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Perfect Competition
Topic 5
Characteristics
Pure Competition
• large number of sellers & buyers
• homogenous (identical) products
• low barriers to entry (free entry and exit from
the industry)
Perfect Competition
• large number of sellers & buyers
• homogenous (identical) products
• low barriers to entry
• perfect market knowledge
• perfect mobility of FoP’s
Lead to
faster
adjustment
Price takers & Price makers
Demand curve for a
Price taker
Demand curve for a
Price maker
Demand curve for a Price taker
• The demand curve facing a perfectly
competitive firm is perfectly elastic,
meaning that the firm can sell as many units
as it wants at the market price, but cannot
sell any quantity if it charges more than the
market price.
• The firm has no market power, no pricing
power at all. It is just a small player in a
large market….. It is a price taker.
Demand curve for a Price maker
• Downward sloping.
• It is just matter of how steep the curve is.
• The more market power a firm has, the
steeper is the demand curve.
• The characteristic of a downward sloping
demand curve is that, normally, if a firm
raises the price of its product, it needs not
lose all its customers, and if it wants to sell
more, it has to cut price.
Demand curve for Individual firm
under PC
Market D curve
Firm’s D curve
P = AR = MR
Revenue Concepts under PC
• Total revenue (TR): Total number of dollars (or dong)
received by a firm from the sale of a product.
• TR = P x Q
• Average revenue (AR): Total revenue per unit of a
product sold
• AR = TR/Q = (P x Q) / Q = P
• Marginal Revenue (MR): Additional revenue received
resulting from the sale of an extra unit of output
P. ΔQ
ΔTR
• MR =
=
=P
ΔQ
ΔQ
Product
Price
(Average
Revenue)
$131
131
131
131
131
131
131
131
131
131
131
Quantity
Demanded
(Sold)
0
1
2
3
4
5
6
7
8
9
10
Total
Revenue
$
0
131
262
393
524
655
786
917
1048
1179
1310
]
]
]
]
]
]
]
]
]
]
Marginal
Revenue
$131
131
131
131
131
131
131
131
131
131
Price, average and marginal revenue,
total revenue (dollars)
P
TR
917
786
655
524
393
262
P = AR = MR
D = MR
131
0
1
2
3
4
5
6
7
8
Quantity demanded (sold)
9
10
Profit Maximisation in the
Short Run
Two approaches to profit maximisation:
• Total Revenue minus Total Cost Approach
• Marginal Revenue, Marginal Cost
Approach
IMPORTANT!
Rules for Profit Maximisation
• Optimum output where: TR – TC = largest
or
• Optimum output where: MR = MC
– or MR closest to MC but MR > MC
– MC cuts MR curve from below
Total Revenue – Total Cost Approach
(Price = $131)
Total
Total
Total
Fixed
Product Revenue Cost
0
1
2
3
4
5
6
7
8
9
10
$
0
131
262
393
524
655
786
917
1048
1179
1310
$ 100
100
100
100
100
100
100
100
100
100
100
Total
Variable
Cost
$
0
90
170
240
300
370
450
540
650
780
930
Total
Cost
$ 100
190
270
340
400
470
550
640
750
880
1030
Profit
– $100
– 59
–8
+ 53
+ 124
+ 185
+ 236
+ 277
+ 298
+ 299
+ 280
Profit Maximisation: MR, MC Approach
Total
Total Fixed
Product Cost
0
1
2
3
4
5
6
7
8
9
10
100
100
100
100
100
100
100
100
100
100
100
Total
Variable
Cost
0
90
170
240
300
370
450
540
650
780
930
Total
Cost
100 ]
190 ]
270 ]
340 ]
400 ]
470 ]
550 ]
640 ]
750 ]
880
]
1030
Price =
Total
MarginalMarginal Economic
Cost Revenue Prof./Loss
90
80
70
60
70
80
90
110
13
0
15
0
$ 131
131
131
131
131
131
131
131
131
131
– $100
– 59
–8
+ 53
+ 124
+ 185
+ 236
+ 277
+ 298
+ 299
+ 280
Short-run equilibrium of industry and firm
under Perfect Competition
P
$
MC
S
Pe
D = AR
= MR
AR
D
O
O
Q (millions)
Qe
Q (thousands)
(a) Industry
fig
(b) Firm
Copyright 2001 Pearson Education Australia
IMPORTANT!
Rules for Profit Maximisation
• Optimal output is where MR = MC
 or MR closest to MC but MR > MC
 MC cuts MR curve from below
IMPORTANT !
Rules for Profit maximization
Short Run
P ≥ AVC
• In the short run, fixed costs will be incurred
whether or not the firm produces. So this
means that total revenue must be at least
equal to total variable cost for the firm to
continue producing.
If P < AVC, firm should shut down
IMPORTANT !
Rules for Profit maximization
Long Run
P ≥ ATC
• In the long run, firms have the option of
closing down and going out of business, so
total revenue must at least cover total costs
( all costs ).
