Perfect Competition

Ch. 20, Economics 9th Ed, R.A. Arnold

Market Structure
In Ch 18 we studied the households/consumers who consume goods to
maximize utility and in Ch 19 – the business firms who produce goods
to maximize profit. The exchange/trade of goods take place in a market.
In the last part of this course we look at the different types of market.
A firm’s decision making (pricing and output decisions) will depend
upon the environment and characteristics of the market in which it sells
its products.
In Ch 20 we look at the perfectly competitive market…
The Theory of The Perfectly
Competitive Market
The theory of the perfectly competitive market is built on the following assumptions:
1) There are many sellers and many buyers, and each is only a small part of the market. They
act independently of one another. And hence none can influence the price in the market.
2) Each firm produces and sells a homogenous product. Each firm sells a product that is
indistinguishable from all other firms’ products in a given industry (e.g. sugar, eggs,
agricultural products). Hence buyers are indifferent to the sellers (it doesn’t matter to
them from which seller they get the good from).
3) Buyers and sellers have all relevant information about prices, product quality, sources of
supply and so forth – perfect information.
4) Firms have easy entry and exit . There are no barriers to entry (e.g. government
restrictions) and exit from the industry.
As a consequence of the first three assumptions, a seller/firm in the
perfectly competitive market (a perfectly competitive firm) is a price
taker, which means it sells all of its product at the price determined in
the market. Why?
Due to (1) the firm cannot influence the price. It cannot charge a higher
price due to assumptions (2) and (3). And there is no incentive to
charge a lower price since they can sell all their products at the market
price (there are many buyers). Hence a firm in a perfectly competitive
market or the perfectly competitive firm is a price-taker.
The demand curve of the firm is a horizontal line drawn at the price
given by the market. The graphical analysis is done next slide.
The Marginal Revenue (MR) Curve of a Perfectly
Competitive Firm is the Same as Its Demand Curve

The title of the slide says it all. Although we should understand why.
Remember: The marginal revenue (MR) is the additional revenue a firm
earns from selling one additional unit of output. If a firm sells an
additional output at $5 what is the additional revenue the firm earns?
Revenue = price x quantity. Here, quantity = 1, P = $5. So the
marginal/additional revenue (MR) = 5 x 1 = $5 = P. Hence, P = MR for a
perfectly competitive firm. And the MR curve is a horizontal line drawn
at the market given price but so is the demand curve (d), hence they
are the same curve.
What level of output does the
perfectly competitive firm produce?
Remember: the objective of any firm is to maximize profit. Therefore, the perfectly
competitive firm produces the output at which the marginal revenue = marginal cost,
MR = MC. Since, P = MR in perfect competition, profit maximization occurs when: P =
MR = MC
Resource Allocative Efficiency: The situation when firms produce the quantity of
output at which price equals marginal cost, P = MC. Note: the perfectly competitive
firm produces the output at which P = MC and hence it is resource allocative efficient.
This means that all units of a good are produced that are of greater value to buyers
than alternative goods that might have been produced using the same resources. In
other words, resources (inputs) are being allocated and used efficiently. And since
resources are limited, resource allocative efficiency is desirable (a good thing).
Case 1, 2 and 3 (p. 466 – 7, 9 th Ed)
Case 1, 2 & 3: study the production of a perfectly competitive firm in the short-run (You
should study them from the textbook. Here we look at the summary of the discussions)
Case 1: If, Price (P) > Average total cost (ATC) > Average variable cost, then the firm will
produce
Case 2: If, P < average variable cost (AVC) then the firm will shut down
Case 3: If, P > AVC but P < ATC then the firm will produce
So we can conclude if P > AVC then the firm produces, if P < AVC it shuts down, in the
short run. But, P = MC. Therefore, the firm only produces (supplies) when MC > AVC. The
supply curve of the perfectly competitive curve is that portion of the MC curve that lies
above the AVC curve.
Or, If TR > TVC then the firm produces. If, TR < TVC it shuts down.
Perfect Competition in the Long Run
According to economic theory- markets, firms and households - tend to reach equilibrium in
the long run. What are the conditions of the long run equilibrium in a perfectly competitive
market (or industry)? For a market, equilibrium means the price is constant (at the equilibrium
price), the quantity supplied (the total amount of output being produced by all the firms) and
quantity demanded are constant (and Qd = Qs) as well. The price will only remain constant (at
equilibrium price) if supply and demand (curves) are constant. The following are the conditions
of the long run equilibrium in a perfectly competitive market:
1) Economic profit is zero i.e. P = SRATC (short run average total cost). Hence existing firms do
not exit the industry and new firms do not enter the industry. So, supply doesn’t change.
2) Individual firms are producing the profit maximizing output: P = MR = MC. Hence no
incentive for individual firms to change the quantity supplied (output). So total output
(sum of the individual firms’ output) in the industry does not change as well.
3) No firm has an incentive to change its plant/factory size to produce its current output; that
is SRATC = LRATC (long run average total cost) at the quantity of output at which P = MC.
Hence, zero economic profit in the long run as well.
The last three conditions ensure that the supply is constant (the supply curve
does not shift). But we have not specified any conditions that will keep the
demand constant. So the demand curve might shift (due to factors discussed in
Ch. 3) and this will cause the perfectly competitive market to move out of
equilibrium. How will it go back to equilibrium?
Let’s assume, the perfectly competitive market is in equilibrium (figure next
page). P = SRATC: All firms earn zero profit. Then, the number of buyers
increases so demand curve shifts right (figure 1 next page). The equilibrium price
increases. New price > SRATC. So there is positive economic profit in the short
run which attracts new firms/sellers (they enter the market easily, since there
are no barriers to entry). The supply in market increases , the supply curve shifts
right (fig 6) and the price decreases until P = SRATC: Zero economic profit (fig 7).
New firms stop entering the market and the market moves to equilibrium.
The Perfectly Competitive Firm and
Productive Efficiency
Remember: The main objective of a firm is to maximize profit.
Profit per unit = price per unit – cost per unit
The perfectly competitive firm takes the price of the market. So price per unit is fixed. The only way it
can increase profit is by reducing cost. Out of the many sellers if one seller can produce the good at
the lowest cost per unit. Then the other sellers can copy his production technique (because of
perfect information) and produce the good at the lowest cost per unit. So every firm in the industry
ends up producing good at the lowest cost per unit (this happens in the long-run in the perfectly
competitive market/industry).
And whenever an industry/firm produces good at the lowest cost per unit, they are said to be
productive efficient. So the perfectly competitive firm is productive efficient.
But what if other firms cannot copy the technology? In that case they cannot compete with the one
seller and they go out of business. The one seller remains - The Monopolist in a Monopoly Market.
Covered in the next slide.