Chapter One

Perfectly Competitive Market

What Is a Market?
A market is a place where two parties can gather to facilitate the exchange of
goods and services. The parties involved are usually buyers and sellers. The market
may be physical like a retail outlet, where people meet face-to-face, or virtual like
an online market, where there is no direct physical contact between buyers and
sellers.

What is Market Structure?

Market structure refers to the nature and degree of competition prevails within a
particular market.

Types of market Structure

 There are four types of market Structure

1. Perfectly Competitive market structure:

2. Monopoly market structure:
3.Monopolistic Competitive market structure:
4.Oligopoly market structure: Clearly, the nature and degree of competition
vary in these markets.

1. What Is Perfect Competition Market?

Perfectly competitive market or perfect compaction is market structure in
which there are a large number of buyers and sellers in the market .in this
market; individuals cannot influence the price of a commodity
 Price is determined by the industry
 Perfect competition is a theoretical market structure where there are many
buyers and sellers with no individual power to influence market price.
1.1 Assumptions of Perfect Competition Market
 Large number of buyers and sellers :The industry or market includes a
large number of firms and buyers so that each individual firm , however
large , supplies only a small part of the total quantity offered in the market,
 All firms sell an identical product (the product is a "commodity" or
"homogeneous,

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  Because of the above two assumptions, individual firms in pure competition
is a price-taker; i.e. firm’s demand curve is perfectly elastic/horizontal
demand curve /, implying that the firm can sell any amount of output at the
prevailing market price, P*.

Figure 1.1 Individual and Market demand curve

Whether an industry is perfectly competitive depends on the demand curve

facing the individual firms. If the demand curve is down ward sloping, then the
firm can change price by changing its output and the industry is not perfectly
competitive ( the firm is not a price – taker )

 All firms are price takers (they cannot influence the market price of their
product).
 Buyers have complete or "perfect" information-in the past, present and
future-about the product being sold and the prices charged by each firm.
 Resources for such a labor are perfectly mobile.
 Firms can enter or exit the market without cost: There is no barrier to
entry into or exit from the industry. Entry or exit may take time, but firms
have freedom of movement in and out of the industry. This assumption is
supplementary to the assumption of large numbers. If barriers exist the
number of firms in the industry may be reduced so that each one of them
may acquire power to affect the price in the market.

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  Absence of transport cost ,
 Government intervention into the market is little or nil or There is no
government intervention in the market (tariffs, subsidies, rationing of
production or demand and so on are ruled out),
 The goal of the firm is profit maximization,
 Perfect mobility of factors of production: The factors of production are free
to move from one firm to another throughout the economy. If it is also
assumed that workers to move between different jobs, which imply that
skills can be learned easily .finally, raw materials and other factors are not
monopolized and labour is not unionized. In short, there is perfect
competition in the markets of factors of production.

Review of Some Basic Concepts:

The Firm’s Demand Curve:

Under perfect competition a firm is a price taker and faces a perfectly elastic
demand curve (see assumption (iii) above). Thus, the graphical presentation of the
firm’s demand curve is horizontal straight line drawn at the going market price.
This implies that the firm can sell any quantity it wishes at the market price P*. If
the firm raises its price above P* its sales will fall to zero since all the customers
realize that they can buy the same/identical product elsewhere at the price P*. In
other words, the demand curve is perfectly elastic at the going market price P*.

