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Microeconomics I
Perfect Competition
By
Kwame Agyire-Tettey (PhD)
Learning outcomes
• The impact of the product market on firms’ prices and output choices is
determined by the nature of the product and the market structure in which they
operate.
• In perfect competition firms produce a homogeneous product and are price-takers
in their output markets.
• All profit-maximising firms choose their output to equate marginal cost and
marginal revenue.
• Under perfect competition marginal cost will equal the market price, and so the
supply curve of firms is determined by the marginal cost curve.
• The long-run supply curve of a competitive industry may be positively sloped,
horizontal, or negatively sloped depending on how input prices are affected by the
industry’s expansion.
• Perfect competition maximizes benefits that consumers receive from the output of
the product in question.
Market Structure and Firm Behaviour
• Market structure is defined by the characteristics that influence the behaviour and
outcomes of the firms activities in that market.
• The structure of the market is determined by the following factors:
• the number of economic agents in the market, both sellers and buyers; their relative negotiation
strength, in terms of ability to set prices; the degree of concentration among them; the degree of
differentiation and homogeneity of products; and the degree of barriers to entry and exit.
• Differences and interactions between these factors leads to the existence of several
market structures, including:
• Perfect competition; imperfect competition; monopoly; oligopoly; monopolistic competition
• Competitive behaviour among economic agents refers to the extent to which
individual firms compete with each other to sell their products.
• Competitive market structure refers to the power that individual firms have over the
market - perfect competition occurring where firms have no market power and hence
no need to react to each other.
Perfectly Competitive Markets: Assumptions
• The theory of perfect competition is based on the following
assumptions:
• Firms sell homogenous product;
• Large number of sellers and buyers;
These two assumptions make each firm a
price-taker. Makes the firm’s demand curve
horizontal.
• Freedom to enter and leave the industry;
• No government interference in the market;
• Firms aim at profit maximisation;
• There is the absence of collusion among firms;
• There is prefect mobility of factors of production;
• Customers and firms are well informed i.e. there is perfect knowledge in the market.
Short-run equilibrium
• For the firm to maximised profit it produces and output level that
equates marginal cost curve to the marginal revenue curve but the
marginal cost should be rising - or by producing nothing if average cost
exceeds price at all outputs.
• Note that price is equal to the marginal revenue, thus, in this market
price is also equal to the marginal cost at equilibrium.
• A perfectly competitive firm is a quantity-adjuster, facing a perfectly
elastic demand curve at the given market price and maximizing profits
by choosing the output that equates its marginal cost to price.
Short-run equilibrium
• At equilibrium in the short-run:
• MR = MC
• Since price is the same as the marginal revenue, it implies
that in equilibrium P=MR=MC
• The slope of the MC must be greater than that of the MR.
However, under perfect competitive market the slope of the
MR is zero, hence in equilibrium the slope of the MC
curve must be positive.
[i]
MC
£ per unit
£ per unit
Alternative Short-run Equilibrium Positions for the Firm
SRATC
[ii]
SRATC
MC
SARVC
0
E
E
p2
q1
Output
£ per unit
p1
0
MC
[iii]
q2
SRATC
E
p3
0
q3
Output
Output
GHC per unit
Shut down point of the firm
MC
SRATC
SRAVC
E
p1
0
q1
Output
Industry or market demand curve
• The horizontal summation of all individual demand curves.
• At higher price consumers will purchase a lesser quantity of the
good
• At lower prices all things being equal consumers will purchase
more of the product.
• The industry or market demand curve is downward sloping,
depicting a negative relationship between price and quantity.
Industry or market demand curve
Price
Price
Dfirm
D
quantity
quantity
The short run Supply Curve for a perfectly competitive Firm
£ per nut
MC
5
5
4
4
AVC
3
3
E0
2
p0
1
2
1
Output
[i] Marginal cost and average variable cost curves
q0
Quantity
[ii] The supply curve
The Supply Curve for a Price-taking Firm
£ per nut
MC
5
5
4
4
AVC
E1
3
E0
2
p1
p0
1
Output
[i] Marginal cost and average variable cost curves
3
2
1
q0
q1
[ii] The supply curve
Quantity
The short run Supply Curve for a perfectly competitive Firm
MC
£ per nut
5
5
E2
4
p2
4
AVC
E1
3
E0
2
p1
p0
1
3
2
1
Output
[i] Marginal cost and average variable cost curves
q0
q1
q2
[ii] The supply curve
Quantity
The short run Supply Curve for a perfectly competitive Firm
GHC per nut
MC
E3
5
E2
4
p3
p2
S
5
4
AVC
E1
3
E0
p1
p0
2
1
3
2
1
q0
Output
[i] Marginal cost and average variable cost curves
q1
q2
Quantity
[ii] The supply curve
q3
The short run Supply Curve for a perfectly competitive Firm
• For a price-taking firm the supply curve has the same shape as its MC curve above the
level of AVC.
• The point E0, where price, p0, equals AVC is the shutdown point.
• As price rises from £2 to £3 to £4 to £5, the firm increases its production from q0 to q1
to q2 to q3 .
