Perfect Competition WD Notes

CI P OT 4
Perfect Competition
Diploma in Total Quality Management Economics Slide # 1

Introduction
• An industry refers to a group of firms that supply

output to a particular market or produces a
similar/same product
Eg. Nissan, Toyota, Honda
 Automobile Industry
• Market structure describes the features of a market

that affect behaviour of firms operating in the
market

Firm and Household Decisions
• Input and output

markets cannot be
considered separately
or as if they operated
independently.

Market Structure
• Features of market structure
• Number of sellers
• Many or few
• Product’s uniformity
• Do firms in the market supply identical products or are there
differences across firms?
• Ease of entry and exit into the market
• Can new firms enter easily or are they blocked by natural or artificial
barriers?
• Knowledge of market/Forms of competition
• Access to information regarding market
• How do firms compete? Pricing/advertising/product differences ?

Characteristics of Perfect Competition
 Numerous sellers are present in the market, all

selling identical products.
 All buyers and sellers are informed about markets
and prices.
 There is free entry into and exit from the market.
 No individual seller or buyer can influence market
price; instead, price is determined by market
supply and demand.

Perfect Competition
• Firms in PC have no control over price

• They are `Price Takers’ i.e. accept and take the
established market price
• Market price is determined by market demand and
market supply
• Why are individual firms price takers ?
• Each is small, relative to size of market
• Buyers are well informed about existing market price
charged
Demand
• Each firm is so small relative to the market that each has no

impact on the market price  each farmer is a price taker
• Because all farmers produce an identical product (?? substitutes

exist), anyone who charges more than the market price will sell
no wheat (i.e. if price goes to $6, quantity demanded falls to 0)
• No farmer would sell at a lower price because they can sell all
they want at the higher price
• Each farmer faces ?? demand at $5. Ed = ??)
• The demand curve faced by an individual farmer is therefore a

horizontal line drawn at the market price.

Exhibit 1: Market Equilibrium and the
Firm’s Demand Curve in Perfect Competition
The market price of wheat of $5 per bushel is determined by the intersection of the market
demand curve and the market supply curve. Once the market price is established, any
farmer can sell all he or she wants at that market price.
(a) Market Equilibrium (b) Firm’s Demand
Price per bushel

Price per bushel
$5 $5 d
D
Bushels of Bushels of
0 1,200,000 wheat per day 0 5 10 15 wheat per day
Demand
 Each firm faces a perfectly elastic demand

curve  the firm’s entire supply can be
sold at the market-determined price
 Profit is the difference between the
average total cost of production and the
selling price, multiplied by the number of
units sold

Short-Run Profit Maximization
• How does the perfectly competitive firm

maximize its total economic profit earned?
• The perfectly competitive firm has no control

over price, however, what the firm does
control is the amount of output produced 
the question facing the PC firm is :
• How much should it produce to earn the greatest
amount of profit?

Two Approaches to Profit Maximisation
• TR – TC Approach
• Produce the quantity of output at which TR
exceeds TC by the greatest amount
• Marginal Analysis Approach
• Produce the quantity of output where
MR= MC

Exhibit : Revenue & Cost Data for PC Firms
Wheat Total Economic

per day Price/kg Revenue TC MC ATC Profit or Loss
0 -- $0 $15.00 -- - $15.00
1 $5 5 19.75 $4.75 $19.75 -14.75
2 5 10 23.50 3.75 11.75 -13.50
3 5 15 26.50 3.00 8.83 -11.50
4 5 20 29.00 2.50 7.25 -9.00
5 5 25 31.00 2.00 6.20 -6.00
6 5 30 32.50 1.50 5.42 -2.50
7 5 35 33.75 1.25 4.82 1.25
8 5 40 35.25 1.50 4.41 4.75
9 5 45 37.25 2.00 4.14 7.75
10 5 50 40.00 2.75 4.00 10.00
11 5 55 43.25 3.25 3.93 11.75
12 5 60 48.00 4.75 4.00 12.00
13 5 65 54.50 6.50 4.19 10.50
14 5 70 64.00 9.50 4.57 6.00
15 5 75 77.50 13.50 5.17 -2.50
16 5 80 96.00 18.50 6.00 -16.00

Extract of Cost & Revenue Data
Qty P=MR=AR TR TC TR – TC
0 $5 $0 $15 - $15
1 $5 $5 $19.75 - $14.75
10 $5 $50 $40.00 $10.00
11 $5 $55 $43.25 $11.75
12 $5 $60 $48 $12.00
13 $5 $65 $54.50 $10.50

