0 Market structure 1:

Overview and
perfect competition

Chapter overview
By perfect competition I propose to mean a state
10.1 Market structure: an overview of affairs in which the demand for the output of
10.2 The equilibrium conditions (for any firm) the individual seller is perfectly elastic.
10.3 Perfect competition JOAN ROBINSON

10.4 The demand for the product of the firm

The system of free competition is a rather peculiar
10.5 The equilibrium of the firm under perfect competition one. Its mechanism is one of fooling entrepreneurs.
10.6 The supply curve of the firm and the market It requires the pursuit of maximum profit in order
supply curve to function, but it destroys profits when they are
actually pursued by a larger number of people.
10.7 Long-run equilibrium of the firm and the industry
OSKAR LANGE
under perfect competition
10.8 Perfect competition as a benchmark The price of monopoly is upon every occasion the
10.9 Concluding remarks highest which can be got.
Important concepts ADAM SMITH

Learning outcomes
Once you have studied this chapter you should be able to
䡲 explain the theoretical differences between the four market structures
䡲 explain the equilibrium conditions for any firm
䡲 list the conditions which have to be met for perfect competition to exist
䡲 explain the demand curve facing the firm under perfect competition
䡲 explain the short-run equilibrium of the firm under perfect competition
䡲 explain the long-run equilibrium of the firm and the industry under perfect competition

In Chapter 9 we examined a firm’s costs of production and distinguished between total, marginal and average cost.
We also distinguished between the short run and the long run and showed how a firm’s costs are determined by
the prices and productivity of the factors of production that it uses.
In this chapter and the next one we derive the equilibrium positions of firms. We want to determine whether or
not it is profitable for a firm to produce and, if so, what quantities of the product the firm should supply at different
prices of the product. To do this, we have to consider demand conditions as well. In other words, we have to
consider both supply and demand.
We assume that firms aim to maximise profit (the difference between revenue and cost). Cost was examined in detail
in Chapter 9 but we still have to examine revenue in more detail. Total revenue (TR) from the production and sale of a
product is calculated by multiplying the quantity sold (Q) by the price (P) of the product. But the price of the product (and
therefore also revenue) depends on the structure of the market. In this book we introduce you to the four standard forms
of market structure: perfect competition, monopoly, monopolistic competition and oligopoly. In this chapter we define the
four types, discuss the equilibrium conditions for any firm and then focus on the position of a firm which operates under
conditions of perfect competition. The other three types of market structures are examined in Chapter 11.
163
10.1 Market structure: an overview
The behaviour of a firm depends on the features of the market in which it sells its product(s) and on its production
costs. The major organisational features of a market are called the structure of the market (or market structure).
These features include the number and relative sizes of sellers and buyers, the degree of product differentiation,
the availability of information and the barriers to entry and exit.
Although we discuss four different market structures in this chapter and the next, you might want to think
of a continuum as shown in Figure 10-1. At the one extreme is perfect competition, followed by monopolistic
competition, oligopoly and (at the other extreme) pure monopoly. All markets fit in somewhere between the two
extremes.
The key features of the four different types of market structure are summarised in Table 10-1. Eight features
or criteria are listed in the first column and the remaining four columns show the position of each market type in
respect of each criterion. Perfect competition is discussed in this chapter and serves as a benchmark against which
the other market structures, which are discussed in Chapter 11, can be compared.

FIGURE 10-1 Market structures

er ec onopolis ic li opoly onopoly

compe i ion compe i ion

aximum ero
De ree o compe i ion

As we move from perfect competition to monopoly, the degree of competition declines, from maximum to zero.
All markets fit in somewhere along this continuum.

TABLE 10-1 Summary of market structures

Feature/ Perfect
Monopolistic competition Oligopoly Monopoly
criterion competition

Number of firms So many that no firm So many that each firm So few that each firm One
can influence the market thinks others will not must consider the others’
price detect its actions actions and reactions

Nature of product Homogeneous/ Heterogeneous/ Homogeneous or A unique product with no

standardised differentiated heterogeneous close substitutes
Entry Completely free Free Varies from free to Completely blocked
restricted
Information Complete Incomplete Incomplete Complete
Collusion Impossible Impossible Possible Irrelevant
Firm’s control over the None Some Considerable, but less Considerable, but limited
price of the product than in monopoly by market demand
and the goal of profit
maximisation
Demand curve for the Horizontal (perfectly Downward-sloping Downward-sloping, may Equals market demand
firm’s product elastic) be kinked curve: downward-sloping

Long-run economic Zero (normal profit only) Zero (normal profit only) May be positive May be positive
profit

164 CHAPT E R 1 0 MA RKET STRUCTURE 1: OVERVI EW A ND PERFECT COM P E T I T I ON

 We now discuss each of the criteria briefly. Note that this is only a preliminary overview. We discuss perfect
competition later in this chapter, and mono-poly, monopolistic competition and oligopoly in Chapter 11.