1. The firm’s Average and Marginal Revenue Curve:

A perfectly elastic demand curve has an important characteristic: the average
revenue (AR) from the sale of every unit will be equal to the marginal revenue
(MR) from the sale of an extra unit. AR is another term for the price at which the
firm sells its product. It is given by total revenue divided by the total quantity sold;
i.e. AR = TR/Q. MR is the change in total revenue resulting from the sale of an
additional unit of the product. That is, MR = dTR/dQ. Since the firm can sell as
much or as little as it wants at the going price, MR must be equal to AR. This can
be shown as below.
AR (or Demand): P = f(Q); & and hence total revenue (R) is the product of
price & quantity sold; that is,

R = P*Q. Therefore:

 AR = R/Q = P*Q/Q = P; and

 MR = dTR/dQ = d(P*Q)/dQ = P[dQ/dQ] = P. Thus, AR, P and MR
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are all the same in perfect competition since demand is
perfectly elastic (or price is fixed).
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 P

P* AR=MR

Q
0

1.2 Short-run Equilibrium of the Firm and Industry

A. Short run equilibrium of the Form

The main objective of a firm is profit maximization .If the firm has to incur a
loss, it aims to minimize the loss .Profit is difference between total revenue
and total cost .

Total Revenue (TR):it is the total amount money a firm receives from a given
quantity of its product sold .It is obtained by multiplying the unit of price of the
commodity and the quantity of that product sold

Total Revenue = Quantity Sold x Price

TR = PQ where P= Price of the product
Q=Quantity of the product

Average Revenue: it is the revenue per unit of item sold. It is calculated by

dividing the total revenue by the amount of the product

AR =TR/Q=PQ/Q =AR=P

There for, the firm‘s demand curve is also the average revenue curve

Marginal Revenue (MR); it is the additional amount of money/revenue the firm

received by selling one more unit of the product. In other words it is the change of
in total revenue resulting from the sale of extra unit of the product .It is
calculated as the ratio of the change in total revenue to the change in the sale
of the product .

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MR= ∆TR/∆Q =∆(PQ)/∆Q =P∆Q/∆Q(because P is constant) MR=P Thus, in a
perfectly competitive market , a firm’s average revenue , marginal revenue and
Price of the product are equal, i.e AR=MR=Df=P

Total cost is the monetary value of all inputs used in the production of goods and
services. Total cost is per unit cost time‘s quantity of output .That is ,TC=ACXQ
or TC=TFC+TVC

Total profit (π) is the difference between total sales revenue and total cost Profit
(π)= total revenue (TR)- total cost (TC), Π =(ARXQ)-(ACXQ). There are two
ways to determine the level of output at which competitive firm will realize
maximum profit or minimum loss.

There are two ways to determine the level of output at which competitive firm will
realize maximum profit or minimum loss. One method is to compare total revenue
and total cost, the other is to compare marginal revenue and marginal cost.

(i) Total revenue – Total cost Approach

Confronted with the market price of its product, the competitive producer
is faced with three related questions
 Should we produce
 If so, what amount?
 What profit or less will be realized
The firm is in equilibrium (maximizes profit when the difference between total
revenue (TR) and total cost (TC) is greatest. The total revenue curve is a straight
line through the origin, showing that price is constant at all level of outputs (see
figure below). The slope of revenue curve is also called marginal revenue
(dTR/dQ). It is constant and equal to the prevailing market price. Note that the firm
maximizes its profit at the output level where the distance between revenue and
cost curve is the greatest. To the left of point ‘a’ and to the right of point ‘b’ there
is a loss because total cost exceeds total revenue.

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 P
TC
TR
Maximum
Profit b

a
C

e
Q Q

Figure 1.2 Short run Profit Maximization (total revenue total- cost approach)

The competitive firm maximizes its profit at Qe, where the distance between the
TR and TC curve is the greatest. The equilibrium of the competitive firm occurs
when the positive difference between total revenue and total cost is greatest.