• For example at a price of £3, the firm produces output q1 and earns the contribution to
fixed costs shown by the dark blue shaded rectangle.
• The firm’s supply curve is shown in part (ii). It relates market price to the quantity the
firm will produce and offer for sale.
• The supply curve of a firm in perfect competition is its marginal cost curve above the
minimum AVC, and the supply curve of a perfectly competitive industry is the sum of
the marginal cost curves of all its firms.
The short run Supply Curve for a perfectly competitive Firm
• The market supply curve is derived on the assumption that factor prices and technology
are given and that there is a large number of firms in the market.
• Thus the total market output at each price is the sum of the outputs supplied by all
firms at the prevailing price.
• The shape of the market supply curve is dependent on:
• Technology;
• Factor prices and
• Size distribution of firms in the market. Note that the firms are not of the same sizes as there are
different entrepreneurial efficiencies.
• These factors will determine the shape of the market supply because they determine the
cost structure of the firms in the market and thus by extension determine the shape of
the industry supply curve.
Short-run market/industry equilibrium
Price
• The intersection of this curve with the market demand curve for the industry’s
product determines market price in the short-run.
S
E
Market price
p0
D
0
q0
Quantity
SR and LR Equilibrium of a Firm in Perfect Competition
SRATC0
MC0
p0
MC*
c0
SRATC*
LRAC
p*
0
q0
q*
SR and LR Equilibrium of a Firm in Perfect Competition
 The firm’s existing plant has short-run cost curves SRATC0 and MC0 while market price is p0.
 The firm produces q0, where MC0 equals price and total costs are just being covered.
 Although the firm is in short-run equilibrium, it can earn profits by building a larger plant and so moving
downwards along its LRAC curve.
 Thus the firm cannot be in long-run equilibrium at any output below q*, because average total costs can
be reduced by building a larger plant.
 If all firms do this, industry output will increase and price will fall until long-run equilibrium is reached at
price p*.
 Each firm is then in short-run equilibrium with a plant whose average cost curve is SRATC* and whose
short-run marginal cost curve, MC*, intersects the price line p at an output of q*.
 Because the LRAC curve lies above p* everywhere except at q*, the firm has no incentive to move to
another point on its LRAC curve by altering the size of its plant.
 Thus a perfectly competitive firm that is not at the minimum point on its LRAC curve cannot be in
long-run equilibrium.
SR and LR Equilibrium of a Firm in Perfect Competition
• At the long-run equilibrium SMC=Minimum SRATC=Minimum
LRATC=LMC=MR=P
• All firms will produce at the minimum LRATC
• However, all firms operating at the minimum LRATC does not imply
that the firms are of the same size and have the same efficiency level.
• Firms the hire more efficient factors of production will be relative more
productive or efficient
Optimal allocation of resources
• Output is produced at the minimum feasible cost in the long run.
• In the long-run consumers pay the lowest price, which is equal to
the cost of producing the commodity.
• The firm’s plant capacity is fully utilised, that is all firms operate at
the full capacity level in the long run.
• The firms earn normal profits in the long run.
Allocative efficiency
• A state of the economy in which production represents consumer preferences;
in particular, every good or service is produced up to the point where the last
unit provides a marginal benefit to consumers equal to the marginal cost of
producing it.
• Firms will supply all those goods that provide consumers with a marginal
benefit at least as great as the marginal cost of producing them because:
• The price of a good represents the marginal benefit consumers receive from consuming
the last unit of the good sold.
• Perfectly competitive firms produce up to the point where the price of the good equals
the marginal cost of producing the last unit.
• In this regard, firms produce up to the point where the last unit provides a
marginal benefit to consumers equal to the marginal cost of producing it.
Productive efficiency
• It is the situation in which a good or service is produced at the lowest possible
cost.
• The presence of competitive forces drive the market price down to the minimum
average cost of the typical firm.
• From the definition of productive efficiency, perfect competition results in
productive efficiency.
• Firm owner strive to earn an economic profit by reducing costs, but in a perfectly
competitive market, firms learn from others and reduce costs.
• Therefore, in the long run, only the consumer benefits from cost reductions.
Long-Run Market Supply
• Increasing-cost industry
• If inputs are specialized, factor prices are likely to rise when the increase in the industry-wide
demand for inputs to production increases.
• This rise in factor costs would force costs up for each firm in the industry and increases the
price at which firms earn zero profit.
• Therefore, in increasing-cost industries, the long-run supply curve is upward sloping.
• Decreasing-Cost Industry
• Input prices may decline to the zero-profit condition when output rises and when new
entrants make it more cost-effective for other firms to provide services to all firms in the
market.
• Constant-Cost Industry
• When market output rises and prices of input remain unchanged thus the entry of new firm
does not affect input prices. The cost curve remain the same. The long-run market supply is a
horizontal curve.
Increasing cost industry
Decreasing-cost industry
Constant-cost industry
Changes in cost and perfect competition
• Changes in fixed cost
• Changes in the variable cost
• Effect of the imposition of a tax