Lecture 2:
Perfectly Competitive Markets
Required Text: Chapter 2
Market Models
Market Structures

Four different types of market structure make up the basis
of most economic modeling:
 Perfect Competition
 Monopoly
 Monopolistic Competition, and
 Oligopoly

The last three types of markets are said to be imperfectly
competitive markets.
Perfect Competition



A market is said to be perfectly competitive if
 There are many buyers and sellers, each with roughly the
same market share. Thus, all buyers are sellers are price
takers in the market
 All sellers sell identical (homogenous) goods
 Information about how to produce and use the good is
freely available – all firms have access to technology
 One can become the seller or buyer with relative ease
(free entry and exit)
In a perfectly competitive market, firms compete with each
other on production/procurement costs.
In a perfectly competitive market, a firm’s marketing
strategy focuses on the level and timing of sales
Perfect Competition

A perfectly competitive faces a horizontal demand curve,
because as a price taker, it faces “a going price” for whatever
amount it sells.


A perfectly competitive firm has U-shaped average cost (AC)
and marginal cost (MC) curves in the short-run



The going price is determined by levels of market demand and
supply.
Short run is the time period within which the fixed factor of
production (i.e., plant size) cannot be adjusted.
There is no fixed factor in the long run
As a profit-making firm, it adjusts its output to equate its
marginal cost (MC) to the going price
Equilibrium condition: MC = P = MR
Revenue of a Perfectly Competitive Firm

Total Revenue: The amount of money received when the
firm sells the product, i.e.,




Since the firm is a price taker under perfect competition, it
sells each additional unit of the product for the same price.
Average Revenue = Total Revenue/Quantity sold


AR = TR/Q = P
Marginal Revenue = Additional revenue earned from
selling an additional unit of the product.


Total Revenue = Price of the product × Quantity of the product sold
TR = P × Q
MR = ∂TR/∂Q = P
Thus, for a competitive firm AR = P = MR
Total Revenue: P×Q
TP = Q
P
TR
AR
MR
0
3
0
0
0
Total Revenue
350.00
10
3
30
3
3
300.00
3
75
3
3
250.00
50
3
150
3
3
200.00
70
3
210
3
3
85
3
255
3
3
95
3
285
3
3
100
3
300
3
3
101
3
303
3
3
Dollars
25
150.00
100.00
50.00
0.00
0.00
20.00
40.00
60.00
Output
TR
95
3
285
3
3
85
3
255
3
3
80.00
100.00
120.00
Average Revenue: TR/Q = P
TP = Q
P
TR
AR
MR
0
3
0
0
0
10
3
30
3
3
25
3
75
3
3
AR
3.50
3.00
50
3
150
3
3
70
3
210
3
3
85
3
255
3
3
$/Unit
2.50
2.00
1.50
1.00
0.50
0.00
0.00
20.00
40.00
60.00
Output
95
3
285
3
3
100
3
300
3
3
101
3
303
3
3
95
3
285
3
3
85
3
255
3
3
AR
80.00
100.00
120.00
Marginal Revenue: ∂TR/∂Q = P
TP = Q
P
TR
AR
MR
0
3
0
0
0
10
3
30
3
3
25
3
75
3
3
50
3
150
3
3
MR
3.50
3.00
70
3
210
3
3
85
3
255
3
3
95
3
285
3
3
100
3
300
3
3
101
3
303
3
3
$/Unit
2.50
2.00
1.50
1.00
0.50
0.00
0.00
20.00
40.00
60.00
3
285
3
3
85
3
255
3
3
100.00
Output
MR
95
80.00
120.00
Profit Maximization by the Competitive Firm:
Approach I: Total Profit = TR – TC
L
TP = Q
TR
TC
Profit
0
0
0
80
-80
1
10
30
105
-75
2
25
75
130
-55
TC, TR, & Profit
350.00
300.00
250.00


50
150
155
-5
4
70
210
180
30
5
85
255
205
50
100.00
6
95
285
235
50
50.00
7
100
300
255
45
8
101
303
280
23
9
95
285
305
-20
10
85
255
330
-75
Dollars
3
200.00
150.00
0.00
0.00
20.00
40.00
60.00
80.00
100.00
Output
TC
TR
On the Diagram, the profit maximizing level of output is the level where
the vertical difference between the TR and TC is the largest.
With P = $3/unit, profits are maximized by producing 95 units of output.
120.00
Profit Maximization by the Competitive Firm:
Approach I: Total Profit = TR – TC
Stage III
Stage II
Stage I
Input (L)
TP (Q)
AP (Q/L)
MP
TC
TR
Profit
80
0
-80
0
0
0.00
1
10
10.00
10
105
30
-75
2
25
12.50
15
130
75
-55
3
50
16.67
25
155
150
-5
4
70
17.50
20
180
210
30
5
85
17.00
15
205
255
50
6
95
15.83
10
235
285
50
7
100
14.29
5
255
300
45
8
101
12.63
1
280
303
23
9
95
10.55
-6
305
285
-20
10
85
8.50
-10
330
255
-75
Max Profi
Max
Output
Profit Maximization by the Competitive Firm:
Approach II: MR = MC

Most managers do not make decisions looking at TR and TC.
Most decisions are made at the “margin.”

