ME_SESSION 18 & 19

MARKET STRUCTURES & PRICING

PRACTICES: Perfect competition
Introduction
Objectives of the session:
1. To understand meaning of market
2. To understand various types of markets
3. To examine how equilibrium price & qty
is determined in different types of
market
4. To determine the level of profit
maximising price
What is common among them?
What is common among
them?
What is common among
them?
What is common among
them?
Competitive Environment
What is Market Structure?
Market structure describes the competitive
environment in terms of:
Number of buyers and sellers.
Potential entrants.
Barriers to entry and exit, etc.
Actual & and potential competitors are
important.
 Market Structure & Degree of
Competition
Market consists of all the actual &
potential buyers & sellers of a
particular product.
Market structure refers to the
competitive environment in which
buyers & sellers operate.
Four types of market structures usually
identified are based on the
competition level
a. Perfect competition
b. Monopolistic competition
c. Oligopoly
d. Monopoly
Four Basic Market Types
 Market Structure

Less Competitive
Perfect Competition
Monopolistic
More Competitive

Competition
Oligopoly
Monopoly
 Characteristics of Perfect
Competition
a. Many buyers & many sellers of a product
b. Product is homogenous
c. Perfect mobility of factors of production
d. Perfect knowledge of market
e. Free entry & free exit
f. No government interference

Examples of Competitive Markets

Agricultural commodities, e.g., cotton.
Stock market, discount retailing, Unskilled labor
market
Fish auction: an example of PC

Auctions of a perishable commodity like fish in

a market period (very short period) can be an
example of Perfect competition.
In a bad weather when few boats go out in a
sea and the catch is small, the price will be
high. In a good weather, the prices will come
down.
The buyers (mostly wholesalers) and the
sellers (mostly fishermen) both have enough
information to take the decisions.
There is competition among buyers as well as
among sellers.
Pricing and Output Decisions in PC

The Basic Business Decision: entering a

market on the basis of the following
questions:
How much should we produce?
If we produce such an amount, how much
profit will we earn?
If a loss rather than a profit is incurred, will
it be worthwhile to continue in this market
in the long run (in hopes that we will
eventually earn a profit) or should we exit?
 Pricing and Output Decisions in
PC
Key assumptions of the perfectly
competitive market

The firm operates in a perfectly competitive

market and therefore is a price taker.
The firm makes the distinction between the
short run and the long run.
The firms objective is to maximize its profit
in the short run. If it cannot earn a profit,
then it seeks to minimize its loss.
The firm includes its opportunity cost of
operating in a particular market as part of
its total cost of production.
Example of a Normal Profit
Suppose a manager of a
convenience store wants to
operate a store of her own. She
knows that she will have to leave
her job of Rs. 45,000 per year and
use Rs. 50,000 of her savings
currently earning 10% of interest.
Normal Profit, Economic Profit &
Economic Loss
Normal Economic Economic
profit Profit loss

Revenue 5,00,000 5,50,000 4,80,000

Accounting 4,50,000 4,50,000 4,50,000

Cost

Opportunity 50,000 50,000 50,000

cost

Profit 0 50,000 -20,000

Competitive Market Equilibrium

Balance of Supply and Demand

Equilibrium is a balance of supply and
demand.
Normal Profit Equilibrium
There are no economic profits in
competitive equilibrium; firms earn a
normal rate of return.
With a horizontal market demand
curve, MR=P, so P=MR=MC=ATC.
Pricing and Output Decisions in PC

Perfectly Elastic demand

curve: consumers are
willing to buy as much as
the firm is willing to sell
at the going market
price.
Firm receives the same
marginal revenue from
the sale of each
additional unit of
product; equal to the
price of the product.
No limit to the total
revenue that the firm can
gain in a perfectly
competitive market.
 Price Determination in Short Run

In PC the firm is price taker.

