Perfect Compition

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Chapter 9

Perfect Competition


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Lecture Plan

Market Morphology Features of Perfect Competition Demand and Revenue of a Firm

Market Demand Curve and Firms DemandCurve Equilibrium of Firm Short Run Price and Output for the Competitive

Industry and Firm Market Supply Curve and Firms Supply Curve Long Run Price and Output for the Industry and

Firm


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Chapter Objectives

To introduce the basics of market morphology andidentify the different market structures.

To examine the nature of a perfectly competitivemarket.

To understand market demand and firms demandunder perfect competition.

To help analyze the pricing and output decisions of aperfectly competitive firm in the short run and long run.


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Market

Defined as the institutional relationship between buyersand sellers.

Market refers to the interaction between buyers andsellers of a good (or service) at a mutually agreed upon

price. Such interaction may be at a particular place, or may

be over telephone, or even through the Internet!

Sellers and buyers may meet each other personally, or

may not ever see each other, as in E-commerce. Thus market may be defined as a place, a function, aprocess.


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Market Morphology

Markets may be characterized on the basis of: Number, size and distribution of sellers in any market

Whether the product is homogeneous or differentiated

Number and size of buyers:

large number of buyers but small size of individual buyer, the market

will be evenly balanced between buyers and sellers. small number of buyers but their size is large, the market is driven by

buyers preferences.

Absence or presence of financial, legal and technologicalconstraints

Thus we have: Perfect Competition

Monopoly

Monopolistic competition

Oligopoly


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Type of

market

Number

of firms

Nature of

product

Number

ofbuyers

Freedom of

entry andexit

Examples

Perfectcompetition

VeryLarge

Homogeneous(undifferentiated)

VeryLarge

Unrestricted Agriculturalcommodities,unskilledlabour

Monopolisticcompetition

Many Differentiated Many Unrestricted Retail stores,FMCG

Oligopoly Few Undifferentiatedor differentiated

Few Restricted Cars,computers,universities

Monopoly Single Unique Many Restricted Indian

Railways,Microsoft

Monopsony Many Undifferentiatedor differentiated

Single Notapplicable

Indian defenseindustry

Market Morphology


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Features of Perfect Competition

Perfect competition may be defined as that marketwhere infinite number of sellers sell homogeneous goodto infinite number of buyers while buyers and sellershave perfect knowledge of market conditions

Features Presence of large number of buyers and sellers

Homogeneous product Freedom of entry and exit

Perfect knowledge Perfectly elastic demand curve Perfect mobility of factors of production No governmental intervention Price determined by market and Firm is a price taker.


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Demand and Revenue of a Firm

Marginal Revenue (MR) = =

= Q. +P. = P (1)

[P is assumed to be given (constant)]. Firms are price takers and can supply as

much as they want at the existing price inthe market, thus:

AR= MR= P(2)

dQ

dTR

dQ

dQ

dQ

dP

PQdQ

d


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Profit, Revenue and Cost Curves of a Firm

Profit () = TR - TC.

Profit curve () beginsfrom the negative axis,implying that the firmincurs losses at an output

less than OQ1. At point A, i.e. output Q1

firm earns no profit noloss.

Firm earns maximum

profit at output OQ*. At point B, TR=TC again;

profit is equal to zero, atoutput OQ2.

Rational firm would try tomaximise profit.

Q*

Q*

Profit

MaximumProfit

TR

Q2

Q2

B

Q1

Q1

A

Output

O

TC

Output

Revenue,Cost,Profit

O

Loss


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Market Demand Curve and Firms

Demand Curve

The market demand curve for the whole industry is astandard downward sloping curve.

An individual buyer is able to get the maximum amount of output

at each existing price, at a given time. The market demand curve is the horizontal summation of

individual demand curves..

The demand curve for an individual firm is a horizontalstraight line showing that

the firm can sell infinite volume of output at the same price.


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Demand Curve

INDUSTRYFIRM

S

SMarketSupply

D

D

MarketDemand

Price

Output

O

Price

Output

O

EP*

Q*

P=AR=MR

Market equilibrium is at the point of intersection (E) of the marketdemand and market supply curves, where equilibrium output for theindustry is given at Q* and price at P*.

Each perfectly competitive firm, being a price taker, takes theequilibrium price from the market as given at P*.


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Since a firm can sell all it wants at this price, it faces aperfectly elastic demand curve for its product hence thedemand curve is straight horizontal line.

It is not worthwhile for the firm to offer any quantity at a

lower price, since it can sell as much as it wants at theprevailing market price.

If it tries to charge higher price its demand will fall tozero.

Hence Total Revenue (TR) of a firm would increase at aconstant rate, i.e. Marginal Revenue would be constant. Average Revenue will be equal to Marginal Revenue.

Hence the demand curve, coincides with the AR and MRcurves.