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number of firms, which varies between one and many. The actual number of firms as
such is not particularly significant – the most important question is the behaviour of firms, in particular whether
or not an individual firm can influence the price at which its product is sold. Perfectly competitive firms are all
price takers (ie they cannot influence the price of their product), but monopolists and imperfectly competitive
firms are price makers or price setters (ie they each have some influence on the price of their product).
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nature of the product. The product may be homogeneous (identical, standardised)
or heterogeneous (differentiated, non-standardised). The distinction between homogeneous and heterogeneous
products is not based on technical differences between them. As we emphasise in Chapter 11, consumers
ultimately decide whether two products are identical or different. Two brands of the same product may be
technically identical, but if they are different in the eyes of buyers, the product is classified as a heterogeneous
or differentiated product.
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entr y (or mobility), refers to the ease or difficulty with which firms can enter and exit the
market. Entry varies from perfectly free (under perfect competition) to totally blocked (under monopoly).
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information (or degree of knowledge) about market conditions available to market
participants. Perfect competitors are assumed to possess full information (or perfect knowledge) of market
conditions, which implies that there is no uncertainty under perfect competition. This assumption also applies
in the case of monopoly. Under monopolistic competition and oligopoly, however, firms have incomplete
information (ie they operate under conditions of uncertainty).
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the basic assumptions. The first of these (ie the fifth criterion in the table) is collusion. Collusion occurs when
two or more sellers enter into an agreement, arrangement or understanding with each other to limit competition
between or among themselves. Collusion, which is common only in oligopoly, is discussed in Chapter 11.
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firm has no control over the price of its product (ie it is a price taker), whereas other firms have a varying degree
of control (but never absolute control) over the prices of their products. They are price makers or price setters.
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shape of the demand curve for the product of the firm, is related to the
previous one. Under perfect competition the individual firm (as a price taker) is faced with a horizontal (or perfectly
elastic) demand curve for its product (at the level of the market price). In contrast, other firms are all faced with
downward-sloping demand curves for their products and therefore have some scope for “making” or “setting”
their own prices. The price elasticities of the demand for their products can, however, vary quite significantly.
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possibility of earning an economic profit in the long run. In this chapter we
explain that perfectly competitive firms do not earn any economic (or supernormal) profits in the long run (only
normal profits). This also applies to the case of monopolistic competition. However, as we explain in Chapter 11,
monopolistic and oligopolistic firms may earn economic profits in the long run.

Table 10-1 provides a concise summary of the most important features of the four basic market structures. You
should refer back to the table while studying this chapter and the next. The various elements of the table are
explained in more detail as we proceed.
There are two basic equilibrium conditions for profit maximisation that all firms operating in any market structure
must adhere to. These two conditions are now explained, and form the basis for the rest of our analysis.

10.2 The equilibrium conditions (for any firm)

Firms operating in any market structure want to maximise profit. Economic profit is the difference between
revenue and cost (which includes normal profit). To examine the behaviour of firms, we therefore have to examine
and combine their revenue and cost structures. Once these are known, two decisions have to be taken:
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in the firm’s interest to produce (but rather to shut down its operations).
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maximised (or losses minimised).

These decisions have to be taken in any firm. We now take a look at the two rules for profit maximisation which
apply to all firms, irrespective of the market conditions under which they operate.
C HA P TER 10 M A R K E T S T RUCT URE 1: OV E RV IE W AND PERFECT COMPETI TI ON 165
The shut-down rule
The first rule is that a firm should produce only if total revenue is equal to, or greater than, total variable cost
(which includes normal profit). This is often called the shut-down (or close-down) rule, but it can also be called
the start-up rule because it does not just indicate when a firm should stop producing a product – it also indicates
when a firm should start (or restart) production. The shut-down rule can also be stated in terms of unit costs – a
firm should produce only if average revenue (ie price) is equal to, or greater than, average variable cost.
In the long run all costs are variable. Production should therefore take place in the long run only if total revenue
is sufficient to cover all costs of production. This is quite straightforward. But what about the short run, when
certain costs are fixed? Should production occur only if total revenue is sufficient to cover total costs (ie total fixed
costs and total variable costs)? The answer is no.
Once a firm is established, it cannot escape its fixed costs. Fixed costs are incurred even if output is zero (ie if the
firm does not produce at all). If the firm can earn a total revenue greater than its total variable costs (or an average
revenue greater than its average variable costs), then the difference can help cover some of the unavoidable
fixed costs of the firm. It would be advisable for the firm to maintain production in the short run, even though it is
operating at an economic loss. If total revenue is just sufficient to cover total variable costs (ie if average revenue
is equal to average variable costs) it is immaterial whether or not the firm continues production – its loss will be
the same in both cases (ie equal to its fixed costs). In such conditions firms tend to continue production in order
to retain their employees and clients.
If total revenue is not sufficient to cover total variable costs (ie if average revenue is lower than average variable
cost), the firm will not produce, because to do so will result in a loss greater than its fixed costs. In other words,
the firm’s losses will be minimised by not producing at all.

