Mousumi Saha

Assistant Professor
Institute of Agribusiness & Development Studies
Bangladesh Agricultural University
 OUTLINE OF THE STUDY

Perfect Competition
Short-run Equilibrium of firm: Identical cost conditions
Shut-down Point
Long-run Equilibrium of firm: Identical cost conditions
Short-run Industry Equilibrium
Long-run Industry Equilibrium
 PERFECT COMPETITION

Perfect competition, as is generally understood, is said to

prevail when the following conditions are found in the market:
i) Large number of buyers and sellers.
ii) Homogeneous product.
iii) Buyers and sellers must have knowledge about the market.
iv) Free entry and free exit.
 SHORT-RUN EQUILIBRIUM OF FIRM

Short-run is a period of time in which the firm can vary output by varying only
the amount of variable factors such as labour, raw materials while fixed factors
remain unchanged.

In the short-run, new firms can neither enter the industry, nor the existing firms
can leave.

The equilibrium of perfectly competitive firm can be explained by two ways:

i) All firms are working under identical cost conditions; and

ii) All firms are working under differential cost conditions.

 SHORT-RUN EQUILIBRIUM OF FIRM:
IDENTICAL COST CONDITIONS

Identical cost conditions implies that all firms are facing same cost-conditions,
that is , their average and marginal cost curves are of the same level and
shapes.

Conditions of equilibrium:

i) MC=MR=Price

ii) MC curve must be rising at the point of equilibrium

 SHORT-RUN EQUILIBRIUM OF FIRM:
IDENTICAL COST CONDITIONS

Three possibilities:
i) When the firm makes supernormal profits;
ii) When it makes only normal profits; and
iii) When it incurs losses, but still does not shut down.
 SHORT-RUN EQUILIBRIUM OF FIRM: IDENTICAL
COST CONDITIONS
Y
SMC
SAC

Q
P1 L1 (AR=MR=P)
Revenue/Cost

F E
H G
R L
P

P2 L2
S

O X
M2 M M1

Output
SAC= Short-run average cost curve

SMC= Short-run marginal cost curve

P1 L1 shows AR=MR=P

At OM1 output, Price= P1 where Q is the equilibrium point.

At M1, M1Q=AR and M1G=AC. So, the per unit profit, AR-AC= GQ.

Total Profit= P1QGH

This profit is called supernormal profit.

There will be a tendency for the new firm to enter the industry to compete away this profit.

But, in the short-run, there is no entry and exit.

So, the existing firm will continue to earn supernormal profit

If price falls at OP, here PL=AR=MR=P. OM is the output level.
At OM output, Price= P where, R is the new equilibrium point.
At M point MR= AR, MR=AC where, AR=AC=MR=0. Profit is zero. Therefore, no loss or no
gain.
OMRP indicates TR=TC
Firm will earn normal profit.
The firm will continue and try to reach its maximum profit.
If price decreases to OP2 ,the output will be OM2.
P2L2= AR=MR=P, S is the new equilibrium point where AR= SM2, AC=EM2, SE= Per
unit loss.
Although the firm incurred losses it will not shut-down.
Because of the characteristics of short-run.
 SHORT-RUN EQUILIBRIUM OF FIRM:
IDENTICAL COST CONDITIONS

From above analysis of equilibrium of the competitive firm in the

short-run, it follows that the firm in shot-run may earn supernormal
profits or no losses or normal profits depending upon the price in the
market.

Firm’s short-run equilibrium is possible in all these three situations.

 SHUT-DOWN POINT
Y

AC
MC

H G
AVC
F N
Revenue/Cost

P2 L1
S

P3 L2
D

O X
M M1

Output
 SHUT-DOWN POINT

•Here, AC, MC and AVC curves are drawn.

•At price OP2, S is the equilibrium point.

•Losses= P2SNF, but the firm covering total VC and the part of FC since
price OP2=M1S is greater than the AVC= M1K at equilibrium output
OM1.

•The firm keep operating at price OP2 .

 SHUT-DOWN POINT

•But, if the price is OP3 ,D is the equilibrium point.

•Here, the firm covers total VC but no part of FC.

•If the price is less than OP3 or MD, the firm will down as it not cover
even the VC.

•Point D is the shut-down point.

