Perfect Competition
Chapter 9
ECO 2023
Fall 2007
Market Structure

Describes the important feature of a market
such as





Number of suppliers
Product’s degree of uniformity
Ease of entry into the market
Forms of competition among firms
A firm’s decisions about how much to
produce or what price to charge depend on
the structure of the market
Market Models




Pure Competition
Pure Monopoly
Monopolistic Competition
Oligopoly
Perfect Competitive Market

A market structure with many fully informed
buyers and sellers of a standardized product
and no obstacles to entry or exit of firms in
the long run
Characteristics





Many independent buyers and sellers
Buyers are small relative to the market
Standardized product – homogeneous
Price takers – individual firms exert no significant
control over product price.
Free entry and exit into the industry
Perfectly Competitive Market

Demand under Perfect Competition


Firm’s demand is perfectly elastic therefore
the demand curve is horizontal
PRICE TAKER

One and only price exists in the market and it is
P
equilibrium price
D
Q
Average Revenue


The firm’s demand schedule is also its average
revenue schedule
Price per unit to purchaser is also revenue per
unit or average revenue
Total Revenue



PXQ
Since price is constant, increase in sales of one
unit leads to increase in total revenue = to price.
Each unit sold adds exactly its constant price to
total revenue
Marginal Revenue



Is the change in total revenue that results from
selling 1 more unit of output
This is the selling price since it is constant
Therefore: MR = AR = Price
Short Run Profit Maximization


Each firms tries to maximize economic profit
Short run – it has a fixed plant



Therefore output is changed through changes in variable
inputs.
It adjusts its variable resources to achieve the output level
that maximizes its profit.
Two ways to determine level of output at which a
competitive firm will realize maximum profit or
minimum loss




Compare total revenue to total cost
Compare marginal revenue to marginal cost
Both apply to all firms
Firms that ignore this strategy do not survive
Example
Bushels
per day
Total Fixed
Costs
Total
Variable
costs
Total
Cost
Total
Revenue
Economic
profit or
loss
Q
TFC
TVC
TC
TR = P X Q
where P
=$131
TR-TC
0
$100
$0
$100
$0
-$100
1
$100
90
190
131
-59
2
$100
170
270
262
-8
3
$100
240
340
393
+$53
4
$100
300
400
524
+124
5
$100
370
470
655
+185
6
$100
450
550
786
+236
7
$100
540
640
917
+277
8
$100
650
750
1048
+298
9
$100
780
880
1179
+299
10
$100
930
1030
1310
+280
Graphically
Total
Revenue
&
Total Cost
Total Revenue
Maximum
Economic
Profit
Total Cost
9
Quantity
Demanded
Marginal Revenue Equals
Marginal Cost

Marginal revenue



The change in total revenue from selling an
additional unit
In perfect competition, marginal revenue is equal
to the market price
The firm will increase production as long as each
additional units adds more to total revenue than to
cost

As long as marginal revenue exceeds marginal cost
Graphically
Total
Prod
uct
Q
Average Fixed
Costs
Average
Variable
Costs
AFC = TFC/Q
0
$
AVC
100.00
Average
Total
Costs
Marginal
Costs
Marginal
Reven
ue
ATC
MC
MR = P
$ 100.00
Economic
Profit
$ (100.00)
$ 90.00
1
$
100.00
$
90.00
$ 190.00
$ 131.00
$
(59.00)
$ 131.00
$
(8.00)
$ 131.00
$
53.00
$ 131.00
$
124.00
$ 131.00
$
185.00
$ 131.00
$
236.00
$ 131.00
$
277.00
$ 131.00
$
298.00
$ 80.00
2
$
50.00
$
85.00
$ 135.00
$ 70.00
3
$
33.33
$
80.00
$ 113.33
$ 60.00
4
$
25.00
$
75.00
$ 100.00
$ 70.00
5
$
20.00
$
74.00
$ 94.00
$ 80.00
6
$
16.67
$
75.00
$ 91.67
$ 90.00
7
$
14.29
$
77.14
$ 91.43
$ 110.00
8
$
12.50
$
81.25
$ 93.75
$ 130.00
Golden Rule of Profit
Maximization
MR = MC
Perfectly Competitive Market

Short run economic profit
Price
MC
ATC
$5
Profit
$4
Demand =
Marginal
Revenue =
Price =
Average
Revenue
Profit
12
Quantity
Perfectly Competitive Market

Minimizing Short-Run Losses


An individual firm in perfect competition has no
control over the market price
Price may be so low that a firm loses money no
matter how much it produces



Can either produce at a loss
Temporarily shut down
Short run

A period too short to allow existing firms to leave the
industry
Perfectly Competitive Market

Decision in the short run

Continue to produce

A firm will produce if


TOTAL REVENUE > VARIABLE COST
Shut down

A firm will shut down

TOTAL REVENUE < VARIABLE COST
Perfectly Competitive Market

Short run Losses
Price
MC
ATC
$5
Loss
$4
Loss
Demand =
Marginal
Revenue =
Price =
Average
Revenue
12
Quantity
Perfectly Competitive Market

Perfect Competition in the Long Run

If short run has ECONOMIC PROFIT





Firms enter the industry
Increase in supply
Price drops
Continues until NO ECONOMIC PROFIT in the long
run
Price = Marginal Cost = Average Total Cost
Perfectly Competitive Market

Perfect Competition in the Long Run

If short run has ECONOMIC Loss





Firms leavethe industry
Decrease in supply
Price rises
Continues until NO ECONOMIC PROFIT in the long
run
Price = Marginal Cost = Average Total Cost
Perfectly Competitive Market

Productive efficiency

The condition that exists when market output is
produced using the least cost combination of
inputs


Minimum average cost in the long run
Allocative efficiency

The condition that exists when firms produce the
output most preferred by consumers

Marginal benefits = marginal cost