Exhibit 3a: Short-Run Profit Maximization
(a) Total Revenue Minus Total cost Total revenue

( $5 × q )
Total Cost
$60
Total dollars
48
TR exceeds TC Max economic
between profit  $12
7 and 14 units BUT…
At Qty = 12, TR exceeds TC 15
by the greatest amount

0 5 7 10 12 14
Bushels of wheat per day

Marginal Analysis Approach
• The PC firm should produce that level of output

where MR = MC
• Marginal revenue ( MR), is the change in total
revenue from selling another unit of output. MR
= Price in PC
• Marginal cost (MC), is the change in total cost
resulting from producing another unit of output

Exhibit : Revenue & Cost Data for PC Firms
Wheat Total Economic

per day Price/kg Revenue TC MC ATC Profit or Loss
0 -- $0 $15.00 -- - $15.00
1 $5 5 19.75 $4.75 $19.75 -14.75
2 5 10 23.50 3.75 11.75 -13.50
3 5 15 26.50 3.00 8.83 -11.50
4 5 20 29.00 2.50 7.25 -9.00
5 5 25 31.00 2.00 6.20 -6.00
6 5 30 32.50 1.50 5.42 -2.50
7 5 35 33.75 1.25 4.82 1.25
8 5 40 35.25 1.50 4.41 4.75
9 5 45 37.25 2.00 4.14 7.75
10 5 50 40.00 2.75 4.00 10.00
11 5 55 43.25 3.25 3.93 11.75
12 5 60 48.00 4.75 4.00 12.00
13 5 65 54.50 6.50 4.19 10.50
14 5 70 64.00 9.50 4.57 6.00
15 5 75 77.50 13.50 5.17 -2.50
16 5 80 96.00 18.50 6.00 -16.00

Extract of Cost & Revenue Data
Qty P=MR TC MC Situation
0 $5 $15.00 -
1 $5 $19.75 $4.75 MR>MC
10 $5 $40.00 $2.75 MR>MC
11 $5 $43.25 $3.25 MR>MC
12 $5 $48.00 $4.75 MR>MC
13 $5 $54.50 $6.50 MR<MC
So long as MR > MC,
The firm will increase quantity supplied as each
additional unit adds more to total revenue than to
total cost. Q increases till the qty where MR=MC
Exhibit 3b: Short-Run Profit Maximization
(b) Marginal Cost Equals Marginal Revenue
Profit is max. where

the marginal cost Marginal cost
curve intersects the Average total cost
marginal revenue
curve, at point e $5 e dMarginal revenue
Profit  average revenue
where output is 12 4
a
Dollars per unit
Bushels of wheat per day

0 5 10 12 15
MR = MC Approach to
Profit Maximisation
• Golden rule of profit maximization:
Generally, a firm will :
expand production if MR > MC
reduce production if MR < MC
• Profit maximisation production level

occurs where MR = MC

Short Run Cost and Revenue Curves
$4.00 Profit maximizing firm

MC
will produce where MR
= MC 
3.00 ATC
2.00
Price and Cost
1.80 AR and MR
1.60
1.40 AVC
1.20
1.00 The firm will produce
.80 13 units at the market
.60 price of $1.80
.40
AFC
.20
0 1 3 5 7 9 11 13 15 17
Quantity
Short-Run Cost and Revenue Curves
$4.00
MC
3.00 ATC
Price and Cost
2.00
D
1.80
AR1 and MR1
1.60
1.40
D1 AVC
1.20 D
1.00
2 If the price falls
.80 to $1.61, where
.60 ATC = MC = AR1
.40 = MR1, the firm is
.20 breaking even
0 1 3 5 7 9 11 13 15 17
Quantity
Short-Run Cost and Revenue Curves
$4.00 If the price falls to $1.20,

MC
the firm is losing money
because ATC is larger
3.00 than AR, but it is
ATC covering its AVC  it
will minimize its losses
Price and Cost
2.00 by producing 11 units

D
1.80
1.60 AVC
1.40 D1 Loss
1.20 AR2 and MR2
D2
1.00
.80
If the price falls below
.60 $0.60, the firm will shut
.40 down because it is not
Shutdown covering its variable cost
.20
0 1 3 5 7 9 11 13 15 17
Quantity
Short-Run Equilibrium: Short-Run Economic Profit,
Break-Even, and Loss Positions
$ $ $ MC ATC
MC ATC MC ATC
AR AR AR
and and and
MR MR MR
0 Q 0 Q 0 Q
Economic Break-Even Loss
Profit
Because different firms may be able to produce at lower costs, some will earn
economic profits, others will just break even, while others will incur losses

