Download Market Structures – Perfect Competition

Market Structures – Perfect Competition
Seher Sarin & Uma Kalkar
Competitive Market: A market in which there are many buyers and many sellers so that each has a
negligible impact on the market price
Perfect Competition: Highest form of competition; must have three main characteristics to exist
 Goods sold by various sellers are quite similar
 Many buyers and sellers in the market (so no single buyer or seller has any influence over the
market price)
 Firms can freely enter and exit the market
Outcome of Perfect Competition
 Since buyers and sellers in perfectly competitive markets must accept the price the market
determines, they are said to be price takers.
 At market price, buyers can buy all they want, and sellers can sell all they want.
Example: In the wheat market, there are thousands of farmers who sell wheat and millions of
consumers who use wheat. Because no single buyer or seller can influence the price of wheat, each
takes the price as given.
Revenue in Perfect Competition
1. Total Revenue: Selling price multiplied by quantity sold (TR = P*Q)
2. Average Revenue: Total Revenue divided by the quantity sold (AR = TR/Q)
3. Marginal Revenue: Change in total revenue from an additional unit sold (MR=ΔTR/ΔQ)
 For a competitive firm, marginal revenue & average revenue = price of good
Profit Maximization
 Produce quantity where total revenue minus total cost
is greatest
 Compare marginal revenue with marginal cost
 If MR > MC – increase production
 If MR < MC – decrease production
 Maximize profit where MR = MC
Short-run
 Market supply with a fixed number of firms
 Short-run decision not to produce anything
 During a specific period of time
 Because of current market conditions
 Firm still has to pay fixed costs
 Shut down if TR<VariableCost
(P<AverageVariableCost)
Exit
 Long-run decision to leave the market
 Firm doesn’t have to pay any costs

Sunk costs: costs that cannot be recovered when deciding to exit, but are ignored when
considering shut down
Short-Run Supply Curve: Part of the marginal-cost curve that lies above average variable cost
 Increase in demand raises price and quantity in the short run
 Each firm supplies a quantity of output so that its marginal cost = price
 Firms earn profits because price now exceeds average total cost.
Long-Run
 Firms can enter and exit the market
 If P > ATC – make positive profit (new firms
enter market)
 If P < ATC – make negative profit (firms exit
market)
 ATC = Average Total Cost
 Process of entry and exit ends when:
 Firms in market make zero economic profit
(P = ATC)
 Because MC = ATC: Efficient scale
 Long run supply curve – perfectly elastic
o Horizontal at minimum ATC
Long-Run Supply Curve: Part of the marginal-cost curve that lies above average total cost
Measuring profit
 If P > ATC
o Positive Profit=TR–TC=(P–ATC) x Q
 If P < ATC
• Loss=TC-TR=(ATC–P) x Q
o Negative profit
Why do competitive firms stay in business if they make
zero profit?
 Profit = total revenue – total cost
 Total cost includes all opportunity costs
 Zero-profit equilibrium
 Economic profit is zero
 Accounting profit is positive
Zero Profit Equilibrium
 Firm’s revenue compensates the owners for the time and money they expend to keep business
going
 The price of the good = firm’s average and marginal revenue.
 Maximize profit: firm finds a quantity of output such that marginal revenue = marginal cost
 Quantity at which price = marginal cost → firm’s marginal cost curve becomes its supply curve.
 Short run: firm cannot recover fixed costs, will shut down if price of the good < average
variable cost


Long run: firm can recover fixed and variable costs, but will exit if the price < average total cost
In a market with free entry and exit, in the long run profits are driven to zero and all firms
produce efficiently