The profit-maximising rule

The second rule is that firms should produce that quantity of the product such that profits are maximised, or losses
minimised. Since the same rule applies for profit maximisation and loss minimisation, we usually refer to profit
maximisation only, and we do not always mention that the aim is also to minimise losses.
Profit maximisation can be explained in terms of total revenue (TR) and total cost (TC) or in terms of marginal
revenue (MR) and marginal cost (MC). Since profit is the difference between revenue and cost it is obvious that
profits are maximised where the positive difference between total revenue and total cost is the greatest.
However, it is usually more useful to express the profit-maximisation condition in terms of revenue and cost per
unit of production. The rule is that profit is maximised where marginal revenue (MR) is equal to marginal
cost (MC).
To understand why profits are maximised where MR = MC, it is useful to consider what happens if MR is not
equal to MC. If marginal revenue MR (ie the addition to revenue as a result of the production of an extra unit of the
product) is greater than marginal cost MC (ie the cost of producing that extra unit), the firm is still making a profit
on the last (extra) unit produced. The firm can therefore add to its total profit by expanding its production until no
extra profit is made on the last unit produced, that is, until the revenue earned from the last unit (MR) is equal to
the cost of producing the last unit (MC). At that quantity the firm’s profit is maximised.
If the firm continues producing beyond that point, the cost of producing each additional unit of output (MC)
will be greater than the revenue gained from selling it (MR). In other words, the firm will make a loss on the
production of each additional unit of output and its profit will therefore decrease. Profits are maximised when
marginal revenue MR is just equal to marginal cost MC.
The different possibilities may be summarised as follows:
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MR is greater than MC (ie MR > MC), output should be expanded.
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MR is equal to MC (ie MR = MC), profits are maximised.
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MR is lower than MC (ie MR < MC), output should be reduced.

As we mentioned earlier, this rule and the shut-down rule apply to any firm, irrespective of the type of market in
which it operates – see Box 10-1. We now apply these rules to a firm operating in a perfectly competitive market.

10.3 Perfect competition

We start our analysis of the behaviour of firms by assuming that there is perfect competition in the goods market.
Recall from earlier chapters that a market consists of all the buyers (demanders) and sellers (suppliers) of the
good or service concerned. Also recall that competition occurs on each side of the market. In the goods market
the buyers compete to obtain the good and the sellers compete to sell the good to the buyers.

166 CHAPT E R 1 0 MA RKET STRUCTURE 1: OVERVI EW A ND PERFECT COM P E T I T I ON

 BOX 10-1 SHORT-RUN DECISIONS OF A FIRM, THE IRRELEVANCE OF SUNK COSTS AND THE
IMPORTANCE OF THE MARGINAL PRINCIPLE

In the long run, when all the inputs are variable, a firm will continue to produce only if total revenue is sufficient
to cover total cost (including normal profit). In the short run, however, the situation is somewhat more compli-
cated and can be summarised as follows:

Yes Continue to produce

Price = AR Is it above AC? Yes Continue to produce

No Is it above AVC?

