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Perfect CompetitionTopic 5

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Character ist ics

Pure Compet it ion large number of sellers & buyers homogenous (identical) products low barriers to entry (free entry and exit from

the industry)

Perfect Competi t ion

large number of sellers & buyers homogenous (identical) products low barriers to entry perfect market knowledge

perfect mobility of FoPs

Lead tofaster

adjustment

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Price takers & Price makers

Demand curve for aPrice taker

Demand curve for aPrice maker

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Demand curve for a Price taker

The demand curve facing a perfectlycompetitive firm is perfect ly elast ic,meaning that the firm can sell as many units

as it wants at the market price, but cannotsell any quantity if it charges more than themarket price.

The firm has no market power, no pricingpower at all. It is just a small player in alarge market.. It is a pr ice taker.

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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 notlose all its customers, and if it wants to sellmore, it has to cut price.

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Demand curve for Individual firmunder PC

P = AR = MR

Firms D curve

Market D curve

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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 aproduct sold

AR = TR/Q = (P x Q) / Q = P

Marginal Revenue (MR): Additional revenue receivedresulting from the sale of an extra unit of output

MR = = = PTR

Q

P. Q

Q

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$131131131

131131131131131131131131

012

3456789

10

$ 0131262

393524655786917

104811791310

]$131

131

131131131131131

131131131

]

]

]

]

]

]

]

]

]

ProductPrice

(AverageRevenue)

TotalRevenue

MarginalRevenue

QuantityDemanded

(Sold)

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TR

Price,averagea

ndmarginalrevenue,

totalrevenue(dollars)

P

Quantity demanded (sold)1 2 3 4 5 6 7 8 9 10

917

786

655

524

393

262

131

0

D = MRP = AR = MR

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Profit Maximisation in theSho rt Run

Two approaches to pro f i t maxim isat ion:

Total Revenue minus Total Cost Approach

Marginal Revenue, Marginal Cost

Approach

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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

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Total Revenue Total CostApproach (Price = $131)

01

23456

789

10

TotalCost

TotalProduct

TotalFixedCost

TotalVariableCost

TotalRevenue Profit

$ 100100

100100100100100

100100100100

$ 090

170240300370450

540650780930

$ 100190

270340400470550

640750880

1030

$ 0131

262393524655786

917104811791310

$100 59

8+ 53

+ 124+ 185+ 236

+ 277+ 298+ 299+ 280

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01

23456

789

10

100

100

100

100

100

100

100

100100

100

100

0

90

170

240

300

370

450

540650

780

930

100190

270340400470550

640750880

1030

]

]]]]]]

]]

]

TotalCost

TotalProduct

TotalFixedCost

TotalVariableCost

MarginalCost

TotalEconomicProf./Loss

Price =MarginalRevenue

Profit Maximisation: MR, MC Approach

90

8070607080

9011013

015

0

$ 131

131131131131131

131131131131

$100

59 8

+ 53+ 124+ 185+ 236

+ 277+ 298+ 299+ 280

S f f

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fig

O O

S

D

(a) Industry

P $

Q (millions)

Pe

(b) Firm

AR D = AR

= MR

MC

Qe

Short-run equilibrium ofindustryandfirmunder Perfect Competition

Q (thousands)

Copyright 2001 Pearson Education Australia

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IMPORTANT!Rules for Profit Maximisation

Optimal ou tpu t is where MR = MC

or MR closest to MC but MR > MC

MC cuts MR curve from below

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IMPORTANT !Rules for Profit maximization

Sho rt Run

P AVC

In the short run, fixed costs will be incurredwhether or not the firm produces. So thismeans that total revenue must be at leastequal to total variable cost for the firm tocontinue producing.

If P < AVC, firm should shut down

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IMPORTANT !Rules for Profit maximization

Long Run

P ATC

In the long run, firms have the option ofclosing down and going out of business, sototal revenue must at least cover total costs

( all costs ).If P < ATC, firm should shut down

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fig

O O

S

D

(a) Industry

P $

Q(millions)

Pe

(b) Firm

AR D = AR

= MR

MC

Qe

ATC

AC

SR Profit maximisation underPerfect Competition

Q(thousands)

Copyright 2001 Pearson Education Australia

S f

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fig

O O

S

D

(a) Industry

P $

Q(millions)

Pe

(b) Firm

AR D = AR= MR

MC

Qe

ATC

AC

SR Profit maximisation underPerfect Competition

Q(thousands)

Copyright 2001 Pearson Education Australia

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fig

O O

(a) Industry

P $

P1

Q(millions)

S

D

(b) Firm

AR1D1= AR1

= MR1

MC

Qe

ATC

AC

SR Loss minimisation underPerfect Competition

Q(thousands)

Copyright 2001 Pearson Education Australia

AV

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fig

Short-run shut-down point

O O

(a) Industry

P $

P2

Q(millions)

S

D2

(b) Firm

AR2

D2= AR2

= MR2

MC ATC

AV

Q

Copyright 2001 Pearson Education Australia

Q1

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Long runEquilibrium under PC

Under PC

P = min. ATC = MR = MCwhy?

