Economics

Markets
Perfect Competition

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 Agenda
Types of Markets

Perfect Competition and its Characteristics

Equilibrium in Perfect Competition

Price and Output Determination in short run

Price and Output Determination in Long run

Practice Questions

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 Types of Markets in Economics

Perfect Competition: Many firms, freedom of entry, homogeneous product, Normal Profit

Monopoly: One firm dominates the market, barriers to entry, possibly supernormal profit

Oligopoly: An industry dominated by a only few firms

Monopolistic Competition: Freedom of entry and exit, but firms have differentiated products.
Likelihood of normal profits in the long term
 Agenda
Types of Markets

Perfect Competition and its Characteristics

Equilibrium in Perfect Competition

Price and Output Determination in short run

Price and Output Determination in Long run

Practice Questions

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 Perfect Competition
Definition
The perfect competition is characterized by the presence of many firms.
They sell identically the same product.
The seller is a price taker that is seller cannot influence the price by increasing or decreasing the supply
 Characteristics of Perfect Competition
Large Number of Firms: Each firm in the industry is so small and its output so negligible that it exercises little
influence over price of the commodity in the market. A single firm cannot influence the price of the product either
by reducing or increasing its output

Large number of buyers : In a perfect competitive market, there are very large number of buyers of the product. If any
consumer purchases more or purchases less, he is not in a position to affect the market price of the commodity. His
purchase in the total output is just like a drop in the ocean. He, therefore, too like the firm, is a price taker

PK is the market price determined by the market forces of

demand and supply. The price taker firm has to adjust and
sell its output at Price PK or OE
 Characteristics of Perfect Competition
Homogeneous Product: Another provision of perfect competition is that the good produced by all the firms in the
industry is identical. In the eyes, of the consumer, the product of one firm (seller) is identical to that of another seller. The
buyers are indifferent as to the firms from which they purchase. In other words, the cross elasticity between the
products of the firm is infinite

No barriers to entry: The firms in a competitive market have complete freedom of entering into the market or leaving the
industry as and when they desire. There are no legal, social or technological! barriers for the new firms (or new capital) to
enter or leave the industry

Profit maximization: For perfect competition to exist, the sole objective of the firm must be to get maximum profit.
Demand Curve in Perfect Comp
 Examples of Perfect Comp Markets
Foreign exchange markets. Here currency is all homogeneous. Also, traders will have access
to many different buyers and sellers. There will be good information about relative prices.
When buying currency it is easy to compare prices
 Agenda
Types of Markets

Perfect Competition and its Characteristics

Equilibrium in Perfect Competition

Price and Output Determination in short run

Price and Output Determination in Long run

Practice Questions

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 Equilibrium of the Firm in Perfect Comp
Equilibrium of the Firm Under Perfect Competition is when

Marginal Revenue = Marginal Cost

If Marginal Revenue is > Marginal Cost you will try to produce more

If Marginal Revenue is < Marginal Cost then why you will produce. Each unit is giving you loss

If Marginal Revenue = Marginal Cost..this is the point at which there is equilibrium

Equilibrium of the Firm in Perfect Comp
A firm under perfect competition faces an infinitely
elastic demand curve or we can say for an individual
firm, the price of the commodity is given in the market

At M MR = MC. But the firm will not produce OM

quantity of good because for OM output, the marginal
cost is higher than marginal revenue. Here MC curve
is cutting MR curve from above

The marginal cost curve cuts the marginal revenue

curve from below at point T. The shaded portion
between M to S level of output shows profit on
production. Here Profit is maximum

In case, the firm increases the level of output from OS,

the additional output adds less to Its revenue than to
its cost. The firm undergoes losses as is shown in the
shaded area
 Agenda
Types of Markets

Perfect Competition and its Characteristics

Equilibrium in Perfect Competition

Price and Output Determination in short run

Price and Output Determination in Long run

Practice Questions

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Short Run Equilibrium and Long Run
Equilibrium

Short Run Analysis

Long Run Analysis

 Short Run Equilibrium – Perfect Comp
Short Run means only some factors of Production can be varied

Equilibrium is achieved when MR = MC

In the short period, a firm at the equilibrium level of output is faced with four types of product
prices in the market which give rise to following results:

(i) A firm earns supernormal profits.

(ii) A firm earns normal profits.

(iii) A firm incurs losses but does not close down.

(iv) A firm minimizes losses by shutting down.

All these short run cases of profits or losses are explained with the help of diagrams.
Super Normal Profits – Short Run – Perfect Comp
MR = AR

Equilibrium Point L

Equilibrium Price is P and output Is N

At N output, the ATC is M or K

Cost is OKMN

Revenue is OPLN

Profit PLMK

The firm would not stop short of ON output because

producing another unit adds more to the revenue than to
cost (MR > MC). Hence, ON is the best level of
output where profit of the firm is maximum
 Normal Profits
Normal Profits: When you earn just to cover all the costs including your opportunity cost or any other implicit Cost

Normal Profit is when Total Revenue = Explicit Cost + Implicit Costs

Normal Profit is also called Zero Economic Profit where Economic Profit = Revenue – Explicit Cost – Implicit Costs
Normal Profits – Short Run – Perfect Comp
MR = AR

Equilibrium Point K

Equilibrium Price is P and output Is M

At M output, the ATC is P or K

Cost is OPKM

Revenue is OPKM

Profit = zero economic profit or just Normal profit

Firm is able to cover both Fixed and Variable Costs

Loss Making But Enough to Cover Variable Cost –
Short Run – Perfect Comp
MR = AR

Equilibrium Point N

Equilibrium Price is P and output is K

At K output, the ATC is S or T

Cost is OTSK

Revenue is OPNK

Loss =PNST
Firm is able to cover the variable cost but not all the fixed
cost

In spite of Loss But still the firm continues because if it

stops down the loss would be EFST which is larger than
PNST
Shut Down – Short Run – Perfect Comp
MR = AR

Equilibrium Point Z

Equilibrium Price is P and output is K

At K output, the ATC is F or T

Cost is OTFK

Revenue is OPZK

Loss =TFPZ

Firm is just able to cover the variable cost and is not

covering the fixed cost

If the price falls below Z, the competitive firm will minimize

its losses by closing down
Short Run Equilibrium and Long Run
Equilibrium

Short Run Analysis

Long Run Analysis

 Long Run Equilibrium – Perfect Comp
Long Run Means when all the factors of Production can be varied

Equilibrium is achieved when MR = MC = Min of ATC

MR = AR = Min of ATC

Equilibrium Point K

Equilibrium Price is P and output is L

Cost is OPKL

Revenue is OPKL

Zero Economic Profit or Normal Profit

No Supernormal Profits in Longer Run

 Long Run Equilibrium – Perfect Comp
Long Run Means when all the factors of Production can be varied

Equilibrium is achieved when MR = MC = Min of ATC

If in short run equilibrium price is at R then firms will earn super

normal profits and hence more firms will enter the markets and
hence the equilibrium price will come down to P in longer run

If in short run equilibrium price is at Z then firms will make loss and
hence more firms will leave the markets and hence the equilibrium
price will increase to P in longer run
 Agenda
Types of Markets

Perfect Competition and its Characteristics

Equilibrium in Perfect Competition

Price and Output Determination in short run

Price and Output Determination in Long run

Practice Questions

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 Practice Questions

Answer: A
Answer B
Answer A
Answer E
Answer E
Answer B
Answer False
Answer B
Answer E
Answer B
Answer D
Answer E
Answer D
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