PERFECT COMPETITION

Market structure
• Principal market structures
• Perfect competition
• Monopoly
• Oligopoly
• Monopolistic competition

• Two dimensions of markets

• Number of producers (one, two, or many)
• Types of goods offered (identical or differentiated)
Market structure
• Number of producers: entry of new firm in the market
• Control over necessary inputs
• Increasing returns to scale
• Government regulations

• Differentiated goods are goods that are different but substitutable by

consumers. e.g. Coke vs. Pepsi; Colgate vs. Pepsodent
• Extent of differentiation determined by the nature of goods and
consumer preferences. e.g. soft drinks, textbooks are easily differentiable
whereas hammers are difficult to differentiate
Market structure
Perfect competition
• Perfect competition: Market structure where each firm is a price taker.
• Agricultural & commodity markets; retail & wholesale; foreign exchange &
stock markets
• Large number of firms each with a small individual market share. e.g. farmers in
agricultural markets
• All firms produce a homogeneous or standardised product. e.g. agricultural
products are homogenous
• Free or unrestricted entry and exit into the market: super-normal profits are
competed away in the long-run
• Buyers have full information about the product and prices charged in the market
Perfect competition
• Demand curve facing a firm under perfect competition
Perfect competition
• Total Revenue (TR) is defined as the product of price charged per unit of
output multiplied by sales
𝑇𝑅 = 𝑃 × 𝑄

• Average Revenue (AR) is the revenue earned per unit of output

𝑇𝑅 𝑃 × 𝑄
𝐴𝑅 = = =𝑃
𝑄 𝑄

• Marginal Revenue (MR) is the change in total revenue due to the sale of an
additional unit of output
∆𝑇𝑅 𝜕𝑇𝑅
𝑀𝑅 = =
∆𝑄 𝜕𝑄
Perfect competition
Quantity (𝑄) Price (𝑃) Total Revenue Average Revenue Marginal Revenue
(𝑇𝑅 = 𝑃 × 𝑄) (𝐴𝑅 =
𝑇𝑅
) (𝑀𝑅 =
∆𝑇𝑅
)
𝑄 ∆𝑄

1 6 6 6 6
2 6 12 6 6
3 6 18 6 6
4 6 24 6 6
5 6 30 6 6
6 6 36 6 6
7 6 42 6 6
8 6 48 6 6
Perfect competition
• Decision-making in the short-run: Two decisions
• The production decision: Whether to produce or shut down
• The output decision: How much to produce?

• The output decision

• The optimal output level is the quantity that maximizes the firm’s economic
profit or minimizes the firm’s losses
• The optimal output level is also the quantity when marginal revenue equals
marginal costs
Perfect competition
• Total Revenue: 𝑇𝑅 = 𝑃 × 𝑄
• Total Cost: 𝑇𝐶 = 𝑇𝑉𝐶 + 𝑇𝐹𝐶
• Profits: 𝜋 = 𝑇𝑅 − 𝑇𝐶 = 𝑃𝑄 − 𝑇𝑉𝐶 − 𝑇𝐹𝐶
• The first-order condition of maximization is
𝜕𝜋
= 0 ⇒ 𝑀𝑅 = 𝑀𝐶 … … (1)
𝜕𝑄

• The second order condition of maximization is,

𝜕2𝜋 𝜕𝑀𝐶
<0⇒ > 0 … … (2)
𝜕𝑄2 𝜕𝑄
• At the optimal output level, 𝑀𝑅 = 𝑀𝐶 and the 𝑀𝐶 curve cuts the price line from below.
The output decision: Earning profits
1 2 3 4 5 6 7

Quantity Total Total Cost Profit (𝐓𝐑 − Marginal Marginal Cost Change in
(𝐐) Revenue (𝐓𝐂) 𝐓𝐂) Revenue 𝐌𝐂 =
∆𝐓𝐂 profit
∆𝐐
(𝐓𝐑) 𝐌𝐑 =
∆𝐓𝐑 𝐌𝐑 − 𝐌𝐂
∆𝐐