Short-Run Firm Supply Curve
• As long as the P > AVC, the firm will

supply the quantity resulting from the
intersection of its upward-sloping marginal
cost curve and its marginal revenue curve
• Firm’s short run supply curve is the portion
of its marginal cost curve that intersects and
rises above the minimum point on its
average variable cost curve

Exhibit 7: Summary of Short-Run
Output Decisions
Marginal cost
The short-run
supply curve is the
5
upward-sloping p5 d5
Average total cost
portion of the
4
marginal cost curve, p4 d
3 Average variable cost 4
beginning at point p3 d3
2. 2
p2 d2
1
p1 d1
Dollars per unit
0 Quantity per period

q2 q3 q4 q5
q1

Exhibit 8: Aggregating Individual Supply to Form Market
Supply
(a) Firm A (b) Firm B (c) Firm C (d) Industry, or market, supply
SA SB SC SASBSC  S
Price per unit
p' p' p' p'
p p p p
0 10 20 0 10 20 0 10 20 0 30 60
Quantity Quantity Quantity Quantity
per period per period per period per period
The short-run industry supply curve is the horizontal sum of all firms’ short-
run supply curves  horizontal summation of the firm level marginal cost
curves

Price and Profit in the Long Run
 Under perfect competition, competitive forces tend to

eliminate economic profits because of the freedom of
firms to enter into and exit from the industry
 Short-run economic profits will in the long run attract
new firms into the industry or provide the incentive for
existing firms to expand output
 Short-run economic losses will in the long run provide
the incentive for some firms to leave the industry or
existing firms to reduce their output

Price & Profit in the Long Run: Long-Run
Equilibrium Price and Economic Profit
Price INDUSTRY Price INDIVIDUAL FIRM

$8 $8
7 S 7 MC
6 S1 6 ATC
5 S2 5 AR and MR
4 4 AR1 and MR1
3 3 AR2 and MR2
2 2
1 D 1
0 Quantity 0 Output
Suppose the initial market price is $5  the profit maximizing firms will be
earning economic profits thus, existing firms have an incentive to expand and
other firms enter the industry. This causes the market supply curve to shift
outward to S1. This process of entry and expansion will continue until the
market supply curve shifts to S2 where the firms are just earning a normal
Diploma in Total Quality Management
profit
Economics Slide # 28
Exhibit 10: Long Run Equilibrium for the Firm and the Industry
(a) Firm (b) Industry, or market
MC S
Dollars per unit
ATC
Price per unit

LRAC
e
p d p
0 q Quantity per period 0 Q Quantity per period

The Role of Resource Costs
 As new firms enter the competitive

industry, the market price of resources and
the ATC for each firm may increase
 Thus, there is an additional competitive
force that works to eliminate economic
profits in the long run

The Long-Run Cost Curve
 Economies of scale
 Forces that cause long-run average cost to fall as
plant size increases
 Optimal scale of operation
 The level of output at which the long-run average
cost is at a minimum
 Diseconomies of scale
 Forces that cause long-run average cost to
increase as plant size increases
Long-Run Average Cost Curve
Each firm in a competitive industry will have to operate

at the optimal scale to remain in business
Cost
AC4
Long-Run AC
AC1 AC2 AC3
Eco f
no m mi es o
Sca ies of e c o no
Di s e
le
Optimal Scale Scal
Output
Forces that cause long- The level of output at Forces that cause long-
run average cost to fall which the long-run run average cost to
as plant size increases average cost is at a increase as plant size
minimum increases

Social Impact of Perfect Competition
 Economic efficiency
 Occurs when firms produce at the minimum
point on their long-run average cost curves i.e.
at the least possible cost
 Allocative efficiency
 Occurs when consumers pay a price equal to
marginal cost
 Producing the amount of output that
consumers value the most
The Efficiency of Perfect Competition
Efficient Allocation of Resources among firms:

• Perfectly competitive firms have incentives to use
the best available technology.
• With a full knowledge of existing technologies,
firms will choose the technology that produces
the output they want at the least cost.
• Each firm uses inputs such that MRPL = PL. The

marginal value of each input to each firm is just
equal to its market price. (P = MC)

The Efficiency of Perfect Competition
Producing What People Want

—the Efficient Mix of Output:
• Society will produce the efficient

mix of output if all firms equate
price and marginal cost.