•But, a rational firm’s owner keep operating and waiting for some good
time.
LONG-RUN EQUILIBRIUM: IDENTICAL
COST CONDITIONS

The equilibrium of perfectly competitive firm to be in long-run

equilibrium must be fulfilled by following two conditions:

i) Price= Marginal Cost

ii) Price= Average Cost

Therefore, Price=MC=AC.
 LONG-RUN EQUILIBRIUM:
IDENTICAL COST CONDITIONS
LMC
Y

LAC
Revenue/Cost

P1
P2 S
P AR=MR

O X
M2 M M1

Output
 LONG-RUN EQUILIBRIUM: IDENTICAL COST
CONDITIONS

When AC curve is falling, MC is below it.

When, AC is rising, MC curve must be above it.

Hence, MC can be equal to AC only at the minimum point of AC curve.

Therefore, it is at the point of minimum where AC curve intersect MC curve
and they are equal.
But, at point OP1 and output level OM1 MC>AC and at point OP2 AC>MC
where output is OM2.

That can not satisfy the two conditions.

SHORT-RUN INDUSTRY EQUILIBRIUM

In a short-run, neither entry nor exit can occur.

Consequently, in a short-run equilibrium, some firms may earn positive

economics profits, others may suffer economic losses, and still others may
earn zero economic profit.

Two conditions:

i) The short-run DD curve for and supply of the product of the industry
must be equal

ii) All the firms in the industry should be in equilibrium whether they
are making profit or having losses.
 SHORT-RUN INDUSTRY EQUILIBRIUM

Short-run industry
supply

ps e
Price

Market demand

Ys e Y

Quantity supplied
Short-run equilibrium price clears the
market and is taken as given by each firm.
 SHORT-RUN INDUSTRY EQUILIBRIUM

The given price is P1. The firm wants to

maximise profits, so it produces at the level
of output where MC = MR. This occurs at MC

point A. Drop a vertical line to find the firm's

output (Q1). At Q1, AR > AC and the
difference between average revenue and
average cost is the distance AB. This is the
profit per unit. To find the total super normal
profit, we must multiply the profit per unit
by the number of outputs. In the diagram,
this is the area ABCP1 (the green box).
 SHORT-RUN INDUSTRY EQUILIBRIUM
The given price is P2. In this case, it is clear that
the firm will not be making a profit. The AC
curve is above the AR curve at all levels of
MC
output. The firm will still want to minimize its
losses, though. This can be done, again, with
the trusty old formula, MC = MR. This occurs
at point D giving output Q2. At Q2, AR < AC
and the difference between average revenue
and average cost is the distance DE. This is the
loss per unit. To find the total losses, we must
multiply the loss per unit by the number of
units. In the diagram, this is the area DEFP2
(the red box).
 SHORT-RUN INDUSTRY EQUILIBRIUM

In the final diagram, at the bottom,

MC
the given price is P3. Again the firm
will produce the level of output for
which MC = MR. This occurs at
point G, giving a level of output of
Q3. Notice that at this point, AR =
AC, so the firm is making normal
profit.
 LONG-RUN ANALYSIS

In the long run, a firm may adapt all of its inputs to fit market
conditions
­ profit-maximization for a price-taking firm implies that price is equal to
long-run MC

Firms can also enter and exit an industry in the long run
­ perfect competition assumes that there are no special costs of entering or
exiting an industry

23
 LONG-RUN ANALYSIS

New firms will be lured/tempted into any market for which

economic profits are greater than zero
­ entry of firms will cause the short-run industry supply curve to shift outward

­ market price and profits will fall

­ the process will continue until economic profits are zero

Existing firms will leave any industry for which economic profits
are negative
­ exit of firms will cause the short-run industry supply curve to shift inward

­ market price will rise and losses will fall

­ the process will continue until economic profits are zero

24
LONG-RUN INDUSTRY EQUILIBRIUM:
CONSTANT-COST CASE

Assume that the entry of new firms in an industry has no effect on the cost
of inputs

­ no matter how many firms enter or leave an industry, a firm’s cost curves
will remain unchanged

•This is referred to as a constant-cost industry

25
 LONG-RUN INDUSTRY EQUILIBRIUM:
CONSTANT-COST CASE
This is a long-run equilibrium for this industry

Price Price P = MC = AC
SMC MC
S

AC

P1

q1 Quantity
Quantity Q1
26
A Typical Firm Market
 LONG-RUN EQUILIBRIUM:
CONSTANT-COST CASE

Suppose that market demand rises to D’

Price Market price rises to P2

Price
SMC MC
S

AC

P2

P1

D’
D

q1 Quantity
Quantity Q1 Q2
27
A Typical Firm Total Market
 LONG-RUN EQUILIBRIUM:
CONSTANT-COST CASE

