ATC
Price

D=MR
P

Notice that the product is being made at

the lowest possible cost (Minimum ATC)
Q
Quantity 62
Allocative Efficiency
Producers are allocating resources
to make the products most wanted
by society.
Graphically it is where
Price = MC
Why? Price represents the benefit
people get from a product.
63
 Long-Run Equilibrium
MC
Price
P MR
Optimal amount
being produced
The marginal benefit to society
(as measured by the price) equals
the marginal cost.
Q
Quantity 64
What if the firm makes 15 units?
MC

MR
Price
$5
The marginal benefit to
$3 society is greater the
marginal cost.
Not enough produced.
Society wants more
15 20 Underallocation
Quantity of resources 65
What if the firm makes 22 units?

MC
$7
MR
Price
$5
The marginal benefit to
society is less than the
marginal cost.
Too much Produced.
Society wants less

20 22 Overallocation of
Quantity resources 66
 Long-Run Equilibrium

MC
ATC
Price

D=MR
P

P = Minimum ATC = MC
EXTREMELY EFFICIENT!!!!
Q
Quantity 67