The Key Efficiency Condition:
Price Equals Marginal Cost
If PX > MCX, society gains value by producing more X
If PX < MCX, society gains value by producing less X
The value placed on Market-determined value of

good X by society resources needed to produce a
through the market, marginal unit of X. MCX is
or the social value of equal to the opportunity cost of
a marginal unit of X. those resources: lost production
of other goods or the value of the
resources left unemployed
(leisure, vacant land, etc).

Efficiency in Perfect Competition
• Efficiency in perfect competition follows from a weighing of values by
both households and firms.

Evaluating the Gains and Losses from Government
Policies--Consumer and Producer Surplus
• Concepts
• Consumer surplus is the total benefit
or value that consumers receive beyond
what they pay for the good.
• Producer surplus is the total benefit or
revenue that producers receive beyond
what it cost to produce a good.

Producer and Consumer Surpluses
Price A The difference between

Sm what consumers would
have been willing to pay
and what they actually pay
for the product
CONSUMER
SURPLUS
B C
Pe
PRODUCER The difference between
SURPLUS
what firms would have
been willing to accept as a
price for the product and
Dm the price they actually
R receive
Qe Quantity
Consumer and Producer Surplus
Price
10
S
D
0
Diploma in Total Quality Management Economics Quantity Slide # 40
Consumer Surplus
Price
10 Consumer
Surplus S
7
Between 0 and Q0
5 consumers A and B
receive a net gain from
buying the product--
consumer surplus
D
0 Q0
Consumer A B Consumer C
ConsumerEconomics Quantity
Producer Surplus
Price
10 Consumer
Surplus S
7
Between 0 and Q0
5 producers receive
a net gain from
selling each product--
Producer producer surplus.
Surplus
D
0 Q0
Quantity
Producer A Producer B Producer C
Diploma in Total Quality Management
Diploma in Total Quality Management Economics
Economics Slide # 42
Change in Consumer and Producer Surplus from
Price Controls
Price To determine the impact of a
governmental policy we can measure
the gain or loss in consumer and
producer surplus. S
Suppose the government

imposes a price ceiling
P0 which is below the
market-clearing price P0.
Q0 Quantity
Change in Consumer and Producer Surplus
from Price Controls
Price
B The gain to consumers is

Price the difference between
P0
Ceiling A C the rectangle A and the
triangle B. i.e. A-B
Pmax
Q1 Q0 Q2 Quantity
from Price Controls
Price
S
•The loss to producers is
the sum of rectangle
B A and triangle C i.e –A-C.
P0
A C •Triangle B and C
together measure
Pmax the deadweight loss.
(sum of ∆ CS + ∆ PS)
D
Q1 Q0 Q2 Quantity
from Price Controls
• Observations:
• The total loss is equal to area B + C.
• The total change in surplus = ∆ CS + ∆ PS
(A - B) + (-A - C) = -B - C
• The deadweight loss is the inefficiency of
the price controls or the loss of the
producer surplus exceeds the gain from
consumer surplus.

When could the consumer experience a net loss in
consumer surplus?
Price D
P0 Effect of Price
Controls When
Demand Is Inelastic
Q2 Quantity
Effect of Price Controls
When Demand Is Inelastic
Price D
B
P0 C If demand is sufficiently
A
Pmax inelastic, triangle B can
be larger than rectangle
A and the consumer
suffers a net loss from
price controls.
Q1 Q2 Quantity
Welfare Loss Under Price Ceiling
Price
When price is
B regulated to be no
higher than P1, the
P0
A C deadweight loss given by
triangles B and C results.
P1
Q1 Q0 Quantity
Welfare Loss Under Price Floor
Price
P2
A B When price is
regulated to be no
P0 lower than P2 only Q3
C will be demanded. The
deadweight loss is given
by triangles B and C
Q3 Q0 Q2 Quantity
Welfare Loss Under Price Floor
Price When price is
regulated to be no
lower than P2 only Q3
S will be demanded.
The
P2 deadweight loss is
A B given
by triangles B and C
P0 C What would the deadweight
loss be if QS = Q2?
Q3 Q0 Q2 Quantity
Price Floors
• Periodically government policy
seeks to raise prices above
market-clearing levels.
• We will investigate this by looking

at a price floor and the minimum
wage.