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fig

Long-run equilibrium under PC

O OD

(a) Industry

P $

Q(millions)

P1

(b) Firm

ATC

AR1

S1

D1

Q(thousands)

Copyright 2001 Pearson Education Australia

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fig

O O

S1

D

(a) Industry: As firms makingsupernormal profits , new firmswill enter the industry. S curve

shifts to right. Price falls.

P $

Q(millions)

P1

(b) Firm

AR1

ATC

PL ARL

QL

Se

D1

DL

Long-run equilibrium under PC

Q(thousands)

Copyright 2001 Pearson Education Australia

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fig

O O

S1

D

(a) Industry: As firms makinglosses , some firms will leavethe industry. S curve shifts to

left. Price rises.

P $

Q(millions)

P1

(b) Firm

AR1

ATC

PL ARL

QL

Se

D

1

DL

Long-run equilibrium under PC

Q(thousands)

Copyright 2001 Pearson Education Australia

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Long run Equilibrium

.

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Long run Equilibrium

Key character ist ics of PC:

large number of sellers & buyers

identical products freedom of entry & exit

Impl icat ion (or conclus ion ) Firms in PC cannot earn economic profits in

the long run

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Efficiency

A l locat ive eff ic iency:

Resources are allocated among firms andindustries to obtain a mix of products

most desired by society (consumers)

Product ive eff ic iency:

The least costly methods of productionare used (ie. goods are produced at thelowest possible costs)

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Efficiency and PerfectCompetition

Priceof product X = the relative worth ofproduct X to the society (or the marginal

benefit/satisfaction the society gets from anadditional unit of X) .

Marginal Costof product X is the cost ofproducing an additional unit of X

(MC measures the sacrifice of other goods inusing resources to produce more of X)

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Efficiency and PerfectCompetition

A l locat ive eff ic iency: P > MC : resources are under allocated

P < MC : resources are over allocated

P = MC : resources are best allocated/utilised

Product ive eff ic iency: P = min ATC

(For more details, read Jackson pp. 276 77)

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Assessment of Perfect Competition

Pros

Productive efficiency: min AC (ie. firms produceat the least-cost output)

Allocative efficiency: P = MC

Consumer gains from low prices (ie. maximumconsumer surplus) Speed of resource reallocation No power groups

Cons

Less scope for R&D Almost no product variety

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Short-Run Supply Curve

For the individual firm: the SR supplycurve is the MC curve above the AVCcurve

For the entire industry: horizontal sum offirms MC curves above AVC

P MC Sh t R S l C

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P = MC: Short-Run Supply Curve

P

Q

MC

AVC

ATC

Cost

sand

reven

ues(dollar

s)

At every price, theMR = MC point

changes the quantitybeing exchanged...

P MC Sh t R S l C

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P = MC: Short-Run Supply CurveP

Q

MC

AVC

ATC

Cos

tsand

revenues(dollars)

MR3Record the

quantity being

supplied foreach price

Q3

P3

P MC Sh t R S l C

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P = MC: Short-Run Supply CurveP

Q

MC

AVC

ATC

Costsand

revenues(dollars)

MR3

Q3

MR2At a lower pricea lower quantity

will be supplied

Q2

P2

P3

P MC Sh t R S l C

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P = MC: Short-Run Supply CurveP

Q

MC

AVC

ATC

Costsand

revenues(dollars)

MR3

Q3

MR2

Q2

P2

P3

At a higher pricea greater quantitywill be supplied

Q4

Break-even

(no rmal prof i t )

po in t

MR4P4

P = MC: Short Run Supply Curve

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P = MC: Short-Run Supply CurveP

Q

MC

AVC

ATC

Costsand

revenues(dollars)

MR3

Q3

MR2

Q2

P2

P3

Q4

Break-even

(no rmal prof i t )

po in t

MR4

Q5

MR5P

4

P5

P = MC: Short Run Supply Curve

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P = MC: Short-Run Supply CurveP

Q

MC

AVC

ATC

Costsand

revenues(dollars)

MR3

Q3

MR2

Q2

P2

P3

Q4

Break-even

(no rmal prof i t )

po in t

MR4

Q5

MR5P

4

P5

MR1P1 Firm should notproduce unless

revenue is at leastable to meet AVC

P = MC: Short Run Supply Curve

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P = MC: Short-Run Supply CurveP

Q

MC

AVC

ATC

Costsand

revenues(dollars)

MR3

Q3

MR2

Q2

P2

P3

Q4

Break-even

(no rmal prof i t )

po in t

MR4

Q5

MR5P

4

P5

MR1P1The Marginal

Cost Curve at points aboveAVC represents the short-run

supply curve

P = MC: Short Run Supply Curve

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P = MC: Short-Run Supply CurveP

Q

MC

AVC

ATC

Costsand

revenues(dollars)

MR3

Q3

MR2

Q2

P2

P3

Q4

MR4

Q5

MR5P

4

P5

MR1P1

Short-run

supp ly curve

(red)

P = MC: Short Run Supply Curve

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P = MC: Short-Run Supply Curve

P

Q

MC1

AVC1

If costs increase...the supply curveeffectively shiftsto the left

MC2

AVC2

P = MC: Short Run Supply Curve

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P = MC: Short-Run Supply Curve

P

Q

MC2

AVC2

MC1

AVC1

If costs decrease...the supply curveeffectively shiftsto the right