No Shut down

The basic difference between short-run and long-run costs is that while certain costs are fixed in the short
run, all costs are variable in the long run. A s n c st is a cost incurred in the past that cannot be changed
by current decisions and cannot be recovered. The firm’s short-run fixed costs are an example of sunk costs.
The firm cannot recover these costs by temporarily stopping production. The firm’s fixed costs are sunk in the
short run and the firm can ignore these costs when deciding whether or not to produce and how much to pro-
duce. Only the variable costs, over which the firm has control, should be taken into account. This explains why
a number of large firms continue to produce despite reporting huge losses. Take a big airline, for example. If
the airline has bought a number of aircraft and cannot resell them, this cost is a sunk cost in the short run. The
opportunity cost of a flight includes only the variable costs of fuel, the wages of pilots and flight attendants,
et cetera. As long as the total revenue from flying exceeds these variable costs, the airline should continue to
operate. The same principle applies to any other firm. Sunk costs should not be taken into account in short-run
decisions.
Sunk costs are also important in everyday life. The principle of “let bygones be bygones” or “don’t cry over
spilt milk” applies to many spheres of life. For example, if you buy an expensive pair of shoes and they turn
out to be very uncomfortable you should not continue wearing them simply because you paid a lot of money
for them. Likewise, if you purchase shares in a company at (say) R10,00 each and the price falls to R6,00,
you should not take the R10,00 that you paid for them into account when deciding whether to keep or sell the
shares. Your decision should be based only on the expected future price of the shares. If there is no prospect
of an increase, you should sell them.
The examples in this box illustrate one of the most important lessons of economics: a a s at t e
PDUJLQDOFRVWVDQGPDUJLQDOEHQHÀWVRIGHFLVLRQVDQGLJQRUHSDVWRUVXQNFRVWV. Do not complain
about yesterday’s losses. Calculate the extra costs you will incur by any decision, and weigh these against its
advantages. Always base decisions on marginal costs and marginal benefits.

Perfect competition occurs when none of the individual market participants (ie buyers or sellers) can
influence the price of the product. The price is determined by the interaction of demand and supply and all the
participants have to accept that price. In perfectly competitive markets all the participants are therefore price
takers – they have to accept the price as given and can only decide what quantities to supply or demand at that
price.

Requirements
Perfect competition exists if the following conditions are met:
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large number of buyers and sellers of the product – the number must be so large that no
individual buyer or seller can affect the market price. Each firm, for example, supplies only a fraction of the
total market supply.
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no collusion between sellers – each seller must act independently.
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identical (ie the product must be homogeneous). There should
therefore be no reason for buyers to prefer the product of one seller to the product of another seller.

C HA P TER 10 M A R K E T S T RUCT URE 1: OV E RV IE W AND PERFECT COMPETI TI ON 167

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as complete freedom of entr y and exit. There must be no barriers to entry in the form of legal, financial,
technological, physical or other restrictions which inhibit the free movement of buyers or sellers.
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perfect knowledge of market conditions. For example, if one firm raises
its price above the market price, it is assumed that all the buyers will know that the other firms are charging a
lower price and will therefore not buy anything from the firm that is charging a higher price.
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no government inter vention influencing buyers or sellers.
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factors of production must be perfectly mobile. In other words, labour, capital and the other factors
of production must be able to move freely from one market to another.

These conditions are clearly very restrictive and it is hardly surprising that no market meets all the requirements
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perfect competitor. Other markets for fresh produce, like meat and fish markets, may also approximate perfect
competition. However, producers often form cooperatives to control the supply of agricultural products, and
government also tends to intervene in markets for agricultural products. The closest approximations to perfect
competition are probably in the international commodity markets where there are thousands of sellers and
ultimately millions of buyers; entry and exit are easy; the products are graded and those in a given grade are
therefore identical; the participants are well informed about market conditions; and they can purchase or sell
large quantities of the product at the ruling market price. In these markets no individual firm has any market
power – all the firms are price takers.
Financial markets, like the JSE, also approximate perfect competition. There are many buyers and sellers, the
goods (eg shares in a company) are homogeneous and anyone is free to participate.

Relevance
But why study perfect competition if it is only approximated in a small percentage of markets?
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perfect competition come close to being satisfied.
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and output.
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compared. This is common practice in all branches of science – even in the natural sciences it is common to
use a model based on a set of very restrictive conditions as a yardstick against which other situations can be
compared.
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in a particular market (including how it deviates from perfect competition), is often sufficient for a meaningful
analysis of that market.

The model of perfect competition can therefore always be useful, provided it is used with sufficient care. Note,
however, that the adjective “perfect” in perfect competition does not mean that it is necessarily the most desirable
form of competition – it simply signifies the highest or most complete degree of competition.

10.4 The demand for the product of the firm

Under perfect competition the price of a product is determined by supply and demand. The individual firm is a
price taker and can sell any quantity at the market price. No firm will charge a price higher than the prevailing
market price because it will then lose all of its customers. Nor will a firm gain anything by charging a price that is
lower than the existing market price, since it can sell as many units of its output as it wishes at the market price.
Under perfect competition the individual firm is faced by a demand curve which is horizontal (or perfectly elastic)
at the existing market price. We call this curve the demand curve for the product of the firm. It is sometimes
also called the firm’s sales curve, the firm’s demand curve, or the demand curve facing the firm. The position
of the individual firm under perfect competition is illustrated in Figure 10-2. The graph on the left shows that the
price of the product (P1) is determined in the market by the forces of supply (SS) and demand (DD). The position of
the individual firm is shown in the graph on the right. The firm can sell any quantity at the prevailing market price.
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price of P1 from any other supplier). Nor will the firm charge a lower price than P1 because it can sell all its output
at a price of P1. The horizontal curve at P1 is the demand curve for the product of the firm.