If P < ATC, firm should shut down
SR Profit maximisation under
Perfect Competition
P
$
MC
S
Pe
ATC
D = AR
= MR
AR
AC
D
O
O
Q (thousands)
Q (millions)
(a) Industry
Qe
fig
(b) Firm
Copyright 2001 Pearson Education Australia
SR Profit maximisation under
Perfect Competition
P
$
MC
S
Pe
ATC
D = AR
= MR
AR
AC
D
O
O
Q (thousands)
Q (millions)
(a) Industry
Qe
fig
(b) Firm
Copyright 2001 Pearson Education Australia
SR Loss minimisation under
Perfect Competition
P
$
ATC
MC
S
AVC
AC
P1
D1 = AR1
AR1
= MR1
D
O
O
Q (thousands)
Q (millions)
(a) Industry
Qe
fig
(b) Firm
Copyright 2001 Pearson Education Australia
Short-run shut-down point
P
$
MC
S
ATC
AVC
P2
D2 = AR2
AR2
= MR2
D2
O
O
Q1
Q
Q (millions)
(a) Industry
fig
(b) Firm
Copyright 2001 Pearson Education Australia
Long run Equilibrium under PC
• Under PC
 P = min. ATC = MR = MC
 why?
Long-run equilibrium under PC
P
$
S1
ATC
P1
AR1
D1
D
O
O
Q (millions)
(a) Industry
Q
(thousands)
(b) Firm
fig
Copyright 2001 Pearson Education Australia
Long-run equilibrium under PC
P
$
S1
Se
ATC
P1
AR1
D1
PL
ARL
DL
D
O
O
Q (millions)
(a) Industry: As firms making
supernormal profits , new firms
will enter the industry. S curve
shifts to right. Price falls.
QL
Q (thousands)
(b) Firm
fig
Copyright 2001 Pearson Education Australia
Long-run equilibrium under PC
P
$
Se
S1
ATC
PL
ARL
DL
P1
AR1
D
1
D
O
O
Q (millions)
(a) Industry: As firms making
losses , some firms will leave
the industry. S curve shifts to
left. Price rises.
QL
Q (thousands)
(b) Firm
fig
Copyright 2001 Pearson Education Australia
Long run Equilibrium
• .
Long run Equilibrium
• Key characteristics of PC:
– large number of sellers & buyers
– identical products
– freedom of entry & exit
• Implication (or conclusion)
– Firms in PC cannot earn economic profits in
the long run
Efficiency
Allocative efficiency:
• Resources are allocated among firms and
industries to obtain a mix of products
most desired by society (consumers)
Productive efficiency:
• The least costly methods of production
are used (ie. goods are produced at the
lowest possible costs)
Efficiency and Perfect
Competition
• Price of product X = the relative worth of
product X to the society (or the marginal
benefit/satisfaction the society gets from an
additional unit of X) .
• Marginal Cost of product X is the cost of
producing an additional unit of X
(MC measures the sacrifice of other goods in
using resources to produce more of X)
Efficiency and Perfect
Competition
• Allocative efficiency:
 P > MC : resources are under allocated
 P < MC : resources are over allocated
 P = MC : resources are best allocated/utilised
• Productive efficiency:
 P = min ATC
(For more details, read Jackson pp. 276 – 77)
Assessment of Perfect Competition
Pros
• Productive efficiency: min AC (ie. firms produce at
the least-cost output)
• Allocative efficiency: P = MC
• Consumer gains from low prices (ie. maximum
consumer surplus)
• Speed of resource reallocation
• No power groups
Cons
• Less scope for R&D
• Almost no product variety
Short-Run Supply Curve
• For the individual firm: the SR supply
curve is the MC curve above the AVC
curve
• For the entire industry: horizontal sum of
firms’ MC curves above AVC
P = MC: Short-Run Supply Curve
Costs and revenues (dollars)
P
ATC
MC
AVC
At every price, the
MR = MC point
changes the quantity
being exchanged...
Q
P = MC: Short-Run Supply Curve
Costs and revenues (dollars)
P
ATC
MC
AVC
P3
Record the
quantity being
supplied for
each price
Q3
Q
MR3
P = MC: Short-Run Supply Curve
Costs and revenues (dollars)
P
ATC
MC
AVC
P3
P2
MR3
MR2
At a lower price
a lower quantity
will be supplied
Q2 Q3
Q
P = MC: Short-Run Supply Curve
Costs and revenues (dollars)
P
ATC
Break-even
(normal profit)
point
MC
MR4
AVC MR
3
MR2
P4
P3
P2
At a higher price
a greater quantity
will be supplied
Q2 Q3 Q4
Q
P = MC: Short-Run Supply Curve
Costs and revenues (dollars)
P
ATC
Break-even
(normal profit)
point
P5
P4
P3
P2
MC
MR5
MR4
AVC MR
3
MR2
Q2 Q3 Q4 Q5
Q
P = MC: Short-Run Supply Curve
Costs and revenues (dollars)
P
P5
P4
P3
P2
P1
ATC
Break-even
(normal profit)
point
MC
MR5
MR4
AVC MR
3
MR2
MR1
Firm should not
produce unless
revenue is at least
able to meet AVC
Q2 Q3 Q4 Q5
Q
P = MC: Short-Run Supply Curve
Costs and revenues (dollars)
P
P5
P4
P3
P2
P1
ATC
Break-even
(normal profit)
point
MC
MR5
MR4
AVC MR
3
MR2
MR1
The Marginal
Cost Curve at points above
AVC represents the short-run
supply curve
Q2 Q3 Q4 Q5
Q
P = MC: Short-Run Supply Curve
Costs and revenues (dollars)
P
ATC
Short-run
supply curve
(red)
P5
P4
P3
P2
P1
MC
MR5
MR4
AVC MR
3
MR2
MR1
Q2 Q3 Q4 Q5
Q
P = MC: Short-Run Supply Curve
P
If costs increase...
the supply curve
effectively shifts
to the left
MC2
MC1
AVC2
AVC1
Q
P = MC: Short-Run Supply Curve
P
MC1
If costs decrease...
the supply curve
effectively shifts
to the right
MC2
AVC1
AVC2
Q