Numerical illustration: Consider the following cost schedule of a certain

competitive firm where market price is given at birr 20. Determine the level of
output that maximizes profit and the maximum profit.
MC TR MR Unit  Total 
Q TFC TVC TC ∆TC/∆Q P*Q ∆TR/∆Q P-AC TR-TC
0 30 0 30 -- 0 -- 0.00 -30
1 30 10 40 10 20 20 20.0 -20
2 30 15 45 5 40 20 -2.5 -5
3 30 21 51 6 60 20 3.00 9
4 30 29 59 8 80 20 5.25 21
5 30 40 70 11 100 20 6.00 30
6 30 54 84 14 120 20 6.00 36
7 30 74 104 20 140 20 5.43 36
8 30 95 125 23 160 20 4.38 35
9 30 124 154 27 180 20 2.89 26
10 30 160 190 36 200 20 1.00 10
Profit maximizing level of output would be 7 units (not 6 units) because more
output is preferred. Thus, maximum profit equals 36 birr.
(ii). Marginal Revenue -Marginal Cost Approach

The total revenue-total cost approach can only indicate the level of profit or loss
but it doesn’t help for analytical interpretation of business behavior. So the
marginal approach is used for further analysis. In this case, the firm’s equilibrium

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occurs at the level of output defined by the intersection of marginal cost (MC) and
marginal revenue (MR) curves (see point e in figure below).

If MR exceeds MC, profit has to been maximized and it pays the firm to expand its
output. If MR is less than MC, the level of profit will be reduced and hence it pays
the firm to cut its production. Thus, it follows that short-run equilibrium occurs
when MC equals MR. Thus, the first condition for profit maximization is that MC
is equal to MR; and the second (or sufficient) condition for equilibrium requires
that MC curve must cut MR curve from below (i.e. the slope of MC should be
greater than the slope of MR).
In short, at equilibrium (maximum profit) the following conditions must be
satisfied:
1. MR = MC; and
2. The slope of MC is greater than slope of MR, or MC is rising). (That is slope
of MC is than zero.

Mathematically, π =TR=TC

Π is maximized when =0

That is, = - =0

MR = MC……………………………………First Order Condition (FOC)

, < 0………………………………………… The Second order

condition of profit maximization

That is , = <0

The Slope of MC and = The slope of MR

Therefore, Slope of MC > Slope of MR…………………..Second order

condition (SOC)

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Slope of MC > 0 (because the slope of is zero )
Graphically, the marginal approach can be shown as follows

MC
C E
P* MR=AR
B
A
Excess

0 Qe Q

Figure 1.3Marginal revenue–Marginal Cost Approach of Profit Maximization

The profit maximizing output is Qe , where MC=MR and MC curve is increasing

.At point C, MR=MC ,but since MC is falling at this point level , it is not
equilibrium output.

Three cases;

 If MR> MC, total profit has not been maximized and it pays the firm to
expand its output. At this condition, total revenue increment(TR) is faster
than total cost increment (MC) and if output is increased, profit would
increase , too. So, it is advisable to expand output and sales in order to
maximize profit.
 If MR<MC, the level of total profit is being reduced and it pays the firm to
cut its production. Under this condition , an increase in output would cause
an incremental Cost (MC) greater than incremental revenue (MR)and
hence, a profit maximizing competitive firm should curtail production and
sales .
 If MR=MC, short run profits are maximized. The equilibrium of the firm
will, therefore, take place when MR=MC at which profits are maximized
.Note that total profit is equal to total revenue – total cost.

The fact that a firm is in short-run equilibrium doesn’t necessarily mean that it
makes excess profits. Whether the firm makes excess profits or loses depends on

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the level of the average cost at short-run equilibrium. If the average cost is
below the price (or AR) at equilibrium, the firm earns excess profit equal to the
shaded are ABeP* in this figure. If AC>P, there is a loss equal to the shaded region
AP*Be. Or if at the profit maximizing equilibrium of competitive firm
(MR=MC), price (average revenue) exceeds average total cost , the competitive
firm realizes abnormal or super normal profit .This profit is also called excess
profit or positive profit .Note that the competitive firm can earn excess (
abnormal profit only in short run .Thus depending on the relationship between
price and ATC, the firm in the short run may earn economic profit, normal profit
or incur loss and decide to shut down business .
Economic /Positive profit/Supernormal/Abnormal profit - The firm will be
earning supernormal profits in the short-run when market price is higher than the
short-run average cost or If the AC is below the market price at equilibrium , the
firm earns positive profit equal to the area between the ATC curve and price
lineup to the profit maximizing output .

