Perfect Competition

NAMES
PROJECT FOR
ROLL NOS

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© 2006 Thomson/South-Western
 Market structure

 Many of the firm’s decisions depend on the

structure of the market in which it operates

 Market structure describes the important

features of a market

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 How is Market Structure
determined?
 Number of suppliers
 Product’s degree of uniformity
 Do firms in the market supply identical products or
are there differences across firms?
 Ease of entry into the market
 Can new firms enter easily or are they blocked by
natural or artificial barriers?
 Forms of competition among firms
 Do firms compete only through prices or are
advertising and product differences common as
well?

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 Perfect Competition

 Individual participants have no control over

the price

 Price is determined by market supply and

demand  the perfectly competitive firm is a
price taker  it must “take” or accept, the
market price

 Firm is free to produce whatever quantity

maximizes profit 4
Perfectly Competitive Market Structure

● Both buyers and sellers are price takers.

● The number of firms is large.
● There are no barriers to entry.
● The firms’ products are identical.
● There is complete information.
● Firms are profit maximizers.

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 Price takers

Both buyers and sellers are price takers.

A price taker is a firm or individual who
takes the market price as given.
In most markets, households are price
takers – they accept the price offered in
stores.

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The Number of firms is large.

Is nothing but that perfect competition

comprises of large number of firm in the
market.

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There are no barriers to entry.

● Barriers to entry are social, political, or economic

impediments that prevent other firms from entering the
market.
● Barriers sometimes take the form of patents granted to
produce a certain good.
● Technology may prevent some firms from entering the
market.
● Social forces such as bankers only lending to certain
people may create barriers.

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The firms' products are
identical or homogenous

This requirement means that each

firm's output is indistinguishable from
any competitor's product.

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There's complete information

● Firms and consumers know all there is to

know about the market – prices, products,
and available technology.
● Any technological breakthrough would be
instantly known to all in the market.

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Firms are profit maximizers.

● The goal of all firms in a perfectly

competitive market is profit and only profit.
● The only compensation firm owners
receive is profit, not salaries.

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 Exhibit 1: Market Equilibrium and the
Firm’s Demand Curve in Perfect Competition
Market price of wheat of $5 per bushel is determined in the left panel by the intersection
of the market demand curve and the market supply curve. Once the market price is
established, farmer can sell all he or she wants at that market price  price taker

(a) Market Equilibrium (b) Firm’s Demand

Price per bushel

Price per bushel

$5 $5 d

D
Bushels of Bushels of
0 1,200,000 wheat per day 0 5 10 15 wheat per day
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 Short-Run

(b) Marginal Cost Equals Marginal Revenue

The Mc curve is the supply

curve. The MC curve
intersects the MR curve at Marginal cost
point e,
Average total cost
At rates of output less than
12 bushels, MR > MC – firm Dollars per unit
can increase profit by $5 e d = Marginal revenue
expanding output Profit = average revenue
At higher rates of output 4 a
MC > MR – firm can increase
profits by reducing output
Profit appears in the blue
shaded rectangle and equals
the price of $5 minus the
average cost of $4, or $1 per
bushel
0 Bushels of wheat
5 10 12 15 per day
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 The demand curve

 Since the firm in perfect competition is a price taker, marginal

revenue from selling one more unit is the market price  MR =
P
 Because the perfectly competitive firm can sell any quantity for
the same price per unit, marginal revenue is also average
revenue
 Average revenue, AR, equals total revenue divided by quantity 
AR = TR / q
 Thus the demand curve is Market price = marginal revenue =
average revenue

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Profit Maximization: MC = MR

 Golden rule of profit maximization:

a firm should expand output as long as marginal revenue
exceeds marginal cost and will stop expanding output before
marginal cost exceeds marginal revenue.
• Thus to maximize profits, a firm should produce where marginal
cost equals marginal revenue

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How to maximize profit

If marginal revenue does not equal marginal cost, a

firm can increase profit by changing output.
The supplier will continue to produce as long as
marginal cost is less than marginal revenue.
The supplier will cut back on production if marginal
cost is greater than marginal revenue.

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 Shutting Down in the Short Run

 The shutdown point is the point at which the

firm will be better off it shuts down than it will
if it stays in business.
 The firm should shut down if it cannot cover
average variable costs.
 A firm should continue to produce as long as
price is greater than average variable cost.

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 Contd..

• If price falls below that point it makes sense to shut

down temporarily and save the variable costs.
• If total revenue is more than total variable cost, the
firm’s best strategy is to temporarily produce at a loss.
• It is taking less of a loss than it would by shutting
down.

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The Shutdown Decision

•MC
•Price
•60

•50 •ATC

•40 •Loss
•P = MR
•30
•AVC
•20
•$17.80 •A
•10

•0
•2 •4 •6 •8 •Quantity
Normal and abnormal profits

Normal profit- is profit just sufficient to

keep that firm in operation.
Abnormal profit-profit earned by firms
over and above normal profits.

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Short run-abnormal profits

Abnormal profits are the main reason why firms

enter into market.
Firms can easily enter and leave the market
due to less barriers
This means the higher the existence of
abnormal profits more firms will be attracted in
the short run. Thus increasing overall market
supply in that industry

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LONG RUN-NORMAL PROFITS

In the long run there is intense

competition due to new entrants of firms
This reduces the market price and thus
firms face diminishing abnormal profits
Due to which some firms may leave the
market in the long run and aim at other
abnormal profit markets.

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 contd….

The long run is therefore where the only firms left

are the most efficient ones, making a normal profit.
The long run equilibrium is where MC=ATC=AR=MR
Thus in perfect competition firms enjoy abnormal
profits in the short run and settle down with normal
profits in the long run.

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 Long Run Equilibrium for the Firm and the Industry

(a) Firm (b) Industry, or market

MC S
Dollars per unit

Price per unit

ATC

e
p d p

•P1 D

q Quantity per period Q •Q2 Quantity per period

0 0
CONCLUSION

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THANK YOU

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