Quick Recap:

Write a brief sentence of the following conditions.

At which point is each condition satisfied:

 Profit Maximisation

 Revenue Maximisation

 Productively efficient

 Normal profit is generated

 Super-normal profit is generated

Quick Recap:
Write a brief sentence of the following conditions. At which
point is each condition satisfied:
 Profit maximisation: MC=MR

 Revenue maximisation: MR= 0

 Productively efficient: MC= AC i.e. lowest point on AC curve

 Normal profit is generated: P(or AR) =AC

 Super-normal profit is generated: P(or AR)>AC

 UNIT 3:
BUSINESS Perfect competition
B E H AV I O U R

How easy would it be for you to set up:

• a newsagents
• an MOT centre
• a window cleaning business?

How easy is it for these firms to differentiate their

products from those of their competitors?

What do these markets have in common?

Market structures
Perfect Competition

 What students need to learn:

a) Characteristics of perfect competition
b) Profit maximising equilibrium in the short run and long run
c) Diagrammatic analysis
Evaluating Relevance of Perfect Competition
 Perfect competition describes a market structure whose assumptions are
strong and therefore unlikely to exist in most real-world markets
 We can however take some useful insights from studying a world of perfect
competition and then comparing and contrasting with “real world” imperfectly
competitive markets and industries
 Economists have become more interested in pure competition because of the
rapid growth of e-commerce as a means of buying and selling goods and
services. And also the popularity of online auctions as a device for allocating
scarce resources
 The model of perfect competition
– the assumptions

 The model of perfect competition is based on the following

assumptions:
Perfect competition is
mainly a theoretical  Homogenous Products (all perfect substitutes)
concept that helps us
 All firms have access to factors of production
to better understand
the workings of real  Large number of buyers & sellers
world markets.
 Free (costless) entry into and exit from the market
 Perfectly elastic demand curve
 Perfect knowledge / information for buyers/sellers
 Profit maximization is assumed as key objective – and consumers
assumed to be utility maximisers

Can you think of any markets that match these

characteristics?
Homogenous (Standardised) Products?

Cement Wheat Sporting Bets

Flowers Fruit in a big Bars in Spanish

street market resorts
 Large numbers of producers

 In perfect competition there are a large number of producers in

the market
 Each firm is relatively small in size and sell to a large number of
small buyers
 All of these producers are price takers i.e. they are not large
enough to influence price
 Each firm can sell all of its output at the current market price
 Therefore, it would not lower its price
 If it were to raise price it would sell nothing as buyers would go to
another seller
 This means that the demand curve for each firm is perfectly
price elastic i.e. horizontal
 D = AR = MR
 Average revenue (Total revenue/output) is always the same
 Marginal revenue (the additional revenue for selling an extra unit) is always
the same
 Identical products

 In perfect competition all products are identical or

To what extent
are wonky homogeneous
vegetables
 Buyers cannot tell the difference between products from
homogeneous?
different firms
 Therefore, there is no branding of products and brand loyalty
does not exist
 In reality firms are unlikely to sell identical products, even
carrots will be of different quality and branding will
differentiate the product in the eyes of the consumer

Can you think of any examples of identical products in the

market?
 Freedom of entry and exit

In the real world  In perfect competition there are no barriers to entry or exit
firms will face a
variety of barriers in  This means firms are free to enter or exit the market if they
both entering and wish to do so
leaving markets.
 Therefore, entry costs will be low or non-existent
 Barriers to entry such as costs associated with capital
expenditure, research and development and start-up of the
business are low or non- existent

To what extent has

digital reduced
barriers to entry in
the book industry?
 Readily available information

In the real world  In perfect competition there is readily available information

buyers and sellers will
face difficulties in
or perfect knowledge
accessing  Perfect knowledge occurs when all economic agents e.g.
information. This has
been made easier in buyers and sellers have a comprehensive understanding of all
the information age factors within a market e.g. prices, availability etc.
with access to
information at our  All buyers will have information about all prices and the
finger tips, for availability of goods and services in the market
example, through the
internet.  All sellers have the same knowhow in how to produce goods
and services so produce the same quality of output

Class discussion:
To what extent have technological advancements made
the theoretical concept of perfect competition more of a
reality?
 The shut-down point

 A firm will remain in operation as long as its selling price

covers its average variable cost
 Above this point it makes a contribution to paying off its fixed
costs
 The shut-down point occurs when price falls below average
variable costs
 At this point the firm is better off closing down rather than
remaining in operation
 Price
The Demand Curve in Perfect Competition

In perfect competition firms face a perfectly elastic demand curve. Each firm
can sell all of its output at the current market price, P. Therefore, it would not
lower its price. If it were to raise price it would sell nothing as buyers would
go to another seller. Thus, the D curve is horizontal.