Each firm increases output to q2

Economic profit > 0

Price Price
SMC MC
S

AC

P2

P1

D’
D

q1 q2 Quantity
Quantity Q1 Q2
28
A Typical Firm Total Market
 LONG-RUN EQUILIBRIUM:
CONSTANT-COST CASE

In the long run, new firms will enter the industry

Economic profit will return to 0

Price
SMC MC Price
S
S’

AC

P1

D’
D

q1 Quantity
Quantity Q1 Q3
29
A Typical Firm Total Market
 LONG-RUN EQUILIBRIUM:
CONSTANT-COST CASE
The long-run supply curve will be a horizontal line
(infinitely elastic) at p1

Price Price
SMC MC
S
S’

AC

P1 LS

D’
D

q1 Quantity
Quantity Q1 Q3
30
A Typical Firm Total Market
 LONG-RUN EQUILIBRIUM:
INCREASING-COST INDUSTRY

The entry of new firms may cause the average costs of all firms to rise
­ prices of scarce inputs may rise

­ new firms may impose “external” costs on existing firms

­ new firms may increase the demand for tax-financed services

31
 LONG-RUN EQUILIBRIUM:
INCREASING-COST INDUSTRY

Suppose that we are in long-run equilibrium in this industry

P = MC = AC
Price
SMC MC Price
S

AC

P1

q1 Quantity Q1 Quantity
32
A Typical Firm (before entry) Total Market
 LONG-RUN EQUILIBRIUM:
INCREASING-COST INDUSTRY

Suppose that market demand rises to D’

Market price rises to P2 and firms increase output to q2

Price SMC MC Price

S

AC

P2

P1
D’

q1 q2 Quantity Q1 Q2 Quantity
33
A Typical Firm (before entry) Total Market
 LONG-RUN EQUILIBRIUM:
INCREASING-COST INDUSTRY
Positive profits attract new firms and supply shifts out

Entry of firms causes costs for each firm to rise

Price SMC’ MC’ Price
S
S’
AC’

P3
P1

D’
D

q3 Quantity Q1 Q3 Quantity
34
A Typical Firm (after entry) Total Market
 LONG-RUN EQUILIBRIUM:
INCREASING-COST INDUSTRY

The long-run supply curve will be upward-sloping

Price SMC’ MC’ Price

S
S’
AC’
LS

p3
p1

D’
D

q3 Quantity Q1 Q3 Quantity
35
A Typical Firm (after entry) Total Market
 LONG-RUN EQUILIBRIUM:
DECREASING-COST INDUSTRY

The entry of new firms may cause the average costs of all firms to fall
­ new firms may attract a larger pool of trained labor

­ entry of new firms may provide a “critical mass” of industrialization

­ permits the development of more efficient transportation and communications

networks

36
 LONG-RUN EQUILIBRIUM:
DECREASING-COST CASE

Suppose that we are in long-run equilibrium in this industry

P = MC = AC
Price Price
SMC MC
S

AC

P1

q1 Quantity Q1 Quantity
37
A Typical Firm (before entry) Total Market
 LONG-RUN EQUILIBRIUM:
DECREASING-COST INDUSTRY

Suppose that market demand rises to D’

Market price rises to P2 and firms increase output to q2

Price MC Price
SMC
S

AC

P2

P1

D’
D

q1 q2 Quantity
Quantity Q1 Q2
38
A Typical Firm (before entry) Total Market
 LONG-RUN EQUILIBRIUM:
DECREASING-COST INDUSTRY

Positive profits attract new firms and supply shifts out

Entry of firms causes costs for each firm to fall

Price
Price
SMC’ S
MC’

S’

AC’

P1

P3 D’
D

q1 q3 Quantity Q1 Q3 Quantity
39
A Typical Firm (after entry) Total Market
 LONG-RUN EQUILIBRIUM:
DECREASING-COST INDUSTRY

The long-run industry supply curve will be downward-sloping

Price Price
SMC’ S
MC’

S’
AC’

P1

P3
D D’ LS

q1 q3 Quantity
Quantity Q1 Q3
40
A Typical Firm (after entry) Total Market
 CLASSIFICATION OF LONG-RUN
SUPPLY CURVES
Constant Cost
­ entry does not affect input costs

­ the long-run supply curve is horizontal at the long-run equilibrium price

Increasing Cost
­ entry increases inputs costs

­ the long-run supply curve is positively sloped

Decreasing Cost
­ entry reduces input costs

­ the long-run supply curve is negatively sloped

41
 REFERENCE

Modern Microeconomics- H.L. Ahuja