0 0 3 -3 — — —
1 6 5 1 6 2 4
2 12 8 4 6 3 3
3 18 12 6 6 4 2
4 24 17 7 6 5 1
5 30 23 7 6 6 0
6 36 30 6 6 7 -1
7 42 38 4 6 8 -2
8 48 47 1 6 9 -3
The output decision
The output decision: Earning profits
The output decision: Breaking even
1 2 3 4 5 6 7

Quantity Total Total Cost Profit Marginal Marginal Cost Change in

(𝐐) Revenue (𝐓𝐂) (𝐓𝐑 − 𝐓𝐂) Revenue 𝐌𝐂 =
∆𝐓𝐂 profit
(𝐓𝐑) ∆𝐓𝐑 ∆𝐐 𝐌𝐑 − 𝐌𝐂
𝐌𝐑 =
∆𝐐

0 0 10 -10 — — —
1 6 12 -6 6 2 4
2 12 15 -3 6 3 3
3 18 19 -1 6 4 2
4 24 24 0 6 5 1
5 30 30 0 6 6 0
6 36 37 -1 6 7 -1
7 42 45 -3 6 8 -2
8 48 54 -6 6 9 -3
The output decision: Breaking even
The output decision: Operating at a loss
1 2 3 4 5 6 7

Quantity Total Total Cost Profit (𝑇𝑅 − Marginal Marginal Cost Change in
(𝑄) Revenue (𝑇𝐶) 𝑇𝐶) Revenue 𝑀𝐶 =
∆𝑇𝐶 profit
(𝑇𝑅) ∆𝑇𝑅 ∆𝑄 𝑀𝑅 − 𝑀𝐶
𝑀𝑅 =
∆𝑄

0 0 13 -13 — — —
1 6 18 -12 6 2 4
2 12 21 -9 6 3 3
3 18 25 -7 6 4 2
4 24 30 -6 6 5 1
5 30 36 -6 6 6 0
6 36 43 -7 6 7 -1
7 42 51 -9 6 8 -2
8 48 60 -12 6 9 -3
The output decision: Operating at a loss
The production decision: P > Minimum AVC
1 2 3 4 5 6 7

Quantity Total Total Cost Profit Total Fixed Total Variable Average
(𝐐) Revenue (𝐓𝐂) (𝐓𝐑 − 𝐓𝐂) Cost Cost Variable
(𝐓𝐑) Cost
0 0 13 -13 13 0 0
1 6 18 -12 13 5 5
2 12 21 -9 13 8 4
3 18 25 -7 13 12 4
4 24 30 -6 13 17 4.25
5 30 36 -6 13 23 4.75
6 36 43 -7 13 30 5
7 42 51 -9 13 38 5.43
8 48 60 -12 13 47 5.62
The production decision: P > Minimum AVC
The production decision: P < Minimum AVC
1 2 3 4 5 6 7

Quantity Total Total Cost Profit (𝐓𝐑 − Total Fixed Total Variable Average
(𝐐) Revenue (𝐓𝐂) 𝐓𝐂) Cost Cost Variable
(𝐓𝐑) Cost

0 0 13 -13 13 0 0
1 6 28 -22 13 15 15
2 12 31 -19 13 18 9
3 18 35 -17 13 22 7.33
4 24 40 -16 13 27 6.75
5 30 46 -16 13 33 6.60
6 36 53 -17 13 40 6.67
7 42 61 -19 13 48 6.86
8 48 70 -22 13 57 7.13
The production decision: P < Minimum AVC
Firm entry & exit: Shift in supply
The output decision: Long-run equilibrium
1 2 3 4 5 6 7