The output level that will maximize profit is determined by
comparing the amount that each additional unit of output adds
to TR and TC.

Recall, Marginal Cost (MC) represents additional cost from
producing an additional unit of output; and Marginal Revenue
(MR) represents addition to TR from selling (producing) an
additional (one more) unit of output, which is equal to the
price of that output.

Thus, MC and MR can be used to determine profit maximizing
level of output.
Profit maximizing Condition: MR = MC
Profit Maximization by the Competitive Firm:
Approach II: MR = MC
L
Q
TR
MR
TC
MC Profit
0
0
0
1
10
30
3
105
2.50
-75
2
25
75
3
130
1.67
-55
3
50
150
3
155
1.00
-5
4
70
210
3
180
1.25
30
80
-80
MR, MC, & Profit
8.00
7.00
6.00
$/Unit
5.00
4.00
3.00
5
85
255
3
205
1.67
50
6
95
285
3
235
3.00
55
7
100
300
3
255
5.00
45
2.00
1.00
0.00
0.00
20.00
40.00
60.00
80.00
100.00
120.00
Output


8
101
303
3
280
25.0
23
9
95
285
3
305
-4.17
-20
10
85
255
3
330
-2.50
-75
MR
MC
The firm will continue to expand production until MR is equal to MC, i.e.,
profit is maximized when MR = MC.
With P being $3/unit, profits are maximized by producing 95 units of output.
Profit Maximization by the Competitive Firm:
Approach II: MR = MC
Stage III
Stage II
Stage I
Input (L)
TP (Q)
AP (Q/L)
MP
MC
MR
Profit
0
-80
0
0
0.00
1
10
10.00
10
2.50
3
-75
2
25
12.50
15
1.67
3
-55
3
50
16.67
25
1.00
3
-5
4
70
17.50
20
1.25
3
30
5
85
17.00
15
1.67
3
50
6
95
15.83
10
3.00
3
50
7
100
14.29
5
5.00
3
45
8
101
12.63
1
25.0
3
23
9
95
10.55
-6
-4.17
3
-20
10
85
8.50
-10
-2.50
3
-75
Max Profit
Max Output
When the Firm Should Produce?
Given price “P”, the AR and
MR are given by the
horizontal line at P.
AR = MR
P
Profit is maximized by
producing Q level of output,
where MR = MC.
A
E
B
D
C
0
Q
TR is given by the area
PAQ0
TFC is given by the area
EBCD
TVC is given by the area
DCQ0
TC is given by the area
EBQ0
Profit is given by the area
PABE
When the Firm Should Produce?
At P1, the firm is making profit
P1
At P2, the firm is at the break-even point
P2
P3
At P3, the firm continues to produce
to minimize loss
P4
At P4, the firm may continue to produce
P5
0
At P5, the firm will close down
Q5 Q4Q3Q2 Q1
Thus, a profit maximizing firm will continue to produce as
long as the price of the product is above the AVC.
Supply

Supply is a direct price and quantity relationship indicating
how suppliers (producers, sellers, & mgrs) of a product
respond to differing price levels.

It states what suppliers are WILLING and ABLE to
supply at a given price.
Derivation of Supply Curves



Supply curve for the individual
firm is based on the cost
structure of the firm & how
managers respond to alternative
product prices as they attempt
to maximize profits.
We discussed earlier that profit
maximizing firms will shut
down if the price of the product
falls below the AVC.
This implies that the MC curve
above AVC represents the
firm’s supply curve.
P1
Q1
The Competitive Firm’s Supply Responses
The Competitive Firm’s Short-Run Supply Curve
Law of Supply

The Law of Supply says that
the quantity of goods &/or
services offered will vary
DIRECTLY with the price.


Price increase will result in
an increase in quantity
supplied.
Price decrease will result in
a decrease in quantity
supplied.
Price
S
P3
P2
P1
Q1

The amount of increase or
decrease, however, depends on
the Elasticity of Supply.
Q2
Q3
Output
Firms and the Industry

A market always involves both buyers and sellers of a
product or commodity.
 It may involve only firms, as when farmers sell grains
to elevators

A firm is an individual business.

The industry is made up of a set of firms competing in a
particular market.
Firm1 + Firm2 + … + Firmn = Industry
The Competitive Industry Supply Curve
The Competitive Industry and the Firm
A Rise in Marginal Costs
Why is the competitive environment
important in marketing?

Marketing managers operate in REAL MARKETS.
Competition is not the same in all markets

Recognize opportunities and constraints of the
environment
Begin to understand firm choices
Begin to understand competitive reaction

