Chapter 6

Competition
(Perfect Competition and Monopoly)

À Firms compete with one another to

attract customers by:
1. Cutting Prices
2. Other means
À Two types of Competition
1. Price Competition: Reducing the prices of
their products below the prices of
competing firms for boosting sales and
profits.

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2. Non-Price Competition: Creating a demand
by Advertising and through both pre and
post sale activities.
À Market Structure refers to certain market
characteristics that influence the firm’s
pricing and output behavior.
À Markets differ from one another due to
differences in the:
1. Number of Buyers and Sellers
2. Nature of the Product
3. Influence over Price
4. Freedom for Entry and Exit

À In Markets where there are a Large

number of small buyers and sellers,
individual firms have little control over
price.
À By Differentiating its product, a firm can
gain some control over price.
À If it is easy for new firms to enter an
industry, existing firms may have little
freedom in their pricing decisions.

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 Market Structures and Characteristics
Perfect Monopolistic Oligopoly Monopoly
Competition Competition

Large Number Many firms Few firms Single firm

of firms

Identical Differentiated Similar or product has

products Products Differentia no close
ted substitutes
Products

Market Structures and Characteristics

Perfect Monopolistic Oligopoly Monopoly
Competition Competition

No barriers to Freedom of Some Effective

entry and exit entry and exit barriers to barriers to
entry entry

No control Small control Substantia Significant

over market over market l control control over
price price over price price

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 Perfect Competition
À Implies complete absence of rivalry among
the firms.
À Individual economic units are very small
relative to the total market.
À Actions of one unit have no impact on
others.
À Units do not have to consider the effect of
their activities on other participants in the
market.
À PC in economic theory has a opposite
meaning to the everyday usage of the term.

Characteristics:
À Large number of buyers and sellers in the
market.
À No single seller is able to exert influence
over price.
À Sellers are price takers, offer their product
at market determined price.
À Individual buyer and seller is an insignificant
player in the market.
À Homogeneous or identical products in the
market- product is totally undifferentiated.

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À Free Entry and Exit.
À Uniform price in the market.
À Buyers have full knowledge about the nature
of the product and the prices charged.
Determination of Market Price
(Equilibrium Price)
À No single entity can affect price.
À Aggregate effect of the participants is
considered.
À Interaction of supply and demand
determines equilibrium price and quantity to
be exchanged.

Market Supply and Demand Schedule

Price($)/Unit Single Firm Mkt. Supply Market Impact

(10 firms) Demand
8 10 100 70 Excess
supply
7 9.5 95 80 Excess
supply
6 9 90 90 Equilibrium

5 8.5 85 100 Excess

Demand
4 8 80 120 Excess
Demand
3 7.5 75 130 Excess
Demand

The Equilibrium Price is $ 6 at which the quantity demanded equals

quantity supplied.

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Price per unit
($)
S
D

7.00

E
Pe

4.00

D
S
0
80 Qe 95 Quantity

À The Equilibrium Price Pe is determined by

the intersection of the S and D curves.
À If the price is > Pe, there is excess S leading
to fall in price.
À If the price is < Pe, there is excess D
leading to rise in price.
AR and MR of a Firm
À For a firm P=AR=MR, since the price is
constant.
À As the firms are Price-takers, demand curve
is perfectly elastic.

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 TR, AR and MR of a Perfectly Competitive Firm

Price Deman TR AR MR
d
10 0 0 - -
10 1 10 10 10
10 2 20 10 10
10 3 30 10 10
10 4 40 10 10
10 5 50 10 10
MR is the same as the AR as the Price remains constant.

Industry Firm

D S

P
AR/MR
Price

S D

0 0 X
Quantity Quantity
(a) (b)

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ÀAs a price taker, the firm faces a
Perfectly Elastic demand curve.
ÀThe demand curve is also known as AR
and MR curve.
Role of Single Firm
ÀNo significant impact on the market
price so far output decisions of
individual producers are concerned.

Equilibrium Analysis
ÀIn a Purely Competitive market there
are Three types of Equilibrium.
1.The Firm
2.The Industry
3.The Market

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À A Firm reaches Equilibrium when MR = MC.

À An Industry attains Equilibrium when there

is neither Entry of new firms into the
industry nor Exit of old firms from it. (Only
when each firm is able to make only normal
profit and reaches its break-even point).

À The Market reaches Equilibrium when QD

equals QS for sale.