SMC
SAC
D e
P* MR=AR
D B
A

0 Qe Q

Figure 1.4 Economic profit of a firm

Loss – If AC is above the market price at equilibrium , the firm earns a negative
profit (Incurs a loss ) equal to area between the AC curve and the price line.

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 SAC
SMC

D e
LOSSC B MR=AR
P*

0 Qe Q

Figure 1.5 A firm Incurring A loss

Normal Profit ( Zero profit ) or break- even point – If the AC is equal to the
market price at equilibrium , the firm gets zero profit or normal profit .

SMC
SAC

P* MR=AR
C B
A

0 Qe
Q

Figure 1.6 A firm earning a normal profit

If P(AR) = ATC , the competitive firm is at break- even point .Here , the firm
earns only normal profit ( zero profit ).Normal profit is the amount of profit
which is equal to form’s opportunity cost of staying in the industry and it is the
return the firm must earn so as to carry on production .It is the maximum
earning that would be necessary to prevent an entrepreneurs from applying his
talent and factors of production elsewhere .
Shut down Operation
If P(AR)<AVC, the competitive firm shuts down operation .The point at which
the firm covers its variable costs is called the closing down pint .In the figure
1.7 below, the closing down point of the firm is denoted by point e. if price
falls below pe The firm does not cover its variable costs and is better off is
closes down .Note that P<AVC does not mean that the firm will exit the
industry .it only means a temporary halt in production.

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.

SMC
ATC SAC
AVC
C D e
P* MR=AR
B
A

0 Qe Q

Figure 1.7 Competitive Firm’s Closing Down decision (where P<AVC)

According to the closing down decision of the competitive firm , the firm
should produce no output if price (AR) falls below the minimum point of AVC
curve ,since at this point the firm cannot cover its variable costs . Thus the
closing down point is the level of output at which the firm minimizes its losses
by shutting operation .
In general,

If Then
P > AC Positive ( economic) profit
P = AC Normal ( zero ) profit, i.e., break-even
point
AVC < P < AC Loss, but the firm continues to produce
P = AVC Shut-down point
P < AVC Loss or no operation

Example: Suppose that the firm operates in perfectly competitive market. The
market price of its product is $10. The firm estimates its cost of production with
the following cost function: TC= 10Q-4Q2 +Q3 .Than find the following questions.
A. What level of output should the firm produce to maximize its profit?
B. Determine the level of profit.
C. What minimum price is required by the firm to stay in the market ?

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Solution

Given : P=$10 and TC=10Q-4Q2 +Q3

A. The profit maximizing level of output is that level of output which
satisfies the following conditions
MR= MC and
MC is rising, thus we have to find MC and MR
MR in perfectly competitive market is equal to the market price. Hence,
MR=10 Alternatively, MR = Where TR= P.Q= 10Q Thus, MR
= =10
MC= =10-8+3Q2
To determine equilibrium output just equate MR and MC
And then solve Q
10-8Q+3Q2 =10
-8Q+3Q2 =0
Q (-8+3Q)=0
Q =0 or =8/3
New we have obtained two different output levels which satisfy the first
order condition of profit maximization.
To determine which level of output maximizes profit we have to use the
second order test at the two output levels .That is ,we have to see which
level satisfies the second order condition of increasing MC .
To see this we determine the slope of MC
Slope of MC= =-8+6Q
At Q = 0, slope of MC is -8+6(0)=-8 which implies that marginal cost is
decreasing at Q=0 Thus ,Q =0 is not equilibrium output because it
doesn’t satisfy the second order condition .
At, Q = 8/3 , slope of MC is -8+6(8/3) =8 .which is positive ,implying MC
is increasing at Q =8/3
B.TR = Price * Equilibrium out put
10 *8/3 = 26.667
TC at Q= 8/3 can be substituting 8/3 for q in TC function, i.e
TC = 10(8/3)-4(8/3)2 +(8/3)3 = 17.186 Thus the equilibrium ( maximum)
profit is
Π =TR – TC
26.667 -17.189 = 9.478(Profit)

