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Perfect Competition
Market Structure/Market Power
• The way a firm behaves (how much output
it decides to produce and the price it sells
its products at) depend on the
STRUCTURE of the market
– mainly regarding the degree of competition
What Is Perfect Competition?
• When a market structure has perfect, total,
equal, absolute competition between firms
• only a model!
• extreme does not exist in the real world;
however, it can be used as a starting point
to base other models off of
Assumptions
• The only necessary condition is that each firm
has no control AT ALL over the price of the
product (price taker)
• Other very common conditions:
–
–
–
–
–
–
Many sellers
Many buyers
Homogenous products
No barriers to entry/exit
Perfect knowledge
Completely mobile factors of production
The Market
S
Price
• Price determined
totally in market place
by demand and supply
– no one would sell
any higher, because
no consumers would
buy, and no one would
sell lower, because
that would be…stupid.
And non-profitmaximizing.
E
P
D
Q
Quantity
The Firm
– Why? Because they
have no control over
price – they must sell
at price P and nothing
more, nothing less –
everyone has
complete knowledge,
and it is easy for firms
to enter/exit
d,
AR,
MR
Price
• Faces a perfectly
elastic demand curve
(and therefore also
average revenue
curve and marginal
revenue curve)
0
Output
Output
• TR = p*q
(where p=price, q=output)
• AR = TR/q = p*q/q = p (this is why the
demand curve=the AR curve on the
previous diagram)
• Each marginal unit is sold at the constant
price, therefore MR = p (this is why the
demand curve=the MR curve on the
previous diagram)
Short Run Equilibrium
– One unit less? Lose
profit to be made on
that unit. MR>MC
– One unit more? Loss
made on that unit,
reducing total profit.
MC<MR
MC
Price
• Profit is maximized at
MR=MC (short run
equ’m), so output is =
to q
ATC
d, AR,
MR
p
q
Output
Short Run Equilibrium (what you just saw)…
NOT TO BE CONFUSED WITH LONG RUN
EQUILIBRIUM!!! (what you are about to
see)

(well not yet)
Why is the short run equ’m diagram shown before
not applicable for long run? Because SNP are
made in short run (when MR=MC; see below):
MC
Price
p
c
0
a
b
q
Output
d, AR,
MR
Firm produces 0-q of output;
this output, multiplied by
average total costs, equals
all costs: this is where q hits
the ATC curve, or at “b”. “c”
represents cost, and “c-b-q0” (blue block) is total costs.
Total revenues = p*q, or “pa-q-0”. So, as normal profit
has been made (break even,
or “c-b-q-0”), SNP has been
made as extra: “p-a-b-c”.
SO this is why short run equ’m (previous
slide) does not equal long run equ’m!
Because…
Long Run Equilibrium: Industry is in equ’m
when normal profit is made and no SNP is
made
So how iS long run equ’m
achieved?
Remember, there is perfect knowledge. So new firms move in to industry to
make SNP. As they do, supply expands and price falls. The supply curve shifts
rightwards; price falls; thus, in the diagram for the single firm (the black slide),
the perfectly elastic demand curve (also showing price) slides downwards.
Firms always produce at MC=MR. Because the demand curve = the price
curve = the MR curve, when the price falls, the MR curve slides down to a new
position and hits a new point on the MC curve. This continues until it reaches
the point where MR=MC=ATC=d=AR. Only normal profit is made – no more
SNP. Total costs now is equal to total revenue. Since no more SNP is being
made, no new firms are attracted into the industry and the process stops.
Let’s see a picture….
Price
Price
S1
ATC
S2
MC
S3
p1
p1
d1, AR1, MR1
p2
p2
d2, AR2, MR2
p3
p3
d3, AR3, MR3
D
0
Q1 Q2 Q3
Quantity
0
Q3 Q2
Q1
Output
Shutdown Point
• In LR Equ’m, a firm cannot produce where
less than normal profits are being made –
they will lose. But in SR Equ’m this can be
justified. Keep this in mind:
– When a firm shuts down, the must pay fixed
costs still. When they are in operation, the
must pay fixed and variable costs
ATC
MC
Price
c
p
d
0
AVC
b
a
d, AR,
MR
e
q
Output
Currently the firm is making a loss: total revenue = 0-q-a-p, and total costs = 0q-b-c. Loss is p-a-b-c. If they shut down, they will produce nothing (therefore no
revenue), but will have to pay the fixed costs (ATC-AVC, or the space between
the two curves). These are equal to d-e-b-c. If the firm doesn’t close down,
though, they will have fixed costs and variable costs. They will also have
revenue. So, revenue covers all variable costs (0-q-e-d), and the surplus (d-ea-p) goes towards covering the fixed costs (d-e-b-c). Now, only a loss of p-ab-c is made instead of d-e-b-c. This is the obvious choice for a profit maximiser.