Unit 6
Perfect Competition
Objectives:
●
Describe the characteristics of perfect competition
●
Illustrate and explain the demand curve facing the
firm under perfect competition
●
Illustrate and explain short term equilibrium of a
firm under perfect competition
●
Illustrate and explain long term equilibrium of a firm
under perfect competition
Market Structures
Perfect
Monopolistic
Competition Competition
Price taker
Oligopoly
A very large
Many sellers A few sellers
number of
sellers
Homogeneous Differentiated Differentiated
Monopoly
Price
maker
One Seller
Unique
product
product
or
productundifferentiated no close
product
substitutes
Characteristics of Perfect Competition
The participants in any market are the buyers and
sellers of the product concerned. Under conditions of
perfect competition the market functions under the
principles of demand and supply explained in Unit 4.
Competition occurs on both sides of the market.
Buyers compete to get the goods while sellers compete
to sell the goods.
For a market to be called competitive, it must meet
certain conditions:
(a) There are a large number of buyers and sellers in
the market. There are so many of them that none
of them can influence the price of the product. Both
buyers and sellers are price takers.
(b) All products in the market are homogeneous.
(c) There is complete freedom for firms to enter or
leave the market.
(d) All buyers and sellers have perfect knowledge of
market conditions.
(e) Factors of production are perfectly mobile – they
are free to move from one market to another.
The Demand Curve
Under perfect competition the firms are price takers.
The price is detemined on the market by the interaction
of demand and supply. The individual firm cannot
influence the price and it has to accept the market price
as given. They can only decide what quantities to
supply at that price.
The individual firm faces a completely horizontal or
perfectly elastic demand curve. The industry’s demand
curve is the normal down-sloping curve.
Demand curves of the industry and the individual firm
Please note:
Under perfect competition D = P = AR = MR
Total, average and marginal revenue under perfect
competition
Quantity Price Total Average Marginal
(units)
per revenue revenue revenue
unit (P X Q) (TR/Q) (ΔTR/ΔQ)
0
5
0
100
5
500
5
5
200
5
1 000
5
5
300
5
1 500
5
5
Quantity Price Total Average Marginal
(units)
per revenue revenue revenue
unit (P X Q) (TR/Q) (ΔTR/ΔQ)
400
5
2 000
5
5
500
5
2 500
5
5
Pricing in the Short Term
If we want to determine whether a firm makes a profit
or a loss, or is just breaking even, we need to compare
its total revenue (TR) with its total cost (TC). In the
short run three situations are possible:
▪ Economic profit: The firm can make an economic
profit. This occurs when the TR is greater than
TC.
▪ Normal profit: The firm can make a normal profit
or break even. This occurs when the TR is equal
to TC.
▪ Loss: The firm can make a loss. This occurs
when TR is less than TC.
The profit-maximising rule: MR = MC
We assume that the goal of the firm is to maximise
profits. When a firm maximises profits, we say that it is
in equilibrium. We can eplain profit maximising in terms
of total revenue (TR) and total cost (TC) or in terms of
marginal revenue (MR) and marginal cost.
If we use total revenue and total cost, we can say that
profits are maximised where the positive difference
between total revenue and total cost is the greatest.
Economists find it more useful to express equilibrium in
terms of marginal revenue and marginal cost. The
marginal revenue is the additional revenue a firm
receives when it sells an additional unit of its product.
The marginal cost is the additional cost to produce one
additional unit of its product.
For a perfectly
competitive firm, the marginal revenue is equal to the
price.
The profit-maximizing rule is as follows:
Equilibrium: where MR = MC
Revenue and cost data of a perfect competitor
Output Price Total Marginal Total Marginal
Total
(Q)
N$ revenue revenue cost
cost
profit\los
(TR)
(MR) (TC) (MC)
(TR –
TC)
0
8
0
800
-800
100
8
800
8
2
000
12
-1 200
200
8
1 600
8
2
300
3
-700
300
8
2 400
8
2
400
1
0
400
8
3 200
8
2
524
1 24
+676
500
8
4 000
8
2
775
2.50
+1 225
600
8
4 800
8
3
200
4 25
+1 600
Output Price Total Marginal Total Marginal
Total
(Q)
N$ revenue revenue cost
cost
profit\los
(TR)
(MR) (TC) (MC)
(TR –
TC)
3
650
8
5 200
8
8
+1 600
600
700
8
5 600
8
4
200
12
+1 400
Equilibrium: total revenue / total cost method
The firm maximises profits in the short term when the
positive difference between total revenue (TR) and
total cost (TC) is the greatest. The maximum profit of
N$1600 is made when the firm produces 650 units of
its product. The firm will therefore be in equilibrium
when it produces 650 units.