168 CHAPT E R 1 0 MA RKET STRUCTURE 1: OVERVI EW A ND PERFECT COM P E T I T I ON

 FIGURE 10-2 The demand curve for the product of the firm under perfect competition
P P
D
S

Price per unit

P1 P1 AR = MR AR =

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S
Q Q
0 0
Quantity per period Quantity per period

The graph on the left shows that the price of the product is determined in the market by demand and supply. The firm can sell its whole
output at that price. This is indicated by the horizontal line on the right. This line is the demand curve for the product of the firm. It is also
called the firm’s sales curve, the firm’s demand curve, or the demand curve facing the firm. The firm’s average revenue (AR) and marginal
revenue (MR) are equal to the price of the product.

Under perfect competition the firm receives the same price for any number of units of the product that it sells.
Its marginal revenue (MR) and average revenue (AR) are thus both equal to the market price, that is, MR =
AR = P. We know that a firm’s total revenue (TR) is equal to the price of the product (P) multiplied by the quantity
sold (Q), ie TR = P × Q (= PQ). Under perfect competition the price is given, thus for each additional unit that the
firm sells, total revenue will increase by an amount equal to the price of the product. This is simply another way of
stating that MR = AR = P.
In Box 10-2 the relationships between price, total revenue, marginal revenue and average revenue are explained
with the aid of a numerical example.

BOX 10-2 TOTAL, MARGINAL AND AVERAGE REVENUE UNDER PERFECT COMPETITION: A
NUMERICAL EXAMPLE

Suppose a firm operates under conditions of perfect competition and that the market price of its product is R20
per unit. The firm is a price taker and its total, average and marginal revenue for the first five units sold will be
as follows:

Quantity Price per unit Total revenue Marginal revenue Average revenue
(units) (rand) (rand) (rand) (rand)
Q P TR MR AR
(= PQ) (= ΔTR/ΔQ = P) (= TR/Q =P)

0 20   0  0
20
1 20  20 20
20
2 20  40 20
20
3 20  60 20
20
4 20  80 20
20
5 20 100 20

The same relationships will apply at greater quantities. The demand curve facing the firm is a horizontal line at
the level of the market price (R20), similar to the one illustrated in the right-hand part of Figure 10-2.

C HA P TER 10 M A R K E T S T RUCT URE 1: OV E RV IE W AND PERFECT COMPETI TI ON 169

10.5 The equilibrium of the firm under perfect competition
We examine the equilibrium (or profit-maximising) position of the firm under conditions of perfect competition.
We combine the cost curves derived in Chapter 9, the two profit-maximising rules which apply to all firms, and
the demand curve for the product of the firm, to examine the equilibrium of the firm under perfect competition.
We know that such a firm is a price taker (ie it has no control over the market price). The firm can only decide to
sell or not to sell at the ruling price. This means that the firm does not have to make any pricing decisions – it can
only choose the output (quantity) at which it will maximise its profits (or minimise its losses). That quantity, we
have seen, is where the positive difference between total revenue TR and total cost TC is at a maximum,
or (which amounts to the same thing) where marginal revenue MR is equal to marginal cost MC, provided, of
course, that average revenue AR (= P) is at least equal to short-run average variable cost AVC (the shut-down rule).
In Section 10.2 we explained that any firm maximises its profit (or minimises its losses) where marginal revenue
MR is equal to marginal cost MC. The marginal revenue of a firm in a perfectly competitive market was derived in
Section 10.4. In Figure 10-2 we showed that the firm’s marginal revenue MR is equal to the market price P of the
product (since each unit of output has to be sold at the market price, over which the individual firm has no control).
The profit-maximising rule in the case of a perfectly competitive firm can therefore also be stated as P = MC (since
MR = P).
Marginal cost was explained in Chapter 9. Recall that the marginal cost curve is U-shaped. However, as explained
in Box 10-3, only the rising part of the MC curve is relevant to our analysis. We now use a numerical example to
explain why profit is maximised when MR (or P, in this case) is equal to MC.
Suppose a firm produces a product which it sells in a perfectly competitive market where the price is R10 per
unit. The