Perfect Competition

Chapter 10
 Perfect Competition
 In a perfectly competitive market, the
relevant decision questions are the following:
1. Given the market price, how much should
we produce?
2. In producing such an amount, how much
of a profit will we earn (or how much of a
loss will we incur?)
3. Should we be in this market at the
present time? What are the long-run
prospects for competing in this market?
 Key Assumptions of Perfect
Competition
 The firm is a price taker.
 The firm makes a distinction between short-
run and long-run.
 The firm’s 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.
 Decision About Price and Quantity

Total Average
Total Variable Average Variable Average
Quantity Fixed Cost Cost Total Cost Fixed Cost Cost Total Cost Marginal
(Q) (TFC) (TVC) (TC) (AFC) (AVC) (AC) Cost (MC)
0 100 0.00 100.00
1 100 55.70 155.70 100.00 55.70 155.70 55.70
2 100 105.60 205.60 50.00 52.80 102.80 49.90
3 100 153.90 253.90 33.33 51.30 84.63 48.30
4 100 204.80 304.80 25.00 51.20 76.20 50.90
5 100 262.50 362.50 20.00 52.50 72.50 57.70
6 100 331.20 431.20 16.67 55.20 71.87 68.70
7 100 415.10 515.10 14.29 59.30 73.59 83.90
8 100 518.40 618.40 12.50 64.80 77.30 103.30
9 100 645.30 745.30 11.11 71.70 82.81 126.90
10 100 800.00 900.00 10.00 80.00 90.00 154.70
11 100 986.70 1,086.70 9.09 89.70 98.79 186.70
12 100 1,209.60 1,309.60 8.33 100.80 109.13 222.90
 Assume that the market price is TL110.
 Given this price, the firm is free to produce as
much as or as little as it desires.
 Since the price to the firm remains
unchanged regardless of its output level, the
firm actually faces a perfectly horizontal
demand curve.
 In other words, the firm’s demand curve is
perfectly elastic.
 Revenue Schedule
Price or
Average Total Marginal
Revenue Revenue Revenue
Quantity AR TR MR
0 110 0
1 110 110 110
2 110 220 110
3 110 330 110
4 110 440 110
5 110 550 110
6 110 660 110
7 110 770 110
8 110 880 110
9 110 990 110
10 110 1,100 110
11 110 1,210 110
12 110 1,320 110
 With a perfectly elastic demand curve, the
customers are willing to buy as much as the
firm is willing to sell at the going market
price.
 The firm receives the same marginal revenue
from the sale of each additional unit of
product.
 The marginal revenue is also the price of the
product.
 Also, from the demand curve, the price is the
average revenue.
 Hence, for a firm operating in a
perfectly competitive market,
AR = MR = P.
 This result indicates that a perfectly
competitive firm’s demand is also its
marginal and average revenue over
the range of output being considered.
 Perfectly Elastic Demand Curve

TL

P= TL110 MR = AR = D

Q
 Different Types of Demand Curves and
Associated Total Revenue Curves

TL/$ TL/$

P = D = AR = MR

P = D = AR

Q Q
MR

TL/$ TL/$
TR
TR

Q Q
 Relevant Question:
Optimal Output Level
 Since the firm is maximizing its profits in the
short-run, there are two equivalent ways in
which the firm can achieve this objective:
1. The firm can produce at the point where
the difference between Total Revenue (TR)
and Total Cost (TC) is at a maximum.
2. The firm can produce at the point where
the difference between Marginal Revenue
(MR) and Marginal Cost (MC) is equal to zero.
Total Revenue - Total Cost
Approach
 The optimal level of output is where
either profits are maximized or losses
are minimized.
 Graphically, this would be the point
where the distance between the total
revenue and total cost curves is
maximized.
 Total Total Cost
Total Total Variable (TC) Total
Quantity Price Revenue Fixed Cost Cost Profit
(Q) (P) (TR) (TFC) (TVC) ()
0 110 0 100 0.00 100.00 -100.00
1 110 110 100 55.70 155.70 -45.70
2 110 220 100 105.60 205.60 14.40
3 110 330 100 153.90 253.90 76.10
4 110 440 100 204.80 304.80 135.20
5 110 550 100 262.50 362.50 187.50
6 110 660 100 331.20 431.20 228.80
7 110 770 100 415.10 515.10 254.90
8 110 880 100 518.40 618.40 261.60
9 110 990 100 645.30 745.30 244.70
10 110 110 100 800.00 900.00 200.00
11 110 1210 100 986.70 1,086.70 123.30
12 110 1320 100 1,209.60 1,309.60 10.40
$/TL

TR

TC

Q* Q

At Q*, the distance between the TR and TC curves is maximized

which means the profits are also maximized.
 Marginal Revenue - Marginal Cost
Approach

 The optimal level of output is where either

profits are maximized or losses are
minimized.
 A firm that desires to maximize its profit (or
minimize its loss) should produce a level of
output at which the additional revenue
received from the last unit is equal to the
additional cost of producing that unit.
 This is the point where MR = MC and
M = 0.
 MR=MC in Perfect Competition
 Recall that

1. The demand curve for the individual firm

is perfectly elastic in this market.