Quantity Total Total Cost Profit Marginal Marginal Cost Change in

(𝐐) Revenue (𝐓𝐂) (𝐓𝐑 − 𝐓𝐂) Revenue 𝐌𝐂 =
∆𝐓𝐂 profit
(𝐓𝐑) ∆𝐓𝐑 ∆𝐐 𝐌𝐑 − 𝐌𝐂
𝐌𝐑 =
∆𝐐

0 0 10 -10 — — —
1 6 12 -6 6 2 4
2 12 15 -3 6 3 3
3 18 19 -1 6 4 2
4 24 24 0 6 5 1
5 30 30 0 6 6 0
6 36 37 -1 6 7 -1
7 42 45 -3 6 8 -2
8 48 54 -6 6 9 -3
The output decision: Long-run equilibrium
The marginal cost curve and the supply curve
The marginal cost curve and the supply curve

Short-run supply curve

Point Price Quantity
𝐴 10 30
𝐵 12 35
𝐶 14 40
𝐷 16 45
𝐸 18 50
The marginal cost curve and the supply curve
Producer surplus
• Variable costs: The minimum price at which the producer is willing to sell his product
• Producer surplus is the difference between the price the producer receives from the sale of
output and the variable costs of production
𝑃𝑟𝑜𝑑𝑢𝑐𝑒𝑟 𝑠𝑢𝑟𝑝𝑙𝑢𝑠 = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 − 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡
= 𝑃𝑟𝑖𝑐𝑒 𝑡ℎ𝑒 𝑠𝑒𝑙𝑙𝑒𝑟 𝑟𝑒𝑐𝑒𝑖𝑣𝑒𝑠 − 𝑇ℎ𝑒 𝑚𝑖𝑛𝑖𝑚𝑢𝑚 𝑝𝑟𝑖𝑐𝑒 𝑎𝑡 𝑤ℎ𝑖𝑐ℎ 𝑡ℎ𝑒 𝑠𝑒𝑙𝑙𝑒𝑟 𝑤𝑜𝑢𝑙𝑑 𝑏𝑒 𝑤𝑖𝑙𝑙𝑖𝑛𝑔 𝑡𝑜 𝑠𝑒𝑙𝑙

• Producer surplus equals the gains from trade

• Profit from production (trade): Total Revenue−Total Fixed Cost−Total Variable Cost
• Profit from shutting-down (not trading): (−Total Fixed Cost)
𝑃𝑟𝑜𝑑𝑢𝑐𝑒𝑟 𝑠𝑢𝑟𝑝𝑙𝑢𝑠 = 𝐺𝑎𝑖𝑛𝑠 𝑓𝑟𝑜𝑚 𝑡𝑟𝑎𝑑𝑒 = 𝑃𝑟𝑜𝑓𝑖𝑡 𝑓𝑟𝑜𝑚 𝑡𝑟𝑎𝑑𝑒 − 𝑃𝑟𝑜𝑓𝑖𝑡 𝑓𝑟𝑜𝑚 𝑛𝑜𝑡 𝑡𝑟𝑎𝑑𝑖𝑛𝑔
= 𝑃𝑟𝑜𝑓𝑖𝑡 𝑓𝑟𝑜𝑚 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 − 𝑃𝑟𝑜𝑓𝑖𝑡 𝑓𝑟𝑜𝑚 𝑠ℎ𝑢𝑡𝑡𝑖𝑛𝑔 − 𝑑𝑜𝑤𝑛
= 𝑇𝑅 − 𝑇𝐹𝐶 − 𝑇𝑉𝐶 − −𝑇𝐹𝐶 = 𝑇𝑅 − 𝑇𝑉𝐶
Producer surplus
Producer surplus
• The producer produces 4 units of the good
• Producer surplus for the first unit: ₹3 ( = ₹4 – ₹1)
• Producer surplus for the second unit: ₹2 ( = ₹4 – ₹2)
• Producer surplus for the third unit: ₹1 ( = ₹4 – ₹3)
• Producer surplus for the fourth (or last) unit: ₹0 ( = ₹4 – ₹4)
• Total producer surplus: ₹6 ( = ₹3 + ₹2 + ₹1 + ₹0)
• Total producer surplus: Total revenue – Total Variable Cost
• Total Revenue: ₹16 ( = ₹4 × 4)
• Total Variable Cost: ₹10 ( = ₹4 + ₹3 + ₹2 + ₹1)
• Total Producer Surplus: ₹6 ( = ₹16 – ₹10)
Producer surplus
• Variable costs: The minimum price at which the producer is willing to sell his product
• Producer surplus is the difference between the price the producer receives from the sale of
output and the variable costs of production
𝑃𝑟𝑜𝑑𝑢𝑐𝑒𝑟 𝑠𝑢𝑟𝑝𝑙𝑢𝑠 = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 − 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡
= 𝑃𝑟𝑖𝑐𝑒 𝑡ℎ𝑒 𝑠𝑒𝑙𝑙𝑒𝑟 𝑟𝑒𝑐𝑒𝑖𝑣𝑒𝑠 − 𝑇ℎ𝑒 𝑚𝑖𝑛𝑖𝑚𝑢𝑚 𝑝𝑟𝑖𝑐𝑒 𝑎𝑡 𝑤ℎ𝑖𝑐ℎ 𝑡ℎ𝑒 𝑠𝑒𝑙𝑙𝑒𝑟 𝑤𝑜𝑢𝑙𝑑 𝑏𝑒 𝑤𝑖𝑙𝑙𝑖𝑛𝑔 𝑡𝑜 𝑠𝑒𝑙𝑙

