Theory of the Firm: Perfect competition
A perfectly competitive industry is highly unlikely to exist in its entirety given the strong assumptions
made about the operation of the market. All markets are “competitive” to one degree or another, but the
vast majority of markets are characterised as “imperfectly competitive”.
We do, though get closer to perfect competition in many markets for agricultural and other primary
commodities. These are the only markets where there are enough sellers of products that are near perfect
substitutes for each other.
Main Assumptions of Perfect Competition
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Each firm produces only a small percentage of total market output. It therefore exercises no
control over the market price. For example it cannot restrict output in the hope of forcing up the
existing market price.
There is perfect _____________ of entry and exit from the industry. This important assumption
ensures all firms make normal profits in the long run.
Firms in the market produce __________________ products that are perfect substitutes for each
other. This leads to each firms being price takers and facing a perfectly elastic demand curve for
their product. Buyers are free to move from one seller to another and will approach the seller
quoting the lowest price.
Perfect knowledge – consumers have perfect information about prices and products sold by all
producers. Producers have perfect knowledge about each others’ costs and technology available
Firms in perfect competition are assumed to be profit maximisers
Short Run Price and Output for the Perfectly Competitive Industry and Firm
In the short run the equilibrium market price is determined by the interaction between market
demand and market supply. In the left hand diagram shown below, 5 RMB is the market-clearing price
and this price is then taken by each of the firms.
The demand curve for a single firm, therefore must be a horizontal line at the ruling price- in other words, a
perfectly elastic demand curve. A firm will sell all its output at the ruling market price. If it tries to sell at
higher prices its demand will drop to zero and there is obviously no incentive to sell at a lower price as it
will not be able to produce an output that matches entire market demand at a lower price and its costs will
rise and it will be forced to raise prices again..
Because the market price is constant for each unit sold, the AR curve (Demand curve) also becomes the
Marginal Revenue curve (MR). AR = MR = Price.
Price (RMB)
S
Price (RMB)
Market for (fake) DVDs in Shanghai
Price/output of one DVD seller
5
D
Quantity
Quantity
Short run profits
It is assumed that firms producing under conditions of perfect competition are profit maximisers. A firm
maximises profits where MR = MC. In the left hand diagram below there is an increase in market demand
for DVDs in Shanghai. This forces equilibrium price up to ______. In the right hand diagram below, the
profit-maximising output is Q1. The firm sells Q1 at price 7 RMB. The area shaded is the economic
(abnormal) profit made in the short run because the ruling market price (7 RMB) is greater than average
total cost at Q1.
Price (RMB)
S
Price (RMB)
Market for (fake) DVDs in Shanghai
Price/output of one DVD seller
7
D1
D2
Quantity
Quantity
Short Run Losses
Losses can occur if either costs rise for firms (maybe due to an increase in DVD production costs) or
demand falls. In the diagram below, the market demand (on the left) falls from D1 to D2. It is costing the
firm on the right more per unit to sell the product than the price of 3 RMB that the firm receives. At the
profit maximising level of output, the firm is making an economic loss (or sub-normal profits).
Price (RMB)
S
Price (RMB)
Market for (fake) DVDs in Shanghai
Price/output of one DVD seller
3
D2
D1
Quantity
The long-run adjustment process- the elimination of abnormal profits
Quantity
If most firms are making abnormal (economic) profits in the short run we expect to see the entry of new
firms into the industry. Firms are responding to the profit motive and abnormal profits act as a __________
for a reallocation of resources towards this market. The addition of new suppliers causes an outward shift in
the market supply curve. This is shown in the left hand diagram below.
The entry of new firms shifts the market supply curve to S2 and drives down the market price to 5 RMB.
At the profit-maximising output level Q2, only normal profits are being made by the firms selling DVDs.
There is no incentive for firms to enter or leave the industry. Thus a long-run equilibrium is established.
Price (RMB)
S1
S2
Price (RMB)
Market for (fake) DVDs in Shanghai
Price/output of one DVD seller
7
5
D1
Quantity
Quantity
If firms are making losses due to an increase in costs then some firms will start to leave the industry
in the long run as losses are unsustainable. Resources will be allocated away from the industry. As
the number of suppliers falls, total market supply will shift _______ and price will ________. Price will
continue to rise until the existing firms are earning normal profits- no more or no less.
The shut down condition
The standard theory for firms in any market structure assumes that a business needs to make at least
normal profit in the long run (ie break even) to justify remaining in the industry but this is not
necessarily a strict requirement for a firm in the short run. Indeed many businesses continue to operate at a
loss when there is a fall in market demand causing prices to fall and revenues to dip below costs.
Consider initially a firm operating in a perfectly competitive market. Using the original example of a DVD
seller, assume that the market price for DVDs is 5 RMB. At this price the seller earns normal profits.
However, due to a spate of poor quality DVDs sold, market demand falls (on left hand diagram) causing
market price to fall to 4 RMB. The DVD seller is forced to accept this new price below his average costs
of production (show on right hand diagram).
Your diagram should show the seller earning ____________ profit. He won’t be able to continue earning a
loss in the long run as his total costs exceed total revenue (and AR>AC). However, in the short run the
seller should continue selling DVDs as long as he is able to cover his variable costs of production. Or,
put another way, so long as Price per unit is greater than or equal to Average Variable Cost. The reason for
this is simple business- as long as the DVD seller is able to get a price that covers the costs of the DVDs
(variable costs) and contributes something towards his fixed costs (profit/petrol/road tax) then it makes
sense to still continue to trade in the SHORT RUN.
So in the short run it is better for the DVD seller to sell something, rather than close down and sell nothing.
If he sells nothing he will have no variable costs but will have to meet his fixed costs. Fixed costs have to
be paid even if output is zero. So for the seller below, it is better for the DVD seller to set an output
where MR=MC as this is where its losses are minimized. On the right hand diagram show: 1) the area of
economic loss 2) Total Revenue for the seller 3) Total Variable Costs 4) contribution to Fixed Costs.
Price (RMB)
S
Price (RMB)
Market for (fake) DVDs in Shanghai
Price/output of one DVD seller
5
4
D2
D1
Quantity
Quantity
In the second example in the diagram below, the market price is so low that the seller is just covering his
average variable costs and no more. (price = 3RMB and cost of DVD to seller = 3RMB) The DVD seller
has reached the shut down price and might consider not getting out of bed and setting up shop. Show this
situation on the diagram on the right hand side.
Price (RMB)
S
Price (RMB)
Market for (fake) DVDs in Shanghai
Price/output of one DVD seller
5
3
D3
D1
Quantity
Quantity
Real Examples of the Shut-Down condition
Shut downs in the real world occur most frequently in primary industries. If the price of gold fails to cover
the direct (variable) costs of extracting it, the gold mine closes. If the price of fish is insufficient to cover
variable costs, the boat will stay in harbour. Farmers will plough crops back into the ground if the price is
below the variable costs of harvesting and transportation to the market.