Perfect Competition

Demand for the product of a perfectly competitive firm

• Price determined by S & D• Price taker • Won’t charge higher or lower than market

price• Horizontal (perfectly elastic) at market price.

Market demand Individual firm

MR = AR = P

The equilibrium of the firm under any conditions

Firms aim to maximise profit

Two rules for profit-maximisation • shut-down rule• profit maximising rule

The shut-down ruleThe shut-down rule: a firm should produce only if total revenue is equal to, or greater than, total variable cost (which includes normal profit).

Profit maximising rule

Profit is maximised where marginal revenue (MR) is equal to marginal cost (MC).

In summary…• When MR > MC, output should be expanded

• When MR = MC, profits are maximised

• When MR < MC, output should be reduced

Equilibrium in terms of total revenue and total cost

Equilibrium in terms of marginal revenue and marginal costPOINT a: MR (R10) – MC (R4) = R6POINT b: MR (R10) – MC (R6) = R4POINT c: MR (R10) – MC (R8) = R2POINT d: MR (R10) – MC (R10) = R0POINT e: MR (R10) – MC (R12) = -R2

Check these out…

Profit Maximising Level

Perfect Competition

Normal profits

Normal profits: occur when total costs = total revenue.

Minimum earnings required to prevent entrepreneur leaving and applying factors of production elsewhere.

Profit is maximised where MR = MC = P2This occurs at Q2At Q2, AR = P2 = AC (C2)As AR = AC, the firm does not earn an economic profit.

Normal profit earned, since all its costs, includingself-employed resources, are fully covered.E2 aka break even point

Can also be found by TR - TCTR = P2 X Q2 = 0P2E2Q2TC = C2 X Q2 = 0C2E2Q20C2E2Q2 (TC) = 0P2E2Q2 (TR)

Economic profits

Economic profits: profit that a business makes that is more than the normal profit.

Economic profit occurs when total revenue > total costs.

AKA excess profit, abnormal profit, supernormal profit or pure profit.

Profit is maximised where MR = MC = P3This occurs at Q3At Q3, AR = P3 and AC = C1At Q3, AR (P3) > AC (C1) Economic profit earned – above breakeven

point.

Can also be found by TR - TCTR = P3 X Q3 = 0P3E3Q3TC = C1 X Q3 = 0C1MQ3

0P3E3Q3 (TR) > 0C1MQ3 (TC)Difference = Economic Profit = C1P1E3M

Economic loss

Economic loss: occurs when a firm makes less than normal profit.

• I.e. price (AR) < AC

Profit is maximised where MR = MC = P3This occurs at Q3At Q3, AR = P3 and AC = C3At Q3, AR (P3) < AC (C3) Economic loss = C3 – P3

Can also be found by TR - TCTR = P3 X Q3 = 0P3E3Q3TC = C3 X Q3 = 0C3MQ3

0P3E3Q3 (TR) < 0C1MQ3 (TC)Difference = Economic Loss = P3C3ME3

If a firm is making an economic loss, should they leave the market?

Depends on average revenue (P) relative to average VARIABLE costs.

If P < AVC, best to leave the industry.

Movement to a long term equilibrium

Movement to a long term equilibrium

Allocative Efficiency

Allocative efficiency: a situation where it is impossible to reallocate the resources to make at least one person better off without making someone else worse off.

Allocative inefficiency: it is possible to make at least one person better off without making someone else worse off.

In such a case the welfare of society can be improved by reallocating the resources.

Society’s welfare maximised when…

P (OC of consuming extra unit) =

MC (OC of producing extra unit)

Are perfectly competitive firms allocatively efficient?• P = MR• Profit maximisation at MR = MC• Therefore they produce at P = MR = MC

Productive efficiencyProductive efficiency: occurs when all the firms in the industry produce where their long-run average or unit costs are at a minimum.

When this occurs – no waste of scarce resources.

Perfectly competitive firms in equilibrium in the long run where average cost is at a minimum – thus productively efficient.