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Chapter 10
PERFECT
COMPETITION

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Learning Outcomes
Firms choices are influenced by the kinds of markets 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 industrys expansion

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Market Structure and Behaviour

Market structure: type of market in which firm operate. Markets can distinguished by the number of firms in the market and the type of products they sell. Competitive Market Structure: The less power an individual firm has to influence the market in which it sells its product, the more competitive that market is.

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Market Structure and Behaviour

Perfectly Competitive Market: Zero market power; many firms, homogenous product Monopoly: Full market power; one firm, unique product, no entry Monopolistic Competition: some market power, many firms, differentiated products Oligopoly: some market power, few firms, entry restricted, differentiated/undifferentiated products.

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Perfectly Competitive Markets

Assumptions Demand and revenue for a firm Short run equilibrium Rules for profit maximizing firms Short run supply curves The allocative efficiency of perfect competitive firm Long run equilibrium

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Assumptions
All the firms in the industry sell an identical or homogenous product. Buyers are well informed about the characteristics of the product and price charged. Output of a firm is a small fraction of the total industry output. Each firm is a price taker. They can not influence the price of the market. There is absolute freedom of entry and exit.

A perfectly competitive firm is one in which individual firms have zero market power.

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Nature of the Perfect Competition

Under perfect competition, there are many small firms, each producing an identical products and each too small to affect the market price. The firm is price taker and too small to affect the market price and simply takes the market price to be given. The perfect competition faces a completely horizontal demand curve. The extra revenue gained from each extra unit sold is the market price.

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The Demand Curve for a Competitive Industry and for One Firm

5 S

4 Price [Rs]

4 D Firm

1 D 100 200 300 400

10

20

30

40

50

60

Quantity [millions of tons] [i] Competitive industrys demand curve

Quantity [thousands of tons] [ii] Competitive firms demand curve

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The Demand Curve for a Competitive Industry and for One Firm

The industrys demand curve is negatively sloped, the firms demand curve is virtually horizontal. The competitive industry has output of 200 million tonnes when the price is Rs.3. The individual firm takes that market price as given and considers producing up to say, 60,000 tonnes. The firms demand curve in part (ii) is horizontal because any change in output that this one firm could manage would leave price virtually unchanged at Rs.3.

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Revenue Concepts for a Price-taking Firm

Quantity sold [units] [q] 10 11 12 Price [p] 3,00 3,00 3,00 3,00 30,00 33,00 36,00 39,00 3,00 3,00 3,00 3,00 TR = p*q AR = TR/q MR = TR/q

3,00
3,00 3,00

13

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Revenue Concepts for a Price-taking Firm The table shows the calculation of total (TR) average (AR) and marginal revenue (MR) when market price is Rs.3.00. For example when sales rise from 11 to 12 units, revenue rises form Rs.33 to Rs.36 making marginal revenue equal to Rs.3. The table illustrates the general result that when price is fixed, average revenue, marginal revenue, and price are all equal.

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Revenue Curve for a Firm

AR = MP = p 3 Rs 39 30

TR

Output

10

0 Output

10

13

[i] Average and marginal revenue

[ii] Total revenue

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Revenue Curve for a Firm

The graph shows the data in the table (slide 10). Because price does not change as the firm varies its output, neither marginal nor average revenue varies with outputboth are equal to price. When price is constant, total revenue is a straight line through the origin whose constant positive slope is the price per unit.

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Short-run Equilibrium
Rules for all profit maximizing firms: Should the firm produce at all? Rule1: A firm should not produce at all, if for all levels of output, the total variable cost of producing that output exceeds the total revenue derived from selling it or, equivalently, if the average variable cost of producing that output exceeds the price at which it can be sold. (The Shutdown Price)

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How Much should the firm produce?

Rule 2: Whenever it is profitable for the firm to produce some output, it should produce the output at which marginal revenue equals marginal cost. Rule 3: An output where marginal cost equals marginal revenue may be either profit maximising or profit minimising. Profit maximising requires that marginal cost be less than marginal revenue at slightly lower outputs and that marginal cost exceed marginal revenue at slightly higher output.

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The Short-run Equilibrium of a Firm in Perfect Competition

Rs. per unit

AVC

Output

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The Short-run Equilibrium of a Firm in Perfect Competition

Rs. per unit

MC
AVC

Output

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The Short-run Equilibrium of a Firm in Perfect Competition

Rs. per unit

MC
AVC

E p=MR=AR

q2 Output

qE

q1

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Total Cost and Revenue Curves

TC TR

Rs.

qE Output

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Total Cost and Revenue Curves

At each output the vertical distance between the TR and TC curves shows by how much total revenue exceeds or falls short of total cost. The gap is largest at output qE which is the profitmaximizing output.