The D curve is also the AR curve as total output divided by price is always the
same.
A perfectly elastic
demand curve. The D curve is also the MR curve. As prices do not change, an additional unit
sold will bring in the same revenue every time.

P
D = AR = MR

0
Output
Price and Output in Perfect Competition
Average revenue equals marginal revenue at every level of output

Price, Market Supply Price, Revenues, Costs and Profits

Cost and Demand Cost for a Competitive Firm

AR=MR
P1

Output Output
Price and Output in Perfect Competition
When drawing perfect competition diagrams, remember to make a clear
distinction between the market and a representative individual firm

Price, Market Supply Price, Revenues, Costs and Profits

Cost and Demand Cost for a Competitive Firm

S
MC

AC

Output Output
Price and Output in Perfect Competition
The market price is set by the interaction of market supply and demand

Price, Market Supply Price, Revenues, Costs and Profits

Cost and Demand Cost for a Competitive Firm

S
MC

P1

AC

Output Output
Price and Output in Perfect Competition
Each individual firm is a price taker in a perfectly competitive market

Price, Market Supply Price, Revenues, Costs and Profits

Cost and Demand Cost for a Competitive Firm

S
MC

P1

AC

Output Output
Price and Output in Perfect Competition
The ruling market price becomes the AR and MR curve for the firm

Price, Market Supply Price, Revenues, Costs and Profits

Cost and Demand Cost for a Competitive Firm

S
MC

P1

AC

Output Output
Price and Output in Perfect Competition
Average revenue equals marginal revenue at every level of output

Price, Market Supply Price, Revenues, Costs and Profits

Cost and Demand Cost for a Competitive Firm

S
MC

AR=MR
P1

AC

Output Output
Price and Output in Perfect Competition
We assume that the aim of each firm is to find a profit-maximising output

Price, Market Supply Price, Revenues, Costs and Profits

Cost and Demand Cost for a Competitive Firm

S
MC
Supernormal
profits
AR=MR
P1

AC
C1

Output Q1 Output
Short Run Allocative Efficiency
In the short run, a profit maximising output is where price = marginal cost

Price, Market Supply Price, Revenues, Costs and Profits

Cost and Demand Cost for a Competitive Firm

S
MC
Price =
marginal
cost
AR=MR
P1

AC
C1

Output Q1 Output
It’s worksheet
time…….
Adjustment to Long Run Equilibrium
 If most firms are making abnormal (economic) profits in the short run, this
encourages the entry of new firms into the industry driven into the market
by the profit motive
 This will cause an outward shift in market supply forcing down the ruling
market price
 The increase in market supply will eventually reduce the ruling market price
until price = long run average cost
 At this point, each firm in the industry is making normal profit where price
(AR) = average cost
 Other things remaining the same, there is no further incentive for movement
of firms in and out of the industry and a long-run equilibrium has been
established where price = average cost at output where MR=MC
The Entry of New Firms in the Long Run
At this market price P1, most firms in the market make supernormal profit

Price, Market Supply Price, Revenues, Costs and Profits

Cost and Demand Cost for a Competitive Firm

S1
MC

AR1=MR1
P
1
AC

Output Output
The Entry of New Firms in the Long Run
The entry of firms causes an outward shift of market supply – price falls

Price, Market Supply Price, Revenues, Costs and Profits

Cost and Demand Cost for a Competitive Firm

S1
MC

S2

AR1=MR1
P
1
AC

P2

Output Output
The Entry of New Firms in the Long Run

Price, Market Supply Price, Revenues, Costs and Profits

Cost and Demand Cost for a Competitive Firm

S1
MC

S2

AR1=MR1
P1

AC

P2

Output Output
The Entry of New Firms in the Long Run

Price, Market Supply Price, Revenues, Costs and Profits

Cost and Demand Cost for a Competitive Firm

S1
MC

S2

AR1=MR1
P1

AC

P2
AR2=MR2

Output Output
Long Run Equilibrium Price and Profit
In long run equilibrium all firms are making normal profits (P=AC)