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C. To stay in operation the firm needs the price which equals at least the minimum
AVC. Thus , to determine the minimum price required to stay in business ,we
have to determine the minimum AVC. AVC is minimum when derivative of
AVC is equal to zero. That is =0
Given the TC function: TC =10Q-4Q2 +Q3, TVC =10Q-4Q2+Q3

AVC = =10-4Q+Q2

=0
-4+2Q =0
2Q/2 =4/2
Q =2 , i.e AVC is minimum when output is equal to 2 units . The minimum
AVC is obtained by substituting 2 for Q in the AVC function ,i. e Min AVC
=10-4(2)+(2)2 =6 Thus , to stay in the market the firm should get a minimum
price $ 6.

The Supply Curve of the Firm and the Industry:

The supply curve of the firm is usually upward sloping, indicating a direct
relationship between price and quantity supplied. This upward sloping supply
curve of the firm could be derived by the points of intersection of its MC curve
with successive demand curves. As it can be seen in figure below, at price P1 the
firm reaches its equilibrium at point e1, producing and supplying Q1 units. If
market price increases to P2 (demand shifts to d2), and the firm will be in
equilibrium at point e2 producing and supplying Q2 units, and so on.

P
Price
S
MC
AVC
P3 e3
P1
e2
P2
P1 e1 P3

0 Q1 Q2 Q3 Q 0 Q1 Q2 Q3 Q

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If the price falls below P1 the firm will not supply any quantity since it doesn’t
cover its variable costs (i.e. the firm will minimize loss by shutting-down the
business in which case it will only pay TFC). Thus, if we plot the successive points
of intersection of MC and demand (or AR) curves, we will obtain the supply curve
of an individual firm. It is identical to the MC curve to the right of (or above) the
shut-down point, e1.
B. Short run Equilibrium of the Industry
Even though the individual or firm’s demand curve is perfectly elastic (horizontal,
the industry demand curve is downward-sloping. Therefore, given the market
demand curve and supply curve of the industry, the market is in equilibrium at a
price which clears the market (i.e. the price at which quantity demanded is equal to
quantity supplied). See figure below for industry equilibrium.

P P Industry Equlb.
Firm’s equlb.
S
MC

P* d P*

D
0 qe q 0 Qe Q

The firm is in equilibrium producing qe level of output at price P*. And the
industry reaches equilibrium at the same price P* but producing Qe of output.
An industry is in equilibrium in the short-run when its total output remains steady,
there being no tendency to expand or contract its output. If all firms are in
equilibrium, the industry is also in equilibrium. For full equilibrium of the industry
in the short-run, all firms must be earning only normal profits.
The condition for this is SMC = MR = AR = SAC. But full equilibrium of the
industry is by sheer accident because in the short- run some firms may he earning
supernormal profits and some incurring losses. Even then, the industry is in short-
run equilibrium when its quantity demanded and quantities supplied are equal at
the price which clears the market.

This is illustrated in Figure 4 where in Panel (A), the industry is in equilibrium at

point E where its demand curve D and supply curve S intersect which determine
OP price at which its total output OQ is cleared. But at the prevailing price OP,

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some firms are earning supernormal profits PE1ST, as shown in Panel (B), while
some other firms are incurring FGE2P losses, as shown in Panel (C) of the figure.