Equilibrium of a Firm
À A Firm is said to be in equilibrium when it
earns Maximum Profits.
À There will be no incentive for the firm to
change either its output or the price of its
products, i.e., the firm finds no incentive for
change.
À The Two Approaches to study Equilibrium
Analysis are:
1. Total Revenue -Total Cost Approach
2. Marginal Revenue– Marginal Cost Approach

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 Revenue & Cost Schedule of a Firm
Output Price/ Unit TR MR TC MC Total Profits

000 8 0 - 800 - -800

100 8 800 8 2000 12.00 -1200 Total Loss
Maximized
200 8 1600 8 2300 3.00 -700
300 8 2400 8 2400 1.00 0 Break-Even
Point
400 8 3200 8 2525 1.25 675
500 8 4000 8 2775 2.50 1275
600 8 4800 8 3200 4.25 1600
650 8 5200 8 3600 8.00 1600 Total Profit
Maximized
700 8 5600 8 4800 24.00 800

TR-TC Approach

À How much Total Revenue the Firm earns

from selling various amounts of its Product
À How much it costs the firm to produce the
same volume of output.
À The level of output where the difference
between the TR and TC will be maximum is
known as Equilibrium output and price
corresponding to the equilibrium output is
known as Equilibrium Price.

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À If TR < TVC at all output levels, the Profit-
maximizing strategy is to Shut down and
absorb the loss due to the TFC, which can
not be avoided in the short –run.
À If there are output levels at which the TR >
TVC, the firm should produce where the
vertical distance between the TR and TC is
at Maximum.
À The firm will be in equilibrium when it
produces 650 units of output, as it earns
maximum profit.

À If TR > TC, then π > 0; if TR = TC then π =

0; and if TR< TC, then π < 0.
À To maximize profits, the firm can choose
that level of Q at which the difference
between TR and TC is maximum, i.e., the
profit maximizing output is Qe and the
maximum profit is MK.

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 Total revenue

Total Cost
Maximum
Profit
Cost and Revenue

0 Output
Qe

MR-MC Approach
À Equilibrium output is that level of output
when the firm’s MR equals MC.
À MR is the addition to the TR as a result of a
unit increase in sales of a firm.
À MC is the addition to the TC as a result of a
unit increase in the output of a firm.
À Maximum profits occur for the firm at that
level of output where its MR = MC, i.e. 650
units.

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À Thus, the profit maximizing output is
determined where the extra revenue
generated by selling the last unit just equals
the MC of producing that unit.
À Beyond equilibrium level of Q, MC > MR and
less than that level MR > MC.
À Profit will be maximum at the Q where MR =
MC.
À Profit function can be π = TR – TC, to
maximize total profit, the first order
condition requires that dπ/ dq = 0.

À dπ/ dQ = dTR/ dQ – dTC/ dQ = 0

À dTR/ dQ = dTC/ dQ
À That is MR = MC.
À Again when total profit is maximum,
marginal profit is 0.
À Marginal Profit is the difference between MR
and MC and when MR = MC, marginal profit
is 0 and total profit is maximum, means the
firm does not gain by expanding its output
further.

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À In Perfect Competition, the demand curve
faced by a firm is horizontal at the price
determined by industry supply & demand
forces.
À Hence, P = MR = AR.
À The first order condition for profit
maximizing is MC = MR = AR = P.
À Equality of MR with MC is just a necessary
and not a sufficient condition of π
maximization.
À The second order condition for profit
maximization requires d2π/ dq2 < 0.

À d 2TR/dQ 2– d 2TC/ dQ2 < 0

or, d 2TR/dQ 2 < d 2TC/ dQ2
À Slope of MR curve should be less than the
slope of the MC curve.
À In perfect competition, MR = P which is
constant.
À Second order condition implies that the
slope of MC curve should be positive or the
MC must be rising.
À MC curve has to intersect the MR curve
from below.

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 Y

MC
Cost/ Revenue

L K
MR= AR
P

0 Q1 Q0 X
Quantity

À As seen, point K can be considered as the

equilibrium point since it satisfies both the
first and second condition.
Issues
1.Should a firm produce at a given market
price?
2.How much should it produce?
1.A firm will produce at any level of output
if TR ≥ TVC or AR ≥ AVC or P ≥ AVC, i.e., TR
exceeds or at least equal to TVC.

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 2. A level of Q at which a firm earns
maximum profits (given perfectly elastic
demand curve) would be the one that
satisfies the following two conditions:
MR = MC and MC cuts MR from below.
Shut down Decisions
À Refers to a Short run decision not to
produce anything during a specific period of
time due to adverse market conditions.
À Exit refers to a Long run decision to leave
the market.

À If a firm has to shut down it has to bear its

Fixed Cost.
À A firm will decide to shut down if the price
of its product is less than the AVC, i.e., TR
< TVC or P < AVC.
À The lowest point of the AVC curve is called
the shut down point.
SR Equilibrium of a Firm
À Is attained at a level of Q which satisfies the
conditions: MR = MC and MC cuts MR from
below.