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Short-run Supply Curves

In perfect competition the firms supply curve is its marginal cost curve for those levels of output for which marginal cost is above average variable cost. S = f(P) for P>= Min(AVC) S=0 for P < Min(AVC) The price taking firm the supply curve has the same shape as its MC curve above the level of min(AVC).

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The Supply Curve for a Price-taking Firm

MC 5 4 AVC 3 E0 2 3 5 4

per nut

p0

q0 Output [i] Marginal cost and average variable cost curves Quantity [ii] The supply curve

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The Supply Curve for a Price-taking Firm

MC 5 4 AVC E1 3 E0 2 p1 3 5 4

per nut

p0

q0 Output [i] Marginal cost and average variable cost curves

q1 Quantity [ii] The supply curve

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The Supply Curve for a Price-taking Firm

MC 5 4 E1 3 E0 2 E2 p2 AVC p1 3 5 4

per nut

p0

q0 Output [i] Marginal cost and average variable cost curves

q1 q2 Quantity [ii] The supply curve

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The Supply Curve for a Price-taking Firm

MC 5 Rs. per nut 4 E1 3 E0 2 E2 E3 p3 p2 AVC p1 3 5 4

p0

q0 Output [i] Marginal cost and average variable cost curves

q1 q2 Quantity [ii] The supply curve

q3

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The Supply Curve for a Price-taking 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 firms supply curve is shown in part (ii). It relates market price to the quantity the firm will produce and offer for sale. It has the same shape as the firms MC curve for all prices above AVC.

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Alternative Short-run Equilibrium Positions for a Firm in Perfect Competition

per unit

per unit

SRATC MC

SRATC E p2

MC

p1

E
SARVC

q1

Output

q2

Output

[i]

[ii]
MC per unit SRATC

p3

0 [iii]

q3

Output

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Short-run Equilibrium Positions for a Firm in Perfect Competition

(i) The firm is making losses

The market price is p1. Because this price is below average total cost, the firm is suffering losses shown by the light blue area. Because price exceeds average variable cost, the firm continues to produce in the short run. Because price is less than ATC, the firm will not replace its capital as it wears out.

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Short-run Equilibrium Positions for a Firm in Perfect Competition

(ii) The firm is just covering all its costs

The market price is p2. The firm is just covering its total costs. It will replace its capital as it wears out since its revenue is covering the full opportunity cost of its capital.

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Short-run Equilibrium Positions for a Firm in Perfect Competition

(iii) The firm is making pure profits

The market price is p3. The firm is earning pure (or economic) profits in excess of all its costs, as shown by the dark blue area. The firm will replace its capital as it wears out.

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Consumers and Producers Surplus

Price

Consumer surplus

E Market price

p0
Producers surplus

D
Total variable cost

q0 Quantity

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Consumers and Producers Surplus

Consumers surplus is the area under the demand curve and above the market price line. The equilibrium price and quantity are p0 and q0. The total value that consumers place on q0 units of the product is given by the sum of the dark yellow, light yellow, and light blue areas. The amount that they pay is p0q0, the rectangle that consists of the light yellow and light blue areas. The difference, shown as the dark yellow area, is consumers surplus.

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Consumers and Producers Surplus

Producers surplus is the area above the supply curve and below the market price line. The receipts of producers from the sale of q0 units are also p0q0. The area under the supply curve, the blue-shaded area, is total variable cost, which is the minimum amount that producers must receive to induce them to supply the output. The difference, shown as the light yellow area, is producers surplus

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The Allocative Efficiency of Perfect Competition

S 1 E p0 4 2 D 3 Competitive market price

q1

q0

q2

Quantity

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The Allocative Efficiency of Perfect Competition

At the competitive equilibrium E consumers surplus is the dark yellow area above the price line Producers surplus is the light yellow area below the price line. Reducing the output to q1 but keeping price at p0 lowers consumers surplus by area 1. It lowers producers surplus by area 2. Assume that producers are forced to produce output q2 and to sell it to consumers, who are in turn forced to buy it at price p0. Producers surplus is reduced by area 3 (the amount by which variable costs exceed revenue on those units). Consumers surplus is reduced by area 4 (the amount by which expenditure exceeds consumers satisfactions on those units). Only at the competitive output, q0, is the sum of the two surpluses maximized.

