TOPIC 7: PERFECT
COMPETITION
MARKET STRUCTURE
Market structure describes the competitive
environment of the market in which firms
operate.
There are four types of market structures
Perfect
competition
Monopoly
Monopolistic competition
Oligopoly
PERFECT COMPETITION
Characteristics of Perfect Competition :
number of small sellers and buyers: There are
many sellers and buyers, each of which is small in
relation to total sales or purchases.
Homogeneous product: All firms produce and sell
identical or the same products.
Complete information: Sellers and buyers have full
access to information regarding anything about the
product.
Free entry and exit: There is no barriers to entry or
exit the market.
Price taker: Each firm is a price taker who can sell as
much product at the market price. Each firm has no
ability to control the market price.
Large
A FIRMS DEMAND CURVE
In a perfectly competitive market,
All
buyers make up the market demand,
All sellers make up the market supply,
Market equilibrium determines the market price.
Each perfectly competitive firm can sell as much
product as it wants at the market price.
The demand curve for each perfectly competitive
firm is horizontal at the market price.
PRICE, AVERAGE REVENUE AND
MARGINAL REVENUE
Total revenue (TR) is the amount of money that a firm
receives from selling its output.
TR = P x Q
Average revenue (AR) is the revenue per unit of output
sold.
AR = TR / Q = P
Marginal revenue (MR) is the additional revenue that
the firm receives when it sells one more unit of output.
MR = TR/Q = P
The
marginal revenue curve is also the demand curve.
AVERAGE REVENUE AND MARGINAL REVENUE
FOR A PERFECTLY COMPETITIVE FIRM
Price (P)
$130
130
130
130
130
130
130
130
130
130
130
Quantity
Demanded
(Q)
0
1
2
3
4
5
6
7
8
9
10
Total
Revenue
(TR)
$0
130
260
390
520
650
780
910
1040
1170
1300
Average
Revenue
(AR)
$130
130
130
130
131
130
130
130
130
130
130
Marginal
R evenue
(MR)
$130
130
130
130
130
130
130
130
130
130
PERFECT COMPETITION IN THE
SHORT RUN
Because
a perfectly competitive firm is a price
taker, it can sell as many output as it wants
at the market price.
How many output that the firm will choose to
produce and sell to maximize its profit?
PROFIT MAXIMIZATION RULE
revenue (MR) is the revenue that the additional unit
of output would add to total revenue.
Marginal
cost (MC) is the cost that the additional unit of
output would add to total cost.
Marginal
If
MR > MC, firm should increase the level of output
If
MR < MC, firm should reduce the level of output
If
MR = MC, firm produces output level that maximizes its profit.
Profit
maximizing condition
MR = MC
For a perfectly competitive firm, profit is maximized when
P = MR = MC
SHORT RUN OUTPUT DECISION
If
P > ATC TR > TC: Firm earns profit
Firm should produce
If P < ATC TR < TC: Firm incurs loss
If
firm continue to produce:
Loss = TC TR = TFC + (AVC - P)Q (1)
If firm shuts down:
Loss = TFC
(2)
When Loss (1) < Loss (2) P > AVC, firm should
continues to produce.
When Loss (2) < Loss (1) P < AVC, firm should
shut down.
SHORT RUN OUTPUT DECISION
Case 1: P > ATC: Firm earn profit and should
produce.
Case 2: AVC < P < ATC: Firm incurs loss and
should continue to produce.
Case 3: P < AVC: Firm incurs loss and should
shut down.
CASE 1: PROFIT MAXIMIZING CASE
CASE 2: LOSS MINIMIZING CASE
Q
0
1
2
3
4
5
6
7
8
9
10
AFC
$100
50
33.33
25
20
16.67
14.29
12.5
11.11
10
AVC
$90
85
80
75
74
75
77.14
81.25
86.67
93
ATC
$190
135
113.33
100
94
91.67
91.43
93.75
97.78
103
MC
$90
80
70
60
70
80
90
110
130
150
MR = P
$80
80
80
80
80
80
80
80
80
80
Profit
or Loss
$-100
-110
-110
-100
-80
-70
-70
-80
-110
-160
-230
CASE 3: LOSS MINIMIZING CASE
Q
0
1
2
3
4
5
6
7
8
9
10
AFC
$100
50
33.33
25
20
16.67
14.29
12.5
11.11
10
AVC
$90
85
80
75
74
75
77.14
81.25
86.67
93
ATC
$190
135
113.33
100
94
91.67
91.43
93.75
97.78
103
MC
$90
80
70
60
70
80
90
110
130
150
MR = P
$60
60
60
60
60
60
60
60
60
60
Profit
or Loss
$-100
-130
-150
-160
-160
-170
-190
-220
-270
-340
-430
SHORT RUN OUTPUT DECISION
If P > ATC, the firm earns economic profit.
If P = ATC, the firm breaks even.
If P < ATC, the firm incurs a loss.
If
AVC < P < ATC: the firm should continue to
produce.
If P < AVC: the firm should shut down.
MARGINAL COST AND SHORT RUN
SUPPLY
The short run supply curve for a perfectly
competitive firm is the portion of its marginal
cost curve that lies above its average variable cost
curve.
This segment of marginal cost curve tells the
amount of output that the firm will supply at
each possible market price.
FIRM AND INDUSTRY: EQUILIBRIUM
PRICE
Market supply curve is the sum of all individual
firms supply curves.
Market supply and demand will determine the
market price.
At a given market price, each firm will choose the
level of output to maximize its profit or minimize
its loss.
PROFIT MAXIMIZATION IN THE
LONG RUN
In the long run, a firm will enter the industry if
such an action would be profitable.
Enter
if TR > TC
TR/Q > TC/Q
P > ATC
In the long run, the firm exits if it incurs loss.
Exit
if
TR < TC
TR/Q < TC/Q
P < ATC
THE LONG RUN SUPPLY
The perfectly competitive firms long run supply
curve is the portion of its marginal cost curve
that lies above average total cost.
LONG RUN EQUILIBRIUM
Entry eliminates economic profits.
Exit eliminates losses.
Long run equilibrium is where:
Price
equals long run average cost P = ATC
Firms earn zero economic profits
