LECTURE 06: PERFECTLY COMPETITIVE MARKETS
CHARACTERISTICS OF PERFECTLY COMPETITIVE MARKETS
1) Price taking
2) Product homogeneity
3) Free entry and exit
PRICE TAKING
The individual firm sells a very small share of the total market output and, therefore, cannot
influence market price. The individual consumer buys too small a share of industry output to
have any impact on market price.
PRODUCT HOMOGENEITY
The products of all firms are perfect substitutes. Examples: Agricultural products, oil,
copper, iron, lumber
FREE ENTRY AND EXIT
Buyers can easily switch from one supplier to another. Suppliers can easily enter or exit a
market.
Discussion Questions
1. What are some barriers to entry and exit?
2. Are all markets competitive?
3. When is a market highly competitive?
4. Do firms maximize profits?
Possibility of other objectives
• Revenue maximization
• Dividend maximization
• Short-run profit maximization
Implications of non-profit objective
• Over the long-run investors would not support the company
• Without profits, survival unlikely
Long-run profit maximization is valid and does not exclude the possibility of altruistic
behaviour.
MARGINAL REVENUE, MARGINAL COST & PROFIT MAXIMIZATION
Determining the profit maximizing level of output
Profit (π) = Total Revenue - Total Cost
Total Revenue (R) = Pq
Total Cost (C) = Cq
Therefore:
π(q ) =R ( q ) −C (q)
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MARGINAL REVENUE, MARGINAL COST & PROFIT MAXIMIZATION
Marginal revenue is the additional revenue from producing one more unit of output.
Marginal cost is the additional cost from producing one more unit of output.
Comparing R(q) and C(q)
Output levels: 0- q0:
C(q)> R(q)
NEGATIVE PROFIT
FC + VC > R(q)
MR > MC
Indicates higher profit at higher output
Question: Why is profit negative when output is zero?
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Output levels: q0 - q*
• R(q)> C(q)
• MR > MC
Indicates higher profit at higher output while Profit is increasing
Output level: q*
R(q)= C(q)
MR = MC
Profit is maximized
Question
Why is profit reduced when producing more or less than q*?
Output levels beyond q*:
R(q)> C(q)
MC > MR
Profit is decreasing
Therefore, it can be said:
Profits are maximized when MC = MR.
Profits are maximized when:
The Competitive Firm
– Price taker
– Market output (Q) and firm output (q)
– Market demand (D) and firm demand (d)
– R(q) is a straight line
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Individual producer sells all units for $ 4 regardless of the producer’s level of output. If the
producer tries to raise price, sales are zero. If the producers tries to lower price he cannot
increase sales
P = D = MR = AR
Profit Maximization point
MC(q) = MR = P
CHOOSING OUTPUT IN SHORT RUN
We will combine production and cost analysis with demand to determine output and
profitability.
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