D curve for the firm is horizontal or (e =
infinity)
Equilibrium price & output is determined where
market D & S are equal to each other.
QD = 625 5P; QS = 175 + 5P
625 5P = 175 + 5P
450 = 10P; P = 45

QD = 625 5P = 625 5(45) = 400

QS = 175 + 5P = 175 + 5(45) = 400
 P C: Short-Run Equilibrium

The best level of output for any firm is where MR

= MC
Demand curve of PC firm = Market price =
Marginal Revenue P= MR
Equilibrium comes where P = MR = MC
Golden rule
Expand output: MR > MC
Stop before MC > MR

Supply curve of PC firm = rising portion of

Marginal Cost or where MC > AVC
It is because the competitive firm always
produces where P = MR = MC, as long as P >
Short-Run Cost and Revenue for a
Perfectly Competitive Firm
 Total cost Total revenue
(=$5 q)
Short-Run Profit
$60 Maximization
Total dollars

Maximum economic
48
profit = $12 (a) Total revenue minus
total cost
15 TR: straight line, slope=5=P
TC increases with output
Bushels of wheat per day Max Economic profit:
0 5 7 10 12 15
where TR exceeds TC by
Marginal cost the greatest amount
Dollars per bushel

Average total cost

e
$5 d = Marginal revenue (b) Marginal cost equals
Profit = Average revenue marginal revenue
4
a MR: horizontal line at P=$5
Max Economic profit:
at 12 bushels,
Bushels of wheat per day where MR=MC
0 5 7 10 12 15
Minimizing Short-Run Losses
 Total cost Total revenue
(=$3 q)
Short-Run Loss
Minimization
Total dollars

$40
30 Minimum economic (a) Total revenue minus
loss = $10
total cost
15
TC>TR; loss
Bushels of wheat per day Minimize loss: 10
0 5 10 15 bushels
Marginal cost Average total cost
Dollars per bushel

(b) Marginal cost equals

Average variable cost
$4.00 marginal revenue
Loss e
3.00 d = Marginal revenue MR=MC=$3; ATC=$4
2.50 = Average revenue P=$3; P>AVC
Continue to produce
Bushels of wheat per day in short run
0 5 10 15
Summary of Short-Run Output Decisions
Break-even
point Marginal cost Firms short-run S curve
5
p5 d5 p5>ATC, q5, economic profit
Average total cost
4
Dollars per unit

p4 d4 p4=ATC, q4, normal profit

Average variable cost
3
p3 d3 ATC>p3>AVC, q3, loss <FC
2
p2 d2 p2=AVC, q2 or 0, loss=FC
p1 1 d1 p1<AVC, shut down,
Shutdown
q1=0,loss=FC
point
0
q1 q2 q3 q4 q5 Quantity per period
 Output Decisions in PC

The point where

P=MR=MC is the
optimal output
(Q*)
Profit = TR TC
=(P - AC) Q*
Output Decisions in PC

The firm incurs a

loss. At the optimum
output level price is
below average cost.
However, since price
is greater than
average variable
cost, the firm is
better off producing
in the short run,
because it will still
incur fixed costs
greater than the loss.
Short-Run Profit Maximization and Market Equilibrium

Market price $5 determines the perfectly elastic S = horizontal sum of the supply curves of all firms in
demand curve (and MR) facing the individual firm. the industry Intersection of S and D: market price $5
Output Determination in Short Run

In the short run some of the inputs are

fixed.
It means the firm should stay in
business even if it is incurring losses as
long as losses are smaller than fixed
cost or can cover up at least variable
cost.

Equilibrium arises where MR = MC

Since in PC, MR = price
Equilibrium = P = MR = MC
Pricing and Output Decisions in PC

Shutdown Point: the lowest price at

which the firm would still produce.
At the shutdown point, the price is equal
to the minimum point on the AVC. This
is where selling at the price results in
zero contribution margin.
If the price falls below the shutdown
point, revenues fail to cover the fixed
costs and the variable costs. The firm
would be better off if it shut down and
just paid its fixed costs.
Class activity
A lamp manufacturer faces a
horizontal demand curve. The
firms total costs are given as
below:
TVC = 150Q 20Q2 + Q3
Below what price the firm should
shut down?
 Answer
MC = 150 40Q +3Q2
AVC = 150 20Q + Q2
At the shutdown point AVC = Price
Thus 150 40Q + 3Q2 = 150 20Q + Q2
= 2Q2 20Q = 0
= 2Q (Q 10) = 0
= Q = 10
P = MC = 150 40(10) +3(100) = 50
If the price fall below 50, the firm should shut
down.
Perfect Competition
in the Long Run

Long run
Firms enter/exit the market
Firms adjust scale of operations
Until average cost is minimized
All resources are variable
Output Determination in Long Run