Demand Curve


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Equilibrium of Firm

Two conditions must be fulfilled for a profitmaximizing firm to reach equilibrium:

First order condition: MR=MC or =0

Second order condition: Slope of MR curve < MCcurve or


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Short Run Price and Output for theCompetitive Industry and Firm

In short run an individual firm may be inequilibrium and may earn

Supernormal profit: AR>AC Normal profit: AR=AC

Losses: AR


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Supernormal Profit

Firm is in equilibrium at OQ*output at market price P*,where both the conditions ofequilibrium are fulfilled.

TR= OP*EQ* (TR= AR.Q)

TC= OABQ* (TC=AC.Q)

Profit = AP*EB

= (OP*EQ*-OABQ*)

This is the supernormal profitmade by the firm in the shortrun, because the market priceP* (AR) is greater thanaverage cost.

Price

OQuantity

P* AR=MR

B

AC

Q

*

E

A

AR>AC

MC


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Supernormal Profit

Firm is in equilibrium at OQ*output at market price P*,where both the conditions ofequilibrium are fulfilled i.e.point E.

TR= OP*EQ* (TR= AR.Q) TC= OABQ* (TC=AC.Q)

Profit = AP*EB

= (OP*EQ*-OABQ*)

This is the supernormal profitmade by the firm in the shortrun, because the market priceP* (AR) is greater thanaverage cost.

Price

OQuantity

P

*AR=MR

B

AC

Q

*

E

A

AR>AC

MC


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Normal Profit

Price

OQuantity

P* AR=MR

AC

Q

*

E

AC=AR=MC=MR

MC

In the short run some firms mayearn only normal profit (whenaverage revenue is equal toaverage cost).

Firm is in equilibrium at OQ*output at market price P*,where both the conditions ofequilibrium are fulfilled.

TR= OP*EQ*

TC= OP*EQ*

TR=TC

Firm makes normal profit, andactually ends up producing atthe break even level of output.


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Subnormal Profit (or Loss)

Firm is in equilibrium at OQ*output at market price P*,where both the conditions ofequilibrium are fulfilled (pointE).

TC= OABQ*

TR= OP*EQ* Loss= P*ABE

= OP*EQ* - OABQ* The firm incurs loss or

subnormal profit in the shortrun because the AC of

producing this output is morethan the market price henceTR


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Exit or Shut Down of Production

Q*

A

FIRM

P* AR=M

R

AC

AVCMC

O

Price

Quantity

A firm incurring losses in theshort run will not withdraw fromthe market, but will wait formarket conditions to improve inthe long run.

Firm would continue productiontill price > average variablecost (P>AVC or AR>AVC).

Point A denotes the shut downpoint, where price P* =AVC=AR.

Any increase in VC above A orany fall in market price belowP* will cause the firm to shutdown.

AVC


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Market Supply Curve and Firms

Supply Curve

Condition I: If Price


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Long Run Price and Output for theIndustry and the Firm

In the long run perfectly competitive firms earn only normal profits.

AR=MR=MC=AC

The reason is the unrestricted entry into and exit of firms from theindustry in the long run.

When existing firms enjoy supernormal profits in the short run newfirms are attracted to the industry to gain profits.

The supply of the commodity in the market increases. Assuming nochange in the demand side, this lowers the price level.

When firms are making losses in the short run, some may be forcedto leave the industry in the long run.

Their exit from the industry causes a reduction in the supply of theproduct and as a result the equilibrium price rises.

This process of adjustment continues up to the point where the priceline becomes tangential to the AC curve.


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Long Run Price and Output for theIndustry and the Firm

Price

OQuantity

P* AR=MR

LAC

LMC

Q1

E1P1

Q*

E*

P2

Q2

E2

Prevailing price is OP1,Equilibrium at Point E1 andOutput OQ1Firms earn supernormalprofit (AR>AC)

This will attract more firms,increase in supply will reducethe price till AC=AR, i.e. at P*

Prevailing price is OP2,Equilibrium at Point E2 andOutput OQ2Firms earn loss (AR


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Summary

A market is a place / process of interaction between sellers andbuyers that facilitates exchange of goods and services at mutuallyagreed upon prices.

Perfect competition is defined as a market structure which has manysellers selling homogeneous products at the market price.

The equilibrium price is determined by demand and supply in the

market Each firm sells a very small portion of the total industry output;

hence it can not affect the price in the market and has to accept theprice given to it by the market. As such, it is regarded as a pricetaker.

A firm faces a perfectly elastic demand curve; hence average

revenue is constant and is equal to marginal revenue. Profit maximizing output is that where marginal cost is equal to

marginal revenue while marginal cost is increasing.


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Summary

In the short run firms can earn supernormal profits, or normal profits,or even loss. This depends on the position of the short run costcurves.

The supply curve of the firm would be identical to the short runmarginal cost curve abovethe minimum point of the AVC curve.

The industry supply curve is obtained by the horizontal summationof the supply curves of all firms in the industry.

In the long run perfectly competitive firms earn only normal profits. Iffirms are making supernormal profits in the short run, this wouldattract new firms and if firms are incurring losses; some firms would

exit the market, leaving existing firms with normal profits in eithercase.

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Perfect Compition