2. The demand curve is also the marginal

revenue curve and the average revenue curve.
 The Case of Economic Profits
Marginal Average
Revenue Average Variable Average Marginal
Quantity (MR = P = Fixed Cost Cost Total Cost Marginal Profit
(Q) AR) (AFC) (AVC) (AC) Cost (MC) (M)
0 110
1 110 100.00 55.70 155.70 55.70 54.30
2 110 50.00 52.80 102.80 49.90 60.10
3 110 33.33 51.30 84.63 48.30 61.70
4 110 25.00 51.20 76.20 50.90 59.10
5 110 20.00 52.50 72.50 57.70 52.30
6 110 16.67 55.20 71.87 68.70 41.30
7 110 14.29 59.30 73.59 83.90 26.10
8 110 12.50 64.80 77.30 103.30 6.70
9 110 11.11 71.70 82.81 126.90 -16.90
10 110 10.00 80.00 90.00 154.70 -44.70
11 110 9.09 89.70 98.79 186.70 -76.70
12 110 8.33 100.80 109.13 222.90 -112.90
 MC
TL/$

economic profit
A B D=MR=AR
P=110 AC

D C
AC=77.30 AVC

0
Q* Q

The area of the rectangle ABCD gives the amount of economic profits.
 The Case of Normal Profits
Average
Marginal Average Variable Average Marginal Marginal Total Profit
Quantity Revenue Fixed Cost Cost Total Cost Cost Profit or Loss
(Q) (MR) (AFC) (AVC) (ATC) (MC) (M) (Q[P– AC])
0 71.87 -100.00
1 71.87 100.00 55.70 155.70 55.70 16.17 -83.83
2 71.87 50.00 52.80 102.80 49.90 21.97 -61.86
3 71.87 33.33 51.30 84.63 48.30 23.57 -38.28
4 71.87 25.00 51.20 76.20 50.90 20.97 -17.32
5 71.87 20.00 52.50 72.50 57.70 14.17 -3.15
6 71.87 16.67 55.20 71.87 68.70 3.17 0
7 71.87 14.29 59.30 73.59 83.90 -12.03 -12.04
8 71.87 12.50 64.80 77.30 103.30 -31.43 -43.44
9 71.87 11.11 71.70 82.81 126.90 -55.03 -98.46
10 71.87 10.00 80.00 90.00 154.70 -82.83 -181.30
11 71.87 9.09 89.70 98.79 186.70 -114.83 -296.12
12 71.87 8.33 100.80 109.13 222.90 -151.03 -447.12
 TL/$ MC

AC

AVC

P=71.87
D=MR=AR

0
Q* Q

The firm is earning normal profits where P = MR = MC = AR = AC.

 The Case of Economic Loss

Average
Marginal Average Variable Average Marginal Marginal Total Profit
Quantity Revenue Fixed Cost Cost Total Cost Cost Profit or Loss
(Q) (MR) (AFC) (AVC) (ATC) (MC) (M) (Q[P– AC])
0 58.00 -100.00
1 58.00 100.00 55.70 155.70 55.70 2.30 -97.70
2 58.00 50.00 52.80 102.80 49.90 8.10 -89.60
3 58.00 33.33 51.30 84.63 48.30 9.70 -79.89
4 58.00 25.00 51.20 76.20 50.90 7.10 -72.80
5 58.00 20.00 52.50 72.50 57.70 0.30 -72.50
6 58.00 16.67 55.20 71.87 68.70 -10.70 -83.22
7 58.00 14.29 59.30 73.59 83.90 -25.90 -109.13
8 58.00 12.50 64.80 77.30 103.30 -45.30 -154.44
9 58.00 11.11 71.70 82.81 126.90 -68.90 -223.29
10 58.00 10.00 80.00 90.00 154.70 -96.70 -320.00
11 58.00 9.09 89.70 98.79 186.70 -128.70 -448.69
12 58.00 8.33 100.80 109.13 222.90 -164.90 -613.56
 TL/$

MC

AC

AVC
loss C
A

P=58.00 D=MR=AR
B D

0
Q* Q

The area of the rectangle ABCD gives the amount of economic loss.
 TL/$

MC

AC

AVC
loss C
A

P=58.00 D=MR=AR
B D

F E
contribution to
fixed cost

0
Q* Q

There is a loss but the firm will continue to operate in the short-run since there is a
positive contribution margin and the firm is recovering some of its fixed costs.
 TL/$ MC

AC

loss
AVC

shutdown price

P=50.00
D=MR=AR
shutdown point
negative contribution
margin

0
Q1 Q2 Q

The firm should shut down since the price cannot cover any of the variable or fixed
costs and continuing to operate would mean increasing losses.
 Perfect Competition in the Long-Run
 In the short-run, the market price may result in
normal profits, economic profits, or economic loss.
 In the long-run, the market price will settle at a point
where the firms earn a normal profit.
 If prices allow firms to earn economic profits in the
short-run, this will induce other firms to enter the
market and the increase in the market supply will
push the market price down, leaving only a normal
profit for the firms to earn.
 If prices are below the level where the
existing firms can at least earn normal profits,
some firms will have to leave the market in
the long-run in order to minimize their losses.
 In the short-run, the firms will stay in the
market if they have losses but a positive
contribution margin at the same time.
 In the long-run, the firms with a loss will
have sufficient time to liquidate all fixed
assets and leave the market.
 S (short-run)
MC
S (long-run)
short-run AC
economic profit
AVC
P
P

Q1 Q1

individual firm market

New firms enter in the long-run to

pursue economic profit.
 Short-run economic S (long-run)
loss; positive MC
contribution margin
AC

AVC
S (short-run)

P
P

Q1 Q1

individual firm market

Firms with an economic loss

exit in the long-run.