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Short-run and Long-run Equilibrium of a Firm in Perfect Competition

SRATC0 MC0

p0 MC* c0 SRATC*

LRAC
p*

q0

q*

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Short-run and Long-run Equilibrium of a Firm in Perfect Competition

The firms 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.

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Short-run and Long-run Equilibrium of a Firm in Perfect Competition

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 shortrun 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.

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Long-run Industry Supply Curves

S0 S0

Price

Quantity

D0

Quantity

Quantity

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Long-run Industry Supply Curves

D0 S0 D0 E0 p0 S0

Price

E0

q1 Quantity S0 D0

q1 Quantity

p0

E0

q1 Quantity

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Long-run Industry Supply Curves

D1 D0 S0 D0 E1 S0

Price

p0

E0

q1 Quantity D0

D1 E1 E0

q1 S0 Quantity

p0

q1 Quantity

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Long-run Industry Supply Curves

D1 D0 S0 p0 E2 LRS p0 E0 D0 E1 E2 LRS S0

Price

q1

q2 D0

D1 E1 E0

q1 S0

q2

(i)

Quantity

(ii)

Quantity

p0 p0

E2

LRS

(iii)

q1 Quantity

q2

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(i) A constant long-run industry supply curve

The initial curves are at D0 and S0. Equilibrium is at E0 with price p0 and quantity q0. A rise in demand shifts the demand curve to D1, taking the short-run equilibrium to E1. New firms now enter the industry, shifting the short-run supply curve outwards. Price is pushed down until pure profits are no longer being earned. At this point the supply curve is S1. The new equilibrium is E2 with price at p2 and quantity q2. The curves shift so that price returns to its original level, making the long-run supply curve horizontal.

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(ii) A Rising long-run industry supply curve

The initial curves are at D0 and S0. Equilibrium is at E0 with price p0 and quantity q0. A rise in demand shifts the demand curve to D1, taking the short-run equilibrium to E1. New firms now enter the industry, shifting the short-run supply curve outwards. Price is pushed down until pure profits are no longer being earned. At this point the supply curve is S1. The new equilibrium is E2 with price at p2 and quantity q2. Profits are eliminated and entry ceases before price falls to its original level, giving the LRS curve a positive slope.

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(iii) A falling long-run industry supply curve

The initial curves are at D0 and S0. Equilibrium is at E0 with price p0 and quantity q0. A rise in demand shifts the demand curve to D1, taking the short-run equilibrium to E1. New firms now enter the industry, shifting the short-run supply curve outwards. Price is pushed down until pure profits are no longer being earned. At this point the supply curve is S1. The new equilibrium is E2 with price at p2 and quantity q2. The price falls below its original level before profits return to normal, giving the LRS curve a negative slope.

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CHAPTER 10: PERFECT COMPETITION

Market Structure and Firm Behaviour Competitive behaviour 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. Elements of the Theory of Perfect Competition The theory of perfect competition is based on the following assumptions: firms sell a homogenous product; customers are well informed; each firm is a price-taker; the industry can support many firms, which are free to enter or leave the industry.

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CHAPTER 10: PERFECT COMPETITION

Short-run Equilibrium
Any firm maximises profits producing the output where its marginal cost curve intersects the marginal revenue curve from below - or by producing nothing if average cost exceeds price at all outputs. A perfectly competitive firm is a quantity-adjuster, facing a perfectly elastic demand curve at the given market price and maximising profits by choosing the output that equates its marginal cost to price. The supply curve of a firm in perfect competition is its marginal cost curve, and the supply curve of a perfectly competitive industry is the sum of the marginal cost curves of all its firms. The intersection of this curve with the market demand curve for the industrys product determines market price.

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CHAPTER 10: PERFECT COMPETITION

The Allocative Efficiency of Perfect Competition

Perfect competition produces an optimal allocation of resources because it maximises the sum of consumers and producers surplus by producing equilibrium where marginal cost equals price.

Long-run Equilibrium
Long-run industry equilibrium requires that each individual firm be producing at the minimum point of its LRAC urve and be making zero profits. The long-run industry supply curve for a perfectly competitive industry may be [i] positively sloped, if input prices are driven up by the industrys expansion, [ii] horizontal, if plants can be replicated and factor prices remain constant, or [iii] negatively sloped, if some other industry that is not perfectly competitive produces an input under conditions of falling long-run costs.