Perfect

Competition
Perfect Competition
• It is that market structure in which a
large number of sellers and buyers
mature their transactions. The product
are homogeneous.
Assumptions
• There are many sellers and many buyers.
• The products sold by the firms are identical
(Homogeneous).
• Entry into and exit from the market are easy,

• No single firm can change the price of

product
• Buyers (consumers) and sellers (firms) have
perfect information
Equilibrium Conditions
• There are two equilibrium conditions
– marginal revenue (MR) must be
equal to marginal cost (MC).
– Slope of Marginal Revenue must be
less than Slope of Marginal Cost
Profit-Maximizing Level of
Output
• Marginal revenue (MR) – the change
in total revenue associated with a
change in quantity.

• Marginal cost (MC) – the change in total

cost associated with a change in quantity.
Marginal Revenue
• TR =P*Q
• MR = dTR/dQ
• AR = TR/Q or P*Q/Q OR AR= P
So if Price does not change then there
would be no change in MR .
In short P=AR=MR
• According to the P Q TR MR AR
assumption, if
price remains
same then MR 10 1 10 10 10
and AR would 10 2 20 10 10
also equal to 10 3 30 10 10
Price
10 4 40 10 10
10 5 50 10 10
Profit Maximization: MC = MR
• To maximize profits, a firm should
produce where marginal cost equals
marginal revenue.
How to Maximize Profit
• The supplier will cut back on production
if marginal cost is greater than marginal
revenue.
• Thus, the profit-maximizing condition of a
competitive firm is MC = MR = P.
Possibilities of Profit and loss
in Perfect Competition
• There are four possibilities in Short run
– Normal profit AR =AC
– Normal Loss AR < AC
– Abnormal Profit AR >> AC
– Abnormal Loss AR << AC
In Long Run
Normal profit LAR =LAC
 Marginal Cost, Marginal
Revenue, and Price
Costs MC
Quantity
Price = MR Margi
Produce nal
$35.00 0 d Cost
60
35.00 1 $28.00
20.00 50
35.00 2 16.00
35.00 3 40 A C P = AR =
14.00 MR
35.00 4 12.00 30 B
35.00 5 A
17.00
35.00 6 22.00 20
35.00 7 30.00
35.00 8 10
40.00
35.00 9 54.00 0
35.00 10 68.00 1 2 3 4 5 6 7 8 910Quantity

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Profit Maximization
Profit Maximization: The
Numbers
MR=MC
Q P TR TC TR-TC MR MC ATC
0 $1 $0 $1.00 -$1.00 $1
1 $1 $1 $2.00 -$1.00 $1 $1.00 $2.00
2 $1 $2 $2.80 -$0.80 $1 $0.80 $1.40
3 $1 $3 $3.50 -$0.50 $1 $0.70 $1.17
4 $1 $4 $4.00 $0.00 $1 $0.50 $1.00
5 $1 $5 $4.50 $0.50 $1 $0.50 $0.90
6 $1 $6 $5.20 $0.80 $1 $0.70 $0.87
7 $1 $7 $6.00 $1.00 $1 $0.80 $0.86
8 $1 $8 $6.86 $1.14 $1 $0.86 $0.86
9 $1 $9 $7.86 $1.14 $1 $1.00 $0.87
10 $1 $10 $9.36 $0.64 $1 $1.50 $0.94
11 $1 $11 $12.00 -$1.00 $1 $2.64 $1.09
The Marginal Cost Curve is
the Supply Curve
• The marginal cost curve is the firm's
supply curve above the point where
price exceeds average variable cost.
 The Marginal Cost Curve is
the Supply Curve
• The MC curve tells the competitive firm
how much it should produce at a given
price.