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À In SR equilibrium, a firm may find itself any
of the situations: losses or profits or breaks
even.
À A firm suffers losses, if at the equilibrium
level of Q, its AC > AR or P.
À Equilibrium point : E
À Equilibrium output: OQ
À Average Revenue: QE
À Average Cost : QK
À Loss per unit : QK – QE = EK
À Total Loss : EK × OQ = Area PEKT

AC

MC
Cost/ Revenue

K
T

E
P
AR = MR

0 X
Q
Quantity

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À A firm earns profits if at the equilibrium
output AR > AC.
À Average Revenue : QE
À Average Cost : QK
À Profit per unit : QE – QK = EK
À Total Profit : EK × OQ = Area PEKT
À A firm breaks even when at the equilibrium
Q its AR = AC.
À Average Revenue : QE
À Average Cost : QE

Y
MC
AC
Cost / Revenue

E
P
AR = MR

T K

0 X
Q
Quantity

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 Y

MC AC
Cost / Revenue

P
E AR = MR

0 X
Q Quantity

À A firm will continue to produce at the

equilibrium level of output when AR ≥ AVC,
otherwise the firm will shut down.

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 Y

MC
AC

AVC
Cost / Revenue

E
P
AR = MR

0 X
Q Quantity

Class Assignment: 1

A perfectly Competitive firm has the following cost

schedule.

Q 0 1 2 3 4 5 6 7 8 9 10

TC 9 20 30 39 47 54 60 67 77 90 109

If the market price is 13$, what output will the firm choose to produce
to maximize profits? What is the maximum profit?

Suppose the market price falls to 6$, how much will the firm choose to
produce now and what will be its profit?

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 Long-run Equilibrium
À Key to LR equilibrium is entry and exit of
firms.
À An Entry-attracting Price: When firms earn
abnormal profits (AR > AC), new firms
enter the industry.
À Supply level goes up, price level falls and all
firms earn zero profit.
À An Exit-inducing Price: When firms incur
losses, exit of firms occur.
À Supply level goes down, price level
increases and firms are in the zero profit
equilibrium.

À Break-even Price: Neither an attraction for

new firms to enter the industry nor for
existing firms to exit.
À The industry will be zero profit equilibrium.
À LR equilibrium of a perfectly competitive
industry obtains when all the firms are in
zero-profit equilibrium.
À When the industry is in equilibrium, each
firm not only earns zero profits but produces
at the lowest point on its LAC curve.
À Resources are used most efficiently to
produce goods at minimum cost.

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À Since firms also earn zero profits, consumers
purchase the commodity at the lowest
possible price.
Industry's Equilibrium SS
Firm's Equilibrium LMC
Y
YY LAC
Cost / Revenue

Price
P P E
E P = MR

DD
0 X 0
Q X
Q

À Class Assignment: 2
A firm produces output at a constant MC of
$6 and has no fixed costs. The demand
position of the firm is given below:

Price $ QD (units)
12 0
10 5
8 10
6 15
4 20

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À Determine the firm’s profit-maximizing
output, price and profit.
À Show that by producing more or less output
the firm would decrease its profit.
À Explain what happens to MR when output is
raised from 15 to 20 units.

MONOPOLY
À Single Producer and a unique product.
À Entry as well as exit totally prohibited.
À No substitute of the product in the market .
À Number of buyers could be large, small or
just one.
À No difference between the industry and the
firm.
À Demand curve facing the monopolist firm is
one faced by the purely competitive
industry which slopes downward.

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À Implies that more could be sold only at the
lower price.
À Firm is a price-maker.
AR and MR of Monopoly Firm
À The MR curve of the monopoly firm placed
below the AR curve.
SR and LR Equilibrium of the Firm
À Profit in both periods
À Loss only in SR
À Normal profit in both periods

Demand curve ( D )
Revenue

AR
0 X
Q
MR Quantity

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 Y

Abnormal
Profits MC AC

K
Price / Cost / Revenue

Z W

E AR

0 X
Q
MR Quantity ( a )

Y
MC
Normal AC
Profits

K
Price / Cost / Revenue

MR AR

0 X
Q Quantity
(b)

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 Y
Loss AC
MC

Price / Cost / Revenue

N U

T K

AR

MR
0 X
Q
Quantity ( c )

Y
Monopoly
gains
LMC
Revenue and Cost

K
N

LAC
T
J Equilibrium

AR
E

MR = MC
MR
0 X
Q
Quantity

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Class Assignment: 3
Suppose that the total cost equation for a
monopolist is given by TC = 500 + 20Q2 ,
Let the demand equation be P = 400 -20Q
and the total revenue equation is
TR = 400Q -20Q2.
What is the profit maximizing price and
quantity?

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