A market is a system by which buyers and sellers transact their business.

The price of a commodity traded in the market is determined by the number of buyers and sellers.

The number of sellers of a product in the market determine the nature and degree of competition.

The nature and degree of competition make the market structure.

It is a market form in which there are large number of sellers and buyers of homogeneous product. There is freedom of entry into and exit from the industry, and all firms in the industry are price takers. Uniform price prevails in the market, and buyers and sellers possess perfect knowledge of market conditions.

(Note: A firm is an individual producing unit, while a group of firms producing a particular commodity make up an industry.)

Many small firms, each of whom produces an insignificant percentage of total market output and thus exercises no control over the ruling market price.

Many individual buyers, none of whom has any control over the market price.

Perfect freedom of entry and exit from the industry. Entry and exit from the market is feasible in the long run. This assumption ensures all firms make normal profits in the long run

Homogeneous products are supplied to the markets that are perfect substitutes. Hence firms are “price takers” and face a perfectly elastic demand curve for their product

Perfect knowledge – consumers have readily available information about prices and products from competing suppliers and can access this at zero cost.

Perfect mobility of goods and factors among firms and even different industries

No transport cost for carrying the product.

1. Firm’s Demand Curve under Perfect Competition

Demand curve of the firm under perfect competition is perfectly elastic as price of the product is fixed by industry and firm is just price taker. So demand curve is parallel to X-axis .The firm has just to take the decision regarding the level of output it wants to produce at the price which is fixed by industry.

Demand curve under perfect competition

2. Industry’s Demand Curve It is also called market demand curve. It refers to total demand for a product in the market. Obviously, at a higher price, demand would be low, while at a lower price, demand would be high.

3. Relation between AR and MR for a FirmFor a firm, AR=MR under perfect competition because price or AR (say) is constant. Therefore AR curve of a firm is a straight line and is parallel to X-axis. Since AR=MR here, AR and MR curves coincide with each other and AR or say demand curve of the firm is perfectly elastic.

Price Quantity TR AR MR

10 1 10 10 10

10 2 20 10 20 – 10 = 10

10 3 30 10 30 – 20 = 10

10 4 40 10 40 – 30 = 10

10 5 50 10 50 – 40 = 10

Example

With increase in demand because of reasons other than price, the price of the commodity increases for the same supply.

With decrease in supply because of reasons other than price, the reduced quantity is supplied at a higher price.

(Graph)e.g. – daily vegetable market, milk

market, stock market etc.

Price determination in market period (very short run):

Output (supply) is assumed to be fixed considering the time period. Hence supply curve is perfectly inelastic.

In such a case, price is determined by demand conditions.

The point at which the demand for a product meets its supply , price related to that point is fixed as market price.

Short run is a functional time period during which a firm cannot change its size as certain fixed factors and the plant cannot be altered.

Since the firm is a price taker, it has a perfectly elastic demand for its product so it can sell whatever it produced at a given price.

Since the price is predetermined, the firm can only decide about the optimum quantity at equilibrium point where profit is maximised.

A firm will go on expanding its output as long as every additional unit produced adds more to its total revenues than what it adds to its total costs..

The firm will not produce a unit which adds more to its total costs than what I adds to its total revenue.

This means the firm will be increasing its profits by expanding its output to the level at which the MR just equals MC.

Let’s understand this with an example

Price/unit

Output

TR (Rs.)

TC (rs.)

Profit MR MC

10 0 0 10 -10 0 0

10 1 10 16 -6 10 6

10 2 20 20 0 10 4

10 3 30 21 9 10 1

10 4 40 22 18 10 1

10 5 50 25 25 10 3

10 6 60 30 30 10 5

10 7 70 37 33 10 7

10 8 80 47 33 10 10

10 9 90 61 29 10 14

10 10 100 81 19 10 20

The equilibrium level of output at a given price is determined by comparing SMC with SMR.

In the short run MR depends on the price of the product.

Price of the product is market determined by the intersection of short period demand and supply curves. (refer graph)

From the firm’s point of view, at this short run price, the demand for the product is perfectly elastic.

Correspondingly, the SAR and SMR curve shall be a horizontal line parallel to the x-axis.

SAR will be equal to SMR as illustrated below.

Quantity

AR= P TR MR

1 250 250 250

2 250 500 250

3 250 750 250

4 250 1000 250

5 250 1250 250

Along with this, the SAC and SMC are drawn in comparison.

Point of equilibrium : SMC= SMR(refer graph)

In short run equilibrium, the profitability of a firm depends on the condition of average revenue and the level of average cost function.

The price is not stable and changes with he changing conditions of demand and supply.

The firm has to adjust its output with respect to changing prices.

When P or AR>AC ; excess profit When AR=AC ;normal profits When AR<AC; losses. (refer graph)

In the long run, the firms can adjust their size or quit the industry and new firms can enter the industry.

When AR>AC , firms make excess profits which lure other firms to enter the industry.

Entry of new firms increases supply and pulls down price, setting equilibrium at a new market price.

The firm will produce a changed quantity of output at which LMR= LMC

At this level, the LAR can be greater than LAC, can be equal to LAC or can be lower than LAC.

In the latter 2 conditions, the firm will earn normal profits or will incur losses.

Firms earning normal profits is the most ideal situation in Long run.

If they face losses, they quit the industry.

LMC= LMR, profit is maximized LAR (Price) = LAC, normal profits LMR = LAR, firm is a price taker LMC= LAC, the firm is operating at minimum average cost.