Perfect Competition

Chapter 11
Perfect Competition
Perfect competition is market structure where:
1. Many firms sell identical products to many buyers,
no single buyer or seller can exert any significant
influence on the market.
2. There are no restrictions on entry into the industry.
3. Existing firms have no advantage over new ones.
4. Sellers and buyers are well Informed about prices.
 Perfect Competition
Perfect Competition arises if the firm’s minimum efficient scale is
small compared to the market demand for the good.
Also if each firm produces a good or service that has no unique
characteristics so that consumers don’t care which firm they buy
from.
Price Takers
Firms in perfect competition are price takers.
Price taker is a firm that cannot influence the market price and
that sets its own price at the market price.
Because it produces a tiny fraction of the total output of a
particular good buyers are well informed about the prices of
other firms.
Economic Profit and Revenue
A firm’s goal is to maximize economic profit, which is equal
to total revenue minus total cost.
Total cost is the opportunity cost of production, which
includes normal profit, the return that the firm’s
entrepreneur can expect to receive on average in an
alternative business.
A firm’s total revenue equals the price of its output
multiplied by the quantity sold (price × quantity).
Marginal revenue is the change in total revenue that
results from a one-unit increase in the quantity sold. In PC,
marginal revenue equals the market price.
 Demand for Firm’s Product and
Market Demand
Demand curve for a perfectly
competitive firm is horizontal.
A horizontal demand curve is
perfectly elastic.
Meaning at the given market
price the firm can sell any
quantity of output.
This means that the products of
different firms are perfect
substitutes of each other.
The market demand curve is
 The Firm’s Decisions in Perfect
Competition
The goal of the competitive firm is to make the maximum
profit possible, given the constraints it faces.
A firm must decide:
1. How to produce at minimum cost
2. What quantity to produce
3. Whether to enter or exit a market
To take the first decision, a firm operates at the minimum
point of the long-run average variable cost curve.
 Firm’s output decisions
A firm’s cost and revenue curves the show the
relationship between a firm’s output and costs and
between its output and revenues, respectively.
Economic profit equals TR minus TC.
A perfectly competitive firm maximizes economic profit
by choosing its output level.
An output at which TC equals TR is called a break-even
point, here the firm’s economic profit is zero.
Because normal profit is part of TC, a firm makes normal
profit at a break-even point.
TR, TC and Economic Profit
Costs and Economic Profit
At the break-even point, where the TC and TR curves
intersect, the profit curve intersects the horizontal axis.
The profit curve is at its highest when the distance
between the total revenue and total cost curves is
greatest.
 Marginal Analysis
Another way of finding the
profit-maximizing output is to
use marginal analysis, by
comparing MC, with MR.
As output increases, MR
remains constant but marginal
cost changes.
If marginal revenue equals
marginal cost (MR = MC), the
firm makes maximum
economic profit.
Profit and loss
We saw how firms produce a quantity of output
where MR=MC, to maximise profits.
A firm might make an economic profit, or break even
(earn a normal profit) or incur an economic loss.
Economic profit/loss= TR-(TFC+TVC)
If the firm expects losses to be permanent, it shuts
down.
If the loss is temporary, it has to decide whether to
shutdown or not.
 Shutdown point
Shutdown point is the price
and quantity at which a firm
is indifferent between
producing and shutting
down.
It occurs when the price
covers the AVC, not the AFC.
If price falls below AVC, the
firm shuts down
temporarily.
If price> AVC, but <ATC, it
operates and incurs a loss
less than TFC.
The Firm’s S-R Supply Curve
A perfectly competitive firm’s
supply curve shows how the
firm’s profit-maximizing output
varies as the market price varies,
other things remaining the same.
If P>Min AVC Profit. Firm
produces where MC=MR. if P
increases, output is increased and
we move up the MC curve.
If P<Min AVC, the firm minimizes
loss by temporarily shutting
down, and producing zero
output.
 The Firm’s S-R Supply
Curve
When P=Min AVC, the firm is
indifferent between
temporarily shutting down and
producing.
A firm never produces an output
between zero and shutdown
point.
At prices above minimum AVC,
the supply curve is the same as
the marginal cost curve above the
shutdown point.
 Short-run Market Supply Curve
The short-run industry
supply curve shows how the
quantity supplied by the
industry varies as the market
price varies when the plant
size of each firm and the
number of firms in the
industry remain the same.
The quantity supplied by the
industry at a given price is
the sum of the quantities
supplied by all firms in the
industry at that price.
Short-run Equilibrium
Market demand and market
supply determine market
price and industry output.
When market demand
changes, market price can
change.
If the demand curve changes
further left and intersects
with the horizontal part of
the market supply curve,
price does not change.
Three possible short-run outcomes:
 Long-Run: Entry and Exit
In the long run, firms respond to economic profit and
economic loss by either entering or exiting an industry.
Firms enter an industry in which firms are making an
economic profit; and firms exit an industry in which firms are
incurring an economic loss.
The immediate effect of entry and exit is to shift the market
supply curve.
If more firms enter an industry, supply increases and the
industry supply curve shifts rightward.
If firms exit an industry, supply decreases and the industry
supply curve shifts leftward.
Entry, Exit and Long-Run Equilibrium:

In the long run firms in a perfectly competitive market only