In the long run as all inputs are variable,

the firm can construct optimum size of
plant where AC is at lowest.
The best level of output is at which
Price = LMC = SATC which is tangent to
Long Term Avg Cost
In the long run the firm earns only
normal profits or zero economic profits
which just cover explicit as well as
implicit costs.
If the firm could not operate at lowest
point at LAC, it will have to leave the
market.
Perfect Competition
in the Long Run

Economic profit in short run

New firms enter market in long run
Existing firms expand in long run
Market S increases
P decreases
Economic profit disappears
Firms break even
 Perfect Competition
in the Long Run
Economic loss in short run
Some firms exit the market in long run
Some firms reduce scale in long run
Market S decreases
P increases
Economic loss disappears
Firms break even
Zero Economic Profit
in the Long Run

Firms enter, leave, change scale

Market:
S shifts; P changes
Firm
d(P=MR=AR) shifts
Long run equilibrium
MR=MC =ATC=LRAC
Normal profit
Zero economic profit
Long-Run Equilibrium for a Firm and the Industry
(a) Firm (b) Industry or market

MC S
Dollars per unit

Price per unit

ATC
LRAC
e
p d p

Quantity Quantity
0 q per period 0 Q
per period
Long run equilibrium: P=MC=MR=ATC=LRAC. No reason for new firms to enter the market
or for existing firms to leave. As long as the market demand and supply curves remain
unchanged, the industry will continue to produce a total of Q units of output at price p.
Output Determination in Long Run
Perfect Competition
and Efficiency

Productive efficiency: Making Stuff Right

Produce output at the least possible cost
Min point on LRAC curve
P = min average cost in long run

Allocative efficiency: Making the Right Stuff

Produce output that consumers value most
Marginal benefit = P = Marginal cost
Allocative efficient market
Creation of Consumer Surplus
Itis defined as the
difference between the
total amount
thatconsumersare
willing and able to pay
for a good or service
(indicated by the
demand curve) and the
total amount that they
actually do pay (i.e. the
market price).
Merits of the Perfect Competition
Higher consumer surplus
Better distribution of wealth &
income as economic profits in the
long-run are zero.
Lowest Long-run AC shows the
efficient use of resources
Ease in shifting resources shows
higher welfare
Relevance of understanding PC

Even though PC is rare in the real world, the

perfectly competitive model is very important
to understand.
It can be applied to those markets which are
close to being perfectly competitive.
It provides the point of reference or standard
against which to measure economic cost or
inefficiencies associated with departures from
perfect competition.
Although perfectly competitive markets are
very few, the basic short-run & long-run
behaviour studied in this model can be found
in all types of market structures.
Implications of Perfect competition
Most important lesson is that it is extremely
difficult to make money.
Must be as cost efficient as possible.
It might pay for a firm to move into a
market before others start to enter.
Firms entry into business and exit from
business are important.
It is always better to enter in the business
when costs are low and demand is rising.
It is always better to exit when costs start
rising and demand becomes saturated due
to free entry.
 Class activity

ABC, Inc., provides recycled toner cartridges

for printers which is perfectly competitive
market. Total and marginal cost relations per
week are:
TC = $830,000 + $10Q + $0.005Q2
where Q is the number of recycled toner
cartridges.
A. Calculate ABCs optimal output and profits
if prices are stable at $150 per toner cartridge.
B. Is it possible to earn economic profits in the
long run?.
A) Calculate ABCs optimal output and profits if
prices are stable at $150 per toner cartridge.
At profit maximization - MR= MC
$150 = $10 + $0.01Q
0.01Q = 140
Q= 14,000
Profits = TR TC
= 150Q [830,000 + 10Q + 0.005Q2]
= 150(14,000) [830,000 + 10(14,000) +
0.005(14,0002)]
=150,000
B) Is it possible to earn economic profits the
long run?.
No because as the firm ABC is making
economic profit, new firms will enter into
market and industry supply curve would shift
outside bringing equilibrium price downwards
where every firm is earning nominal profits or
zero economic profits.
Concepts learnt
Market mechanism
Price and non-price competition
Entry and exit barriers
Price taking firm
Equilibrium of the firm
Short-run equilibrium
Shut-down point
Long-run equilibrium
Implications of PC for the economy