Perfect Competition

Dr Kishor Bhanushali
Faculty – Economics
IBS-Ahmedabad
 Introduction
Assumptions:
2. Large number of buyers and sellers
3. Homogeneous products
4. Free entry and exit
5. Perfect knowledge about the market

Market Firm

Price Price
S

P E
P P=AR=MR

0 Q Q
0
The demand for a competitive firm’s output is infinitely elastic at the
market price. The output of any firm is a perfect substitute for tht of any
other firm. Average revenues and marginal revenue are equal to price since
the firm is a price taker
 Equilibrium Condition
1. MC = MR = Price
2. MC curve must cut MR curve from below
Whether or not there are positive profits depends on the
relationship between total cost and total revenue or average
Y cost and average revenue
MC

Cost
&
Revenue A B
MR=AR
P

X
o M N
Output
 Short Run Equilibrium of Firm Under
Perfect Competition
The short run is defined as a period sufficient to
allow the firm to adjust its output by increasing
or decreasing the amount of variable factors of
production but during which the fixed factors of
production can not be altered. Thus in the short
run the size and kind of the plant cannot be
changed, nor can new firms enter the industry

Equilibrium Conditions

- Firm making supernormal profit

- Firm making normal profit
- Firm making losses but does not shut down
- Shut down point
Equilibrium with Super Normal Profit
MC
AC

C D
AR=MR=P

B A

X
0 Q
Quantity
 Equilibrium with Normal Profit
MC
AC

C AR=MR=P
D

X
0 Q
Quantity
 Equilibrium with Loss
MC
AC

B
A

C AR=MR=P
D

X
0 Q
Quantity
Equilibrium with Shut Down Point
MC
AC

AVC

B
A

C AR=MR=P
D

X
0 Q
Quantity
 Equilibrium of the Firm under Perfect Competition

1. Identical costs
Revenue & Costs 2. Homogeneous factors of productions
3. Constant factor prices
AC
MC
AVC

K’
H N
F
P2 L1

K
P3 L
D
L2
P4
Shut Down Point

0 M M1 Output
Long Run Equilibrium of Firm Under
Perfect Competition
The long run is a period of time long
enough to permit changes in the variable
as well as fixed factors.
In the long run the firm can change their
output by increasing their fixed
equipments or new plant
New firms can also enter the industry in
the long run as well as existing firms can
leave the industry
Price=Marginal Cost=Minimum Average
Cost
Supply Behavior of a Competitive Firm
The supply curve of a firm shows the amount of
output that the firm is will supply at different
prices. The supply curve of a firm can be deduced
form the principle of profit maximization just as
the demand curve of an individual can be
deduced from the principle of utility maximization
principle
The supply will depend on the price of the output
if prices is greater than or equal to minimum AVC
Industry supply curve can be obtained by adding
the supply curves of the individual firms
horizontally
The short run supply curve of a firm is the
upward rising portion of the MC curve which lies
above the AVC curve
 Long Run Supply Curve
In the long run the MC curve is not the supply curve
of the firm because in the long run, only one pint on
MC curve can be the equilibrium point where the firms
earns only normal profit. If the existing firms earn
excess profit new firms enter into the industry and
this will shift the short run market supply curve to the
right. The new equilibrium price may remain above
the original level or may return to original level
depending on the cost conditions of the industry
Long run equilibrium of the firm
= SMC = LMC = LAC = SAC = P = MR
If the industry is constant cost industry, the long run
supply curve will be a horizontal straight line.
If the industry is increasing cost industry the long run
supply curve will be upward rising
If the industry is decreasing cost industry the long run
supply curve will be downward sloping
 Efficiency of Competitive Market
The concept of efficiency
- Efficient allocation of resources
among firms
- Efficient allocation of goods produced
between the consumers
- Efficient allocation of products
 Effects of Taxation (Lump Sump Tax)

Lump sum tax is like fixed cost of the firm

Upward shift in AFC and ATC curves
AVC and MC are not affected since lump sum tax is
fixed cost
Equilibrium position is not affected in the short run
Sam out put will be produced and the market
supply are prices are not change in the short run
Assuming that firm before the imposition of tax was
in the long run equilibrium earning just normal
profit, it will not now cover its higher average total
cost costs and will go out of the business in the
long run. Thus in the long run the market supply
curve will shift upward to the left; in the new
equilibrium the output will be lower, the prices will
be higher and there will be fewer firms in the
industry
 Effects of Taxation (Profit Tax )
This tax takes the form of a percentage of the
net profit of the firm. The effect of the profit
tax are the same as with those of lump sum
tax. The profit tax wile reducing the profit will
not effect its MC. Hence in the short run the
equilibrium of the firm and the industry will
not change
In the long run, exit of firms will be inevitable
if the pre-tax period firms were earning only
normal profit. In the long run the supply in
the market would shift to the left and a new
equilibrium would be reached with the higher
price, lower quantity produced and a smaller
number of firms
 Effects of Taxation (Specific Sales Tax )
Given amount of money per unit of output
produced
MC curve which is also the supply curve of
the firm shifts upward to the left, and the
amount of produced at a prevailing price will
be reduced
The market supply will shift upward to the
left and the price will rise.
The burden of the tax born by the consumer
depends on the price elasticity of supply,
given the market demand. In general more
elastic the market supply the higher is the
proportion of the specific tax that the
consumer will bear and less burden of the
firm from the specific tax