Equilibrium in terms of total revenue and total cost
Equilibrium: Marginal Revenue and Marginal Cost
Method
Whether the firm is making a profit or a loss will
depend on whether the price is above or below the
average total cost curve (AC or ATC).
We don’t use the AFC curve. On the diagrams the
vertical distance between AVC and AC represents
AFC.
Three situations can arise in the short term:
(a) The firm can make an economic profit.
(b) The firm can make a normal profit.
(c) The firm can make a loss.
Situation (a): Economic profit
●
Equilibrium is indicated by A where MR = MC
●
Equilibrium output is Q1
●
Equilibrium price is P1 (P = D = AR = MR)
●
Average (total) cost is C
●
Profit per unit is CP1
●
Total revenue is the area P1AQ10 (P x Q)
●
Total cost is the area BQ10C (AC x Q)
●
Total profit is the shaded area P1ABC (TR – TC)
Situation (b): Normal profit
●
Equilibrium is indicated by D where MR = MC
●
Equilibrium output is Q2
●
Equilibrium price is P2 (P = D = AR = MR)
●
Average (total) cost is P2
●
Profit per unit is zero
●
Total revenue is the area P2DQ20 (P x Q)
●
Total cost is the area P2DQ20 (AC x Q)
●
Total profit is zero (TR – TC)
Situation (c): Economic loss
●
Equilibrium is indicated by F where MR = MC
●
Equilibrium output is Q3
●
Equilibrium price is P3 (P = D = AR = MR)
●
Average (total) cost is D
●
Loss per unit is DP3
●
Total revenue is the area P3FQ30 (P x Q)
●
Total cost is the area DEQ30 (AC x Q)
●
Total loss is the shaded area P3DEF (TR – TC)
The Shut-down rule
The shut-down rule states that a firm should only
produce if the price is equal to or greater than the
average variable cost (AVC). The intersection of the
MC curve with the AVC curve is the shut down point.
Point F on the diagram is the shut-down point.
The short run supply curve
The marginal cost curve indicates how many of a good
a firm will supply at a given price. Therefore, the rising
part of the MC curve above the AVC curve (i.e. the
shut-down point) is the firm’s short term supply curve.
Activity 1
What is wrong with this graph? Is the firm maximizing
its profit?
Activity 2
The diagram shows the short term cost situation of a
hypothetical profit maximizing firm under perfect
competition. Use the information to complete Table 1.
If the market
price is:
Equilibrium
output is:
At this output:
Average:
Marginal
revenue is:
Marginal cost
is:
Average
(total) cost is:
Profit (+) or
loss (-) per
unit is:
Total revenue
is:
Total cost is:
Total profit
(+) or loss (-)
N$100
N$80
N$60
If the market
price is:
is:
N$100
N$80
N$60
Feedback
If the market
N$100
price is:
Equilibrium
500
output is:
N$80
N$60
400
300
At this output:
AR is:
N$100
N$80
N$60
MR is:
N$100
N$80
N$60
MC is:
N$100
N$80
N$60
ATC / AC is:
N$85
N$80
N$80
Profit or loss
per unit is:
(P – AC)
+ N$15
0
- N$20
TR is: (P x Q) N$50 000
N$32 000 N$18 000
If the market
N$100
price is:
TC is: (AC x
N$42 500
Q)
Total profit or
loss is:
(TR – TC)
+ N$7 500
(economic
profit)
N$80
N$60
N$32 000 N$24 000
0
(normal
profit)
- N$6 000
(economic
loss)
Pricing in the Long Term
In the short term the individual firm can make an
economic profit, a normal profit or a loss. In the long
term however, the industry will only be in equilibrium
when all firms make normal profits.
If firms are making short term economic profits:
●
More firms will enter the market. All market
participants have perfect knowledge of market
conditions and an economic profit will be an
incentive for other firms to enter the market.
●
When this happens, market supply will increase
and the supply curve will shift to the right.
●
The equilibrium market price will decrease. Profits
will also decrease until all firms in the market make
normal profits.
If firms are making short term economic losses:
●
Some firms will be forced to shut down and they will
leave the market.
●
This will decrease the market supply and the supply
curve will shift to the left.
●
The equilibrium market price will increase. Profits
will also increase until all firms remaining in the
market are making normal profits.
Long term equilibrium under perfect competition
In the long term the firm will be operating at the
minimum point of both the long-run average cost curve
(LRAC) and the short term average cost curve (SRAC)
where it obtains full economies of scale. Long term
equilibrium occurs where price is P and the business is
operating at point E and output Q. Any increase or
decrease in output would result in the firm making a
loss.
Activity
The diagram below illustrates the cost position of a firm
operating in a perfectly competitive market immediately
following the introduction of a cost-saving innovation.
1.
What initial advantage is the firm enjoying from
the innovation?
2. Can this advantage remain? Justify your answer
by noting what will be taking place in the industry in
the long term.