Price Floor
Price
P0
D
Q0 Quantity
Price Floor
Price
Pmin If producers produce

Q2, the amount Q2 – Q1
P0 will go unsold.
D
Q1 Q0 Q2 Quantity
Price Floor
Price
Pmin The change in producer

A surplus will be
B
P0 C A - C - D. Producers
may be worse off.
D
Q1 Q0 Q2 Quantity
The Minimum Wage
Price
The market clearing

w0 wage is w0.
D
L0 Quantity
The Minimum Wage
Price
wmin
Firms are not allowed to
w0
pay less than wmin . This
results in unemployment.
Unemployment
D
L1 L0 L2 Quantity
The Minimum Wage
Price
wmin
A The deadweight loss
B
w0 C is given by
triangles B and C.
Unemployment
D
L1 L0 L2 Quantity
Price Supports and
Production Quotas
• Much of agricultural policy is based

on a system of price supports,
often combined with incentives to
reduce or restrict production

Price Supports
Price
S
The government establishes

P0 a policy to maintain a
price above PO.
Q0
Price Supports
Price To maintain a price Ps
the government buys
Qg S quantity Qg . The change in
consumer surplus = -A - B,
Ps and the change in producer
D
A surplus is A + B + D
B
P0
D + Qg
Q1 Q0 Q2
Price Supports
Price
S
Qg
The cost to the
Ps government is the
D
A
B
speckled rectangle
P0
Total Welfare Loss
= D – (Q2-Q1)
D + Qg
Q1 Q0 Q2
Price Supports
• Cost to the government (taxes):
• (Q2 - Q1)PS
• Total welfare cost:

• ∆ CS + ∆ PS – Cost to govt
• (-A-B) + (A+B+D) - (Q2 – Q1)Ps
• D – (Q2 – Q1)Ps

Price Supports
• Question:
• Is there a more efficient way to
increase farmer’s income by A + B +
D?
• Yes….but…

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CI P OT 4

Diploma in Total Quality Management Economics Slide # 1

• An industry refers to a group of firms that supply

Eg. Nissan, Toyota, Honda

• Market structure describes the features of a market

Diploma in Total Quality Management Economics Slide # 2

• Input and output

Diploma in Total Quality Management Economics Slide # 3

Diploma in Total Quality Management Economics Slide # 4

 Numerous sellers are present in the market, all

Diploma in Total Quality Management Economics Slide # 5

• Firms in PC have no control over price

• Each firm is so small relative to the market that each has no

• Because all farmers produce an identical product (?? substitutes

• Each farmer faces ?? demand at $5. Ed = ??)

• The demand curve faced by an individual farmer is therefore a

Diploma in Total Quality Management Economics Slide # 7

(a) Market Equilibrium (b) Firm’s Demand

Price per bushel

 Each firm faces a perfectly elastic demand

Diploma in Total Quality Management Economics Slide # 9

• How does the perfectly competitive firm

• The perfectly competitive firm has no control

Diploma in Total Quality Management Economics Slide # 10

Diploma in Total Quality Management Economics Slide # 11

Wheat Total Economic

Diploma in Total Quality Management Economics Slide # 12

10 $5 $50 $40.00 $10.00

11 $5 $55 $43.25 $11.75

12 $5 $60 $48 $12.00

13 $5 $65 $54.50 $10.50

Diploma in Total Quality Management Economics Slide # 13

(a) Total Revenue Minus Total cost Total revenue

At Qty = 12, TR exceeds TC 15

by the greatest amount

Bushels of wheat per day

Diploma in Total Quality Management Economics Slide # 14

• The PC firm should produce that level of output

Diploma in Total Quality Management Economics Slide # 15

Wheat Total Economic

Diploma in Total Quality Management Economics Slide # 16

(b) Marginal Cost Equals Marginal Revenue

Profit is max. where

Bushels of wheat per day

Generally, a firm will :

expand production if MR > MC

reduce production if MR < MC

• Profit maximisation production level

Diploma in Total Quality Management Economics Slide # 19

$4.00 Profit maximizing firm

$4.00 If the price falls to $1.20,

2.00 by producing 11 units

Diploma in Total Quality Management Economics Slide # 23

• As long as the P > AVC, the firm will

Diploma in Total Quality Management Economics Slide # 24

0 Quantity per period

Diploma in Total Quality Management Economics Slide # 25

p' p' p' p'

Diploma in Total Quality Management Economics Slide # 26

 Under perfect competition, competitive forces tend to

Diploma in Total Quality Management Economics Slide # 27

Price INDUSTRY Price INDIVIDUAL FIRM