• The firm can do not better than produce

the quantity at which marginal cost equals
marginal revenue which in turn equals
price.
The Marginal Cost Curve is
the Firm’s Supply Curve
Marginal cost
$70 C
60
50
Cost, Price

A
40
30 B
20
10
0 1 2 3 4 5 6 7 8 9 10 Quantity
Firms Maximize Total
Profit
• Firms seek to maximize total profit, not
profit per unit.
– Firms do not care about profit per unit.
– As long as increasing output increases
total profits, a profit-maximizing firm should
produce more.
Profit Maximization Using
Total Revenue and Total Cost
• Profit is maximized where the vertical
distance between total revenue and
total cost is greatest.
• At that output, MR (the slope of the
total revenue curve) and MC (the slope
of the total cost curve) are equal.
 Profit Determination Using Total
Cost and Revenue Curves
TC TR
$385 Loss
Total cost, revenue

350
315 Maximum profit =$81 Profit
280
245
210 $130
175
140
105 Profit =$45
70
35 Loss
0
1 2 3 4 5 6 7 8 9 Quantity
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Total Profit at the Profit-
Maximizing Level of Output
• The P = MR = MC condition tells us
how much output a competitive firm
should produce to maximize profit.
• It does not tell us how much profit the
firm makes.
Determining Profit and Loss
From a Table of Costs
• Profit can be calculated from a table of
costs and revenues.
• Profit is determined by total revenue
minus total cost.
 Costs Relevant to a Firm

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 Costs Relevant to a Firm

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Determining Profit and
Loss From a Graph
• Find output where MC = MR.
– The intersection of MC = MR (P)
determines the quantity the firm will
produce if it wishes to maximize profits.
Determining Profit and
Loss From a Graph
• Find profit per unit where MC = MR.
– Drop a line down from where MC equals MR,
and then to the ATC curve.
– This is the profit per unit.
– Extend a line back to the vertical axis to
identify total profit.
 Determining Profit and
Loss From a Graph
• The firm makes a profit when the ATC
curve is below the MR curve.

• The firm incurs a loss when the ATC curve

is above the MR curve.
 Determining Profits Graphically
Price MC Price MC Price MC
65 65 65
60 60 60
55 55 55
50 50 50 ATC
45 45 ATC 45
40 D A P = MR 40 40 Loss P = MR
35 35 35
Profit P = MR
30 B ATC 30 30 AVC
25 C AVC 25 AVC 25
20 E 20 20
15 15 15
10 10 10
5 5 5
0 0 0
1 23 4 5 67 891012 1 23 4 5 67 891012 1 23 4 567 89 1 12
Quantity Quantity Quantity 0
a) Profit case (b) Zero profit case (c) Loss case

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 Loss Minimization
Average cost of a unit of output

Market
price
falls

Revenue
generated by a
unit of output
The Shutdown Point
• The firm will shut down if it cannot
cover average variable costs.
– A firm should continue to produce as long
as price is greater than average variable
cost.
– If price falls below that point it makes
sense to shut down temporarily and save
the variable costs.
The Shutdown Point
• If total revenue is more than total
variable cost, the firm’s best strategy is
to temporarily produce at a loss.
• It is taking less of a loss than it would by
shutting down.
The Shutdown Decision
MC
Price
ATC
60

50 Loss

40
P = MR
30
AVC
20
$17.80 A
10

0
2 4 6 8 Quantity
Perfect Competition
Long Run
 Normal Profit in the Long Run
• Entry and exit occur whenever firms are earning
more or less than “normal profit” (zero
economic profit).
– If firms are earning more than normal profit, other firms
will have an incentive to enter the market.
– If firms are earning less than normal profit, firms in the
industry will have an incentive to exit the market.
 Market Response to an Increase in
Demand
Price Market Price Firm
MC
S0SR
S1SR AC
B B
$9 $9
C Profit
7 SLR 7
A
A

D1
D0
0 1,200Quantity
700 840 0 1012Quantity
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Practice Questions
• A firm faces a demand curve Q =100 −2 P
and cost curves . Find the AC =MC =10
profit maximizing output (Q)
at which the profit is
maximum.
Practice Question
1 3
TC = q − 0.2q + 4q + 10
2

300
Q = −200 P + 12000

1. Calculate the short run supply curve from the given

information's
2. Find short run equilibrium output and price.