Lecture 4
Perfect Competition
OUTLINE
Perfect Competition and Why It Matters
How Perfectly Competitive Firms Make Output Decisions
Entry and Exit Decisions in the Long Run
Efficiency in Perfectly Competitive Markets
Introduction: A Scenario
Three years after graduating, you run your own business.
• You must decide what and how much to produce, what price to
charge, how many workers to hire, etc.
What factors should affect these decisions?
• Your costs (studied in preceding chapter)
• Expected prices
• The market structure (How much competition you face)
We begin by studying the behavior of firms in perfectly competitive
markets.
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● Market structure - the conditions in an industry, such as number of
sellers, how easy or difficult it is for a new firm to enter, and the type of
products that are sold.
● Perfect competition - each firm faces many competitors that sell
identical products.
• 4 criteria:
• many firms produce identical products,
• many buyers and many sellers are available,
• sellers and buyers have all relevant information to make rational
decisions,
• firms can enter and leave the market without any restrictions.
Consequence
● Price taker - a firm in a perfectly competitive market that must take the
prevailing market price as given.
How Perfectly Competitive Firms Make Output
Decisions
● A perfectly competitive firm must accept the price for its output as
determined by the product’s market demand and supply.
● A perfectly competitive firm must accept the price for its inputs as
determined by the input’s market demand and supply.
● Thus, a perfectly competitive firm has only one major decision to
make - what quantity to produce?
● The maximum profit will occur at the quantity where the difference
between total revenue and total cost is largest.
Profit = TR - TC
The Revenue of a Competitive Firm
●Total revenue (TR)
TR = P x Q
●Average revenue (AR)
AR =
●Marginal revenue (MR)
The change in TR from an
additional unit sold.
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TR
= (P*Q)/Q =>AR= P
Q
∆TR
MR =
∆Q
Total Cost and Total Revenue at the Raspberry Farm
P= $4
Quantity
(Q)
Total Cost
(TC)
Total Revenue
(TR)
Profit
0
$62
$0
−$62
10
$90
$40
−$50
20
$110
$80
−$30
30
$126
$120
−$6
40
$138
$160
$22
50
$150
$200
$50
60
$165
$240
$75
70
$190
$280
$90
80
$230
$320
$90
90
$296
$360
$64
100
$400
$400
$0
110
$550
$440
$−110
120
$715
$480
$−235
Total Cost and Total Revenue at a Raspberry Farm
● Total revenue for a perfectly competitive firm is a straight line sloping up;
the slope is equal to the price of the good.
● Total cost also slopes up, but with some curvature.
● At higher levels of output, total cost begins to slope upward more steeply
because of diminishing marginal returns.
● The maximum profit will occur at the quantity where the difference
between total revenue and total cost is largest.
Profit Maximization
Profit = TR – TC
Profit = (Price of final good * Quantity of output) – (Prices of inputs * Quantity of inputs)
Relationship between TR and Quantity of output
TR increases at a constant rate as the quantity of output increase. (Price of final good is constant from the standpoint of the firm, only true in a competitive market)
Relationship between TC and Quantity of output
TC increases as the quantity of output increase but at varying rates. It could increase at a diminishing or constant or increasing marginal product.
The firm has no control over the price of the final goods and price of inputs. It is a price taker in both markets.
The firm has control over how many units to produce and how many units of inputs to hire (labor in our example, in the short run)
When the firm produces more units of the final good
 TR increases (at constant rate)
When the firm produces more units of the final good
 TC increases (at varying rates)
So, the firm must find the balance between the quantity of output and the quantity of input (labor) that max profits. Both are interdependent in profit maximization.
Cost maximization vs. profit maximization
In this chapter the firm picks the quantity of final product to max profits.
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Profit Maximization
Comparing Marginal Revenue and Marginal Costs
● Marginal revenue (MR) - the additional revenue gained from
selling one more unit.
change in total revenue
MR =
change in quantity
● Marginal cost (MC) - the cost per additional unit sold.
change in total cost
MC = change in quantity
What Q maximizes the firm’s profit?
Marginal Analysis
To find the answer, “think at the margin.”
