BECO1000 Principles of Microeconomics (010), 2023/2024-1

PERFECT COMPETITION
(Textbook: Chapter 12)

Characteristics of a Perfectly Competitive Industry

1. There are many firms, each small relative to the industry, and many buyers.
This arises when the minimum efficient scale of a firm is small relative to the market
demand for the good or service. In this situation, there is room in the market for many
firms.

2. Firms produce and sell homogeneous (or identical) products (perfect substitutes). Thus,
consumers do not care which firm’s good they buy.
3. Firms and buyers have perfect information about the industry (including product prices
and product quality).
Firms in perfect competition are price takers. A price taker is a firm that cannot influence the
market price because its production is an insignificant part of the total market. No single firm
can influence the price - it must “take” the equilibrium market price. Each firm’s output is a
perfect substitute for the output of the other firms, so the demand for each firm’s output is
perfectly elastic.

4. There is free entry and exit of firms.

This drives zero profit for the firm in the long run.

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Revenue Functions
TOTAL REVENUE (TR = P x Q)
This is the total amount that a firm takes in from the sale of its product.

AVERAGE REVENUE (AR = TR / Q)

This is the average revenue that a firm takes in from the sale of each unit of output.

MARGINAL REVENUE (MR = TR /Q)

This is the change in total revenue that a firm takes in from a one-unit of change in output.

AR = TR / Q = P x Q / Q = P (in general)
MR = TR /Q = (P x Q) / Q = (P x Q) / Q = P (under perfect competition)
 P = AR = MR

= AR = P

Profit Maximization
The goal of each firm is to maximize economic profit, which equals total revenue (TR) minus
total cost (TC). Total cost is the opportunity cost of production, which includes normal profit.

At low output levels, the firm incurs an economic loss since it cannot cover its fixed costs. At
intermediate output levels, the firm makes an economic profit. At high output levels, the firm
again incurs an economic loss since the firm faces steeply rising costs because of diminishing
returns. The firm maximizes its economic profit when it produces 9 sweaters a day.

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The firm can use marginal analysis to determine the profit-maximizing output.

If MR > MC, profit can be increased by raising output since each additional unit of output
increases revenue by more than its cost of production.
If MR < MC, profit can be increased by lowering output since each additional unit of output
costs more to produce than the additional revenue generated.

Profit-maximizing output is thus q*, where (P =) MR = MC [profit-maximizing condition].

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Short-Run Supply Curve

P = minimum AVC is the shutdown point. This point corresponds to price and quantity at
which it is indifferent between producing the profit-maximizing output and shutting down.
Economic profit = TR - TC = TR – (TVC + TFC) = P x Q - AVC x Q – TFC
= (P - AVC) x Q - TFC
Shutting down means Q = 0
Producing profit-maximizing quantity means MR (= P = AVC) = MC
So either way, economic profit = - TFC = - AFC x Q, with per unit economic profit = - AFC

If prices fall below this point, a firm will shut down without producing any output and incur a
loss equal to TFC. This is because if the firm produces the quantity at which MR (= P) = MC,
the firm’s economic loss will be larger than TFC.
Economic profit = (P - AVC) x Q - TFC > -TFC if P < AVC
shutdown condition: P < min AVC

If prices are above this point, the firm produces the quantity at which MR (= P) = MC, with
economic loss smaller than TFC.
Economic profit = (P - AVC) x Q - TFC < -TFC if P > AVC
production condition: P > min AVC

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The marginal cost curve above the shutdown point shows the profit-maximizing level of output.
That is, the short-run supply curve of a perfectly competitive firm is the portion of its MC
curve that lies above its AVC curve.

The short-run market supply curve is the horizontal sum of the individual firm supply curves
(marginal cost curves above AVC) in the industry.
 Below the shutdown price ($17), all firms will shut down. [vertical market supply curve]
 At the shutdown price, some firms will produce the profit maximizing quantity (7 sweaters)
where MR (= P) = MC, and others will produce zero. [horizontal market supply curve]
 Above the shutdown price, all firms will produce the profit maximizing quantity. [upward-
sloping market supply curve]

Short-Run Equilibrium
Market demand and short-run market supply determine the market price and market output.
Changes in demand bring changes to short run market equilibrium.

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Short-Run Profitability of a Firm
In short-run equilibrium, a firm might make an economic profit, break even, or incur an
economic loss.
Economic profit = TR – TC = (P x Q) – (ATC x Q) = (P – ATC) x Q
< 0 (economic loss) if P < ATC
= 0 (breakeven/zero economic profit) if P = ATC
> 0 (economic profit) if P > ATC
profit condition: P > ATC

Long-Run Equilibrium
ENTRY
The economic profit in the short run is a signal for new firms to enter the market in the long
run. As entry takes place, supply increases and the market supply curve shifts rightward. As
supply increases with no change in demand, the market price falls. New firms will stop entering
the market when competition drives economic profit down to zero. Entry results in an increase
in market output, but each firm’s output decreases. Because the price falls, each firm moves
down its supply curve and produces less. Because the number of firms increases, the market
produces more.

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EXIT
The economic loss in the short run is a signal for existing firms to exit the market in the long
run. As exit takes place, supply decreases and the market supply curve shifts leftward. As
supply decreases with no change in demand, the market price rises. Existing firms will stop
exiting the market when economic loss is uplifted to zero. Exit results in a decrease in market
output, but each firm’s output increases. Because the price rises, each firm moves up its supply
curve and produces more. Because the number of firms decreases, the market produces less.

Shift in Long Run Equilibrium

A DECREASE IN DEMAND
A decrease in demand shifts the market demand curve leftward. The price falls and the quantity
decreases. Starting from long-run equilibrium, firms make economic losses. The market price
is now below the firm’s minimum average total cost, so each firm makes an economic loss.
Economic loss induces some firms to exit the market, which decreases the market supply and
the price starts to rise. As the price rises, the quantity produced by each firm starts to increase
and each firm’s economic loss starts to fall. Eventually, enough firms have exited for the
decreased market supply and decreased market demand to be in balance and economic profit
is back to zero. Firms no longer exit the market. The main difference between the initial and
new long-run equilibrium is the number of firms in the market. Fewer firms produce the
equilibrium quantity.

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TECHNOLOGICAL ADVANCES CHANGE SUPPLY
Starting from a long-run equilibrium, when a new technology becomes available, production
costs are lowered, which shifts the ATC and MC curves downward. Firms that use the new
technology make economic profit. Economic profit induces some new-technology firms to
enter the market. The market supply increases and the price starts to fall. With the lower price,
old-technology firms incur economic losses. Some exit the market; others switch to the new
technology. Eventually all firms are using the new technology. The market supply has increased
and firms are making zero economic profit.

Long-Run Equilibrium and Efficiency

At the market level, the market demand (D) and market supply (S) determine the equilibrium
price and quantity. Consumers have made the best available choices on the demand curve, and
firms are producing at least cost on the supply curve. Marginal social benefit equals marginal
social cost, so resources are used efficiently, and total surplus (including consumer surplus and
producer surplus) is maximized.

At the firm level, the long-run equilibrium is characterized by P* = SRMC = SRAC = LRAC,
so that the firm is maximizing economic profit, which equals zero, and producing at the lowest
possible long run average cost.