The Perfectly Competitive Market

Economics 11 UPLB

Market Economy

the market is a system where buyers and sellers exchange goods or services market is actually a very logical mechanism that helps answer the basic economic questions of what, how much and for whom to produce different commodities. system continually allocates goods and services to various units with the help of a pricing mechanism

The Market System

a market for commodities - rice, milk, water, coffee, clothes and many others. a market for the inputs used in the production of these commodities like steel, minerals and labor. Each market may have a different structure:
the number of sellers or buyers demand for the commodity control in the market.

Two General Types of Markets

I. II.

the Perfectly Competitive Market [5 main features] the imperfect market

Monopoly one firm Oligopoly two or more, but few firms Monopolistic competition many firms selling differentiated products.

5 Features of Perfectly Competitive Market

1. Smallness of buyers and sellers relative to the market 2. Homogeneous product 3. Absence of artificial restraints or controls 4. Perfect mobility of goods and resources 5. Perfect information

The Demand Curve Faced by the Firm

since the firm cannot control the market price, owing to its smallness relative to the market, the firm can actually sell as much output as it wants without influencing the price. the firm in perfect competition faces a perfectly elastic demand curve
P d Q

the equilibrium price is still determined in the market by the forces of demand and supply

Revenues of the Firm

Total revenue (TR) is the firm's gross income from the sale of its product TR=P.Q Marginal revenue (MR) is the additional revenue earned from each additional unit of output sold. MR=TR/Q

Average revenue (AR) is total revenue divided by output. AR=TR/Q

Market
Price D S

Firm

P*

P*

0 Equilibrium price is determined in the market

0 Once determined, a firm can sell as much as it wants at that price

Market
Price D D2 S

Firm

P2 P*

P2 P*

d2 d

0 Equilibrium price is determined in the market

0 Once determined, a firm can sell as much as it wants at that price

Supply Price Price P* Demand Q Q

P*

Output (A) Market

Output (B) Firm

FIGURE 6.1. The market and firm demand curves for a perfectly competitive good. In the left panel of this diagram, we find a downward sloping market demand curve for the good. Its intersection with the market supply curve determines the equilibrium price (P*) that will prevail in the market. Since a perfectly competitive firm can sell all that it wants at P*, the firms demand curve is the horizontal line shown at the right panel of this diagram.

Price, MR and AR
Q 0 1 2 3 4 5 P 200 200 200 200 200 200 TR 0 200 400 600 800 1000 MR 200 200 200 200 200 AR 200 200 200 200 200

Under pure competition, P = MR = AR

Revenue

600

TR

400

P = 200

MR = AR

Output

Total Cost, Total Revenue, and Profit at Different Levels of Output

Output (Q) 0 1 2 3 4 5 6 7 8 9 10 Price (P) 200 200 200 200 200 200 200 200 200 200 200 Total Revenue (TR) 0 200 400 600 800 1000 1,200 1,400 1,600 1,800 2,000 Marginal Revenue (MR) ~ 200 200 200 200 200 200 200 200 200 200 Total Cost (TC) 500 591 668 737 804 875 956 1,053 1,172 1,319 1,519 Marginal Cost (MC) ~ 91 77 69 67 71 81 97 119 147 200 Profit () -500 -391 -268 -137 -4 125 244 347 428 481 481

11
12 13 14 15

200
200 200 200 200

2,200
2,400 2,600 2,800 3,000

200
200 200 200 200

1,784
2,119 2,529 3,019 3,599

265
335 410 490 580

416
281 71 -291 -599

Profit
0 0 Q0 Q* Q1 TR Q Q

Total Revenue, Total Cost

TR,TC

Output

TC

Deriving profits from the TR and TC curves

Top panel

Profits or losses are measured by the vertical distance between the TR and TC curves. For quantities between Q0 and Q1, the TR curve is above the TC curve. For these levels of output, the firms profits are positive. The TR and TC curves intersect at output levels Q0 and Q1. This means that the firms profits at these levels of output are zero since TR=TC. For output levels to the left of Q0 and to the right of Q1, the TR curve is below the TC curve, which implies that the profits are negative.
a bell-shaped profit curve. firms profits are highest at Q* where the slope of the TR curve (MR) and the slope of the TC curve (TC) are equal. Hence, Q* is the firms profitmaximizing level of output.

Bottom Panel

MC P* profit 150 C E D A AC B AVC

Price, Revenue and Cost

200

MR = AR

100

Q*

0
Output

Total Revenue TR = 0P*AQ*, Total Cost TC = 0CBQ*, Profit = CP*AB

Profit maximization for a perfectly competitive firm

The firm maximizes its profit at the intersection of the MR and MC curves (point A) This means that the firms profitmaximizing level of output is equal to Q*. How large is the firms profit?

The firms total revenue is equal to the product of the price (line segment 0P*) and its output (line segment 0Q*). This suggests that its total revenue is equal to the area 0P*AQ*. On the other hand, the firms total cost is equal to the product of its average cost at Q* (line segment 0C) and its output (line segment 0Q*). This means that total cost is equal to the area 0CBQ*. Since profit is equal to TR less TC, it is therefore equal to the difference between areas 0P*AQ* and 0CBQ*. In other words, the firms profit is equal to CP*AB

EFFECT OF A FALL IN PRICE FROM P1 TO P2

MC P1 AC P2 profit AVC P2= MR2= AR2

Price, Revenue and Cost

0
Output

Q2 *

Q2 *

The effects of a fall in the output price

Since profit maximization requires the equality between MR and MC, the fall in the price leads to a fall in the firms output from Q1 to Q2 . Profit also decreases

IF PRICE FALLS TO P3 WHERE P=AC

MC

Price, Revenue and Cost

AC AVC P3 P3= MR3= AR3

0
Output

Q3 *

At P3, P=AC, so TR=TC, profit is zero

Break even point

When price falls down to P3 , price equals the lowest point of the firms average cost curve. This means that the firms total cost and total revenue are equal Thus, the firms profit at P3 is equal to zero. We refer to this as the break-even point.