Source: Article Shared by Natasha Kwatiah

1.3 Long-Run Equilibrium of the Firm and Industry

A. Long-Run Equilibrium of the Firm

In the long-run since all inputs are variable the firm has the option of adjusting its
plant size as well as output to achieve maximum profit. Similarly, adjustment f the
number of firms in the industry in response to profit motivation is the key element
in establishing long-run equilibrium.
In the long-run firms are in equilibrium when they have adjusted their plant so as
to produce at the minimum point of their LAC curve. Thus, in the long-run firms
earn just normal profit (or zero economic profit). Thus in the long-run all costs
are variable and there are no fixed costs. The firm is in the long-run equilibrium
under perfect competition when it does not want to change its equilibrium output.
It is earning normal profits. If some firms are earning supernormal profits, new
firms will enter the industry and supernormal profits will be competed away. If
some firms are incurring losses, some of the firms will leave the industry till all
earn normal profits. Thus there is no tendency for firms to enter or leave the
industry because every firm must earn normal profits. “In the long-run, firms are in
equilibrium when they have adjusted their plant so as to produce at the minimum
point of their long-run AC curve, which is tangent (at this point) to the demand
(AR) curve defined by the market price” so that they earn normal profits.
Assumptions:
This analysis is based on the following assumptions:
 Firms are free to enter into or leave the industry.
 All firms are of equal efficiency.

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  All factors are homogenous. They can be obtained at constant and
uniform prices. SMC
 Cost curves of firms are uniform.
 The plants of firms are equal, having given technology.
 All firms have perfect knowledge about price and output.

Given these assumptions, each firm of the industry will be in long-run equilibrium
when it fulfills the following two conditions.

(1) In equilibrium, its short-run marginal cost (SMC) must equal to its long-run
marginal cost (LMC) as well as its Short-run Average Cost (SAC) and its long-run
Average Cost (LAC) and both should equal MR=AR=P.

Thus the first equilibrium condition is:

SMC = LMC = MR = AR = P = SAC = LAC at its minimum point, and

(2) LMC curve must cut MR curve from below: Both these conditions of
equilibrium are satisfied at point E in Figure 5 where SMC and LMC curves cut
from below SAC and LAC curves at their minimum point E and SMC and LMC
curves cut AR = MR curve from below. All curves meet at this point E and the
firm produces OQ optimum output and sells it at OP price.

Source: Article Shared by Natasha Kwatiah

Since we assume equal costs of all the firms of industry, all firms will be in
equilibrium in the long-run. At OP price a firm will have neither a tendency to
neither leave nor enter the industry and all firms will earn normal profits.

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 B. Long-Run Equilibrium of the Industry

The industry is in equilibrium in the long-run when all firms earn normal profits.
There is no incentive for firms to leave the industry or for new firms to enter it.
With all factors homogeneous and given their prices and the same technology, each
firm and industry as a whole are in full equilibrium where LMC = MR = AR (-P) =
LAC at its minimum.

Such an equilibrium position is attained when the long-run price for the industry is
determined by the equality of total demand and supply of the industry.

Source: Article Shared by Natasha Kwatiah

The long-run equilibrium of the industry is illustrated in Figure 6 (A) where the
long-run price OP is determined by the intersection of the demand curve D and the
supply curve S at point E and the industry is producing OM output. At this price
OP, the firms are in equilibrium at point A in Panel (B) at OQ level of output
where LMC = SMC = MR =P ( = AR) = SAC = LAC at its minimum.

At this level, the firms are earning normal profits and have no incentive to enter or
leave the industry. It follows that when the industry is in long-run equilibrium,
each firm in the industry is also in long-run equilibrium. If both the industry and
the firms are in long-run equilibrium, they are also in short-run equilibrium.

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EXERCISE
Suppose you are the manager of a watch-making firm operating in a competitive
market. Your cost of production is given by C = 100 + Q2, where Q is the level of
output and C is total cost.
a) If the price of watches is birr 60, how many watches should you produce to
maximize profit?
b) What will your profit level be?
c) What is the minimum price that enables you stay in the watch market?

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