• Producer surplus equals the gains from trade

• Profit from production (trade): Total Revenue−Total Fixed Cost−Total Variable Cost
• Profit from shutting-down (not trading): (−Total Fixed Cost)
𝑃𝑟𝑜𝑑𝑢𝑐𝑒𝑟 𝑠𝑢𝑟𝑝𝑙𝑢𝑠 = 𝐺𝑎𝑖𝑛𝑠 𝑓𝑟𝑜𝑚 𝑡𝑟𝑎𝑑𝑒 = 𝑃𝑟𝑜𝑓𝑖𝑡 𝑓𝑟𝑜𝑚 𝑡𝑟𝑎𝑑𝑒 − 𝑃𝑟𝑜𝑓𝑖𝑡 𝑓𝑟𝑜𝑚 𝑛𝑜𝑡 𝑡𝑟𝑎𝑑𝑖𝑛𝑔
= 𝑃𝑟𝑜𝑓𝑖𝑡 𝑓𝑟𝑜𝑚 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 − 𝑃𝑟𝑜𝑓𝑖𝑡 𝑓𝑟𝑜𝑚 𝑠ℎ𝑢𝑡𝑡𝑖𝑛𝑔 − 𝑑𝑜𝑤𝑛
= 𝑇𝑅 − 𝑇𝐹𝐶 − 𝑇𝑉𝐶 − −𝑇𝐹𝐶 = 𝑇𝑅 − 𝑇𝑉𝐶
Numerical Problem 1
In a perfectly competitive market, the market determined price of a product is ₹20 and the total cost
functions of the firm is given by,
𝑇𝐶 = 𝑄 2 + 4𝑄 + 20
Find the profit maximizing output and the maximum output.
• Revenue function: 𝑇𝑅 = 20𝑄
• Cost function: 𝑇𝐶 = 𝑄 2 + 4𝑄 + 20
• Profit function: 𝜋 = 𝑇𝑅 − 𝑇𝐶 = 16𝑄 − 𝑄 2 − 20
• First order condition of maximization:
𝜕𝜋
= 16 − 2𝑄 = 0 ⇒ 𝑄 = 8
𝜕𝑄
• Second order condition of maximization:
𝜕2𝜋
= −2 < 0
𝜕𝑄 2
• Maximum profit: 𝜋 = 16 × 8 − 8 2 − 20 = 44
THANK YOU