PRICE falls below AC at P4

MC

Price, Revenue and Cost

AC AVC C B loss A E D P4= MR4= AR4

P4

Q4 *

Output

If price falls below AC at P4. The firm incurs a loss but must continue to produce to minimize losses.

Loss Minimization at a price between the minimum AC and AVC curves

If the output price (such as P4) is between the minimum points of the AC and AVC curves, MR = MC at point A, and the best output level is equal to Q4. The firm is experiencing losses at P4. TR<TC implying a loss of P4 CBA. To minimize its losses, the firm will continue to produce. If the firm decides to stop production, it will still continue to pay for its fixed costs ECBD Since area ECBD is larger than P2CBA, its losses from closing down are larger than its losses from continued production.

At P5 = min AVC, the loss is equal to the Total Fixed Cost (TFC), which is the also the loss if the firm did not produce. Therefore the firm should shut down.
MC

Price, Revenue and Cost

AC AVC

loss P5 P5= MR5= AR5

Q 5*
Output

Note that Q changes as P changes. Given the P, Q is determined at P=MC. There for the MC curve traces the firms supply curve, but only above the minimum AVC
MC

Price, Revenue and Cost

P1 P2

AC AVC

P3 P4 P5

Q5 Q4 Q3

Q2 Q1

Output

Firms Supply Curve:

Portion of MC curve above the AVC curve MC

Price, Revenue and Cost

P1 P2

AC AVC

P3 P4 P5 loss P= MR= AR

Q5 Q4 Q3

Q2 Q1

Output

Long Run Equilibrium

Suppose that the price level (determined by D-S) is such that it is profitable for firms to operate.
Positive profits will attract new firms into the industry. Supply curve will shift to the right Price will decline until profit is driven down to zero.

Long Run Equilibrium

Suppose that the price level (as determined by D-S conditions) is such that it not profitable for firms to operate.
Negative profits will make some firms leave the industry. Supply curve will shift to the left Price will increase until profit is no longer negative.

P D S0 MC SAC P0 P1 LAC MR, AR P0 P1 S1

Q1

Q0

At Po, firms are reaping profits. New firms are attracted as long as profits are positive. Supply curve shifts to the right, so price falls.

The entry or exit of firms will stop only when profit is reduced to zero. This is at the lowest point of the LAC curve.

COST

LMC

LAC

SMC1 SAC1 P MR, AR

0 Long Run Equilibrium of the Industry: P = LMC = SMC, P = LAC = SAC

Constant cost industry

Suppose that the industrys initial long-run equilibrium corresponds to price and output levels P0 and Q0, respectively. With an increase demand from D0 to D1 short-run equilibrium price and quantity increase The higher price makes the industry profitable. Firms will be encouraged to enter the industry. This causes a rightward shift in the market supply curve. We have a constant cost industry if the shift in the supply curve leads to a long-run equilibrium wherein the market price goes back to P0.

P D0 D1 S0 S1

P1 P0 Price
Long Run Supply Curve

Q Q0 Q1 Quantity

COST

LMC

LAC

SMC1 P1 P0 SAC1 MR1 MR0

The increase in price will make the industry profitable. This will result in entry of new firms. The increased supply will drive the price down until profits are back to zero at P0.

Increasing cost industry

Suppose that the industrys initial long-run equilibrium corresponds to price and output levels P0 and Q0, respectively. With an increase demand from D0 to D1 short-run equilibrium price and quantity increase. The higher price makes the industry profitable. Firms will be encouraged to enter the industry. The entry of firms causes LAC to shift upwards. We have a increasing cost industry if the shift in the supply curve leads to a long-run equilibrium wherein the market price P1 is greater than P0.

COST

LMC
LAC1 LAC0 SMC1 SAC1 MR1 MR0

P1 P1 P0

Q 0 Q1

The increase in price will make the industry profitable. The entry of new firms causes the LAC to increase (move up). Equilibrium will be established at P1,Q1

P D0 D1 S0 S1

Long Run Supply Curve

P1 P1 P1 P0

Price

Q Q0 Q1 Quantity INCREASING COST INDUSTRY

Decreasing cost industry

Industrys initial long-run equilibrium corresponds to price and output levels P0 and Q0, respectively. An increase demand from D0 to D1 results in higher equilibrium price and quantity. The higher price makes the industry profitable. Firms will be encouraged to enter the industry. However, the entry of firms causes LAC to shift downwards. We have a decreasing cost industry if the shift in the supply curve leads to a long-run equilibrium wherein the market price P1 is less than P0.

COST
LAC0 LAC1 P1 P0 P1 SMC1 SAC1 MR1 MR0

Q1

Q0

The initial increase in price will make the industry profitable. However, the entry of new firms will cause the LAC to decrease (shift downward). Equilibrium will be established at P1,Q1

P D0 D1 S0 S1

P1 P0

Price

P1
Long Run Supply Curve

Q Q0 Quantity DECREASING COST INDUSTRY Q1

Letter from parents to son

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Letter from parents to son

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Letter from parents to son

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Itang at Inang
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