If Q increases by one unit

Revenue rises by MR or P (in the competitive
market structure only)
Cost rises by MC
If MR > MC, then increase Q to raise profit
If MR < MC, then reduce Q to raise profit
So Profit is max when

MR=MC
Alternately: Profit = TR – TC
Maximization of the profit function: ▲Profit/▲Q = (▲TR/▲Q) – (▲TC/▲Q) and set to zero (see previous
diagram)
 MR = MC
The profit-maximizing choice for a perfectly competitive firm will occur at the level
of output where
MR=MC.
Note:
For each unit, a firm in a competitive market receives the price, which is
determined by the entire market participants, and is constant for an individual firm.
So, MR = P
This is true only for a firm in a competitive market. Because the firm takes the
price as given.
Marginal Revenues and Marginal Costs at
the Raspberry Farm: Raspberry Market
● The equilibrium price of raspberries is determined through the
interaction of market supply and market demand at $4.00.
Marginal Revenues and Marginal Costs at the Raspberry Farm
Quantity
Total Cost
Marginal
Cost
Total
Revenue
Marginal
Revenue
Profit
0
$62
-
$0
$4
-$62
10
$90
$2.80
$40
$4
-$50
20
$110
$2.00
$80
$4
-$30
30
$126
$1.60
$120
$4
-$6
40
$138
$1.20
$160
$4
$22
50
$150
$1.20
$200
$4
$50
60
$165
$1.50
$240
$4
$75
70
$190
$2.50
$280
$4
$90
80
$230
$4.00
$320
$4
$90
90
$296
$6.60
$360
$4
$64
100
$400
$10.40
$400
$4
$0
110
$550
$15.00
$440
$4
-$110
120
$715
$16.50
$480
$4
-$235
Marginal Revenues and Marginal Costs
at the Raspberry Farm: Individual Farmer
● For a perfectly competitive firm, the marginal revenue curve is a horizontal line
because it’s equal to the price of the good ($4), determined by the market.
● The marginal cost curve is sometimes initially downward-sloping, if there is a
region of increasing marginal returns at low levels of output.
● It is eventually upward-sloping at higher levels of output as diminishing marginal
returns kick in.
MC and the Firm’s Supply Decision
Rule: MR = MC at the profit-maximizing Q.
At Qa, MC < MR.
Costs
MC
So, increase Q
to raise profit.
At Qb, MC > MR.
So, reduce Q
to raise profit.
MR (P)
P1
At Q1, MC = MR.
Profit is maximized
Changing Q would lower profit.
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Qa Q1 Qb
Q
MC and the Firm’s Supply Decision
If price rises to P2,
then the profit-maximizing
quantity rises to Q2.
Costs
The MC curve determines the
firm’s Q at any price.
P2
MR2
Hence,
P1
MR
The MC curve is
the firm’s supply
curve.
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MC
Q1
Q2
Q
Profits and Losses with the Average Cost Curve
Does maximizing profit (producing where MR = MC) imply an actual
economic profit?
The answer depends on the relationship between price and average
total cost, which is the average profit or profit margin.
A Firm’s Short-run Decision to Shut Down
Cost of shutting down: revenue loss = TR
Benefit of shutting down: cost savings = VC
(firm must still pay FC in the short run, SR )
So, shut down if TR < VC
Divide both sides by Q:
TR/Q < VC/Q
(P*Q)/Q < VC/Q
So, firm’s decision rule is: Shut down if P < AVC
Produce if P > AVC
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Production Decisions
If P > ATC, then firm produces
Q, where MR= P = MC, at
positive profit
Costs
MC (S)
If ATC >P > AVC, then firm
produces Q, where P = MC, at
a loss
ATC
AVC
If P < AVC, then firm shuts
down (produces Q = 0).
Q
The firm’s SR supply curve is the portion of its MC curve above AVC.
The firm’s LR supply curve is the portion of its MC curve above ATC.
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Q
A Firm’s Long-Run Decision to Exit
Cost of exiting the market: revenue loss = TR
Benefit of exiting the market: cost savings = TC
(zero FC in the long run)
So, firm exits if TR < TC
Divide both sides by Q  TR/Q=AR=P
Write the firm’s decision rule as:
Exit if P < ATC
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