Price, Market Supply Price, Revenues, Costs and Profits

Cost and Demand Cost for a Competitive Firm

S1
MC

S2

AR1=MR1
P1

AC

P2
AR2=MR2

Output Q2 Output
A Normal Profit LR Equilibrium
Normal profits where AR=AC – i.e. just enough profits to keep resources in their current use

Price, Market Supply Price, Revenues, Costs and Profits

Cost and Demand Cost for a Competitive Firm

S1
MC

S2

AC

P2
AR2=MR2

Output Q2 Output
The ShutGoogle
Down andPrice
Apple’s(Short
RevenueRun)

A business needs to make at least normal profit in the

long run to justify remaining in an industry but in the
short run a firm will produce as long as price per unit > or
Price equal to average variable cost (AR = AVC). This is called
the shutdown price in a competitive market.

P1: Price = average

cost, normal profits MC
made
AC
P1 AVC

P2
P=Min AVC is the
shut down price for a
P2: Price = average competitive firm in
variable cost short run

Output
The ShutGoogle
Down andPrice
Apple’s(Short
RevenueRun)

The very low price P3 is less than average variable cost

and the firm is making a heavy loss. Assuming that the
fixed costs are lost if production is closed down, if the
Price firm shuts down it will lose distance AB per unit and if
continues to supply, the loss of AC per unit.

A
MC

AC
P1 AVC

B
P2

P3
C

Output
Evaluating Assumptions of the Model
1. Most firms have some amount of price-setting power – they are price makers
not price takers!
2. Dominance in real world markets of differentiated / branded products
3. Highly complex products, there always information gaps facing consumers
4. Impossible to avoid search costs even with the spread of digital/web
technology
5. Patents, control of intellectual property, control of key inputs are all ignored
by the competitive model
6. Rare for entry and exit in an industry to be costless
Perfect Competition and Efficiency
 Allocative efficiency:
 In both the short and the long run, price is equal to marginal cost (P=MC) and
thus allocative efficiency is achieved. No one can be made better off without
making some other agent at least as worse off – i.e. we achieve a Pareto
optimum allocation of resources.
 Productive efficiency:
 Productive efficiency occurs when the equilibrium profit maximising output is
supplied at minimum average cost. This is attained in the long run for a
competitive market. Output is at lowest point of LRAC
 If a firm is producing at the lowest point of their average cost curve this also
means that the firm must be X efficient
 Dynamic efficiency:
 We assume that a perfectly competitive market produces homogeneous
products – in other words, there is little scope for innovation designed purely
to make products differentiated from each other and allow a supplier to
establish some monopoly power.
Characteristics of Competitive Markets
1. Lower prices because of many competing firms. The cross-price
elasticity of demand for one product will be high suggesting that
consumers are prepared to switch their demand to the most
competitively priced products in the marketplace.
2. Low barriers to entry – the entry of new firms provides competition
and ensures prices are kept low
3. Lower total profits and profit margins than in monopoly
4. Greater entrepreneurial activity. For competition to be improved and
sustained there needs to be a genuine desire on behalf of
entrepreneurs to innovate and to invent to drive markets
5. Economic efficiency
 Competition will ensure that firms move towards productive
efficiency and avoid X inefficiency
 The threat of competition should lead to a faster rate of
technological diffusion, as firms have to be responsive to the
changing needs of consumers. This is known as dynamic efficiency.
The Real World of Imperfect Competition

 Suppliers may exert control over the quantity of goods and services supplied
and also exploit their monopoly power by having control over market prices
 On the demand-side, consumers may have monopsony (buying) power against
their suppliers because they purchase a high percentage of total demand.
 There are always some barriers to the contestability of a market and far from
being homogeneous; most markets are full of heterogeneous products due to
product differentiation
 Most consumers have imperfect information and preferences are influenced by
persuasive marketing
 There may be imperfect competition in related markets such as the market
for key raw materials, labour and capital goods.
 TEST YOURSELF

MC
Price P

S S1

AC

P
D = AR = MR

P1
D1 = AR1 = MR1

0 Q1 Q 0 Q
Output

Firm Industry

Can you reproduce this diagram showing what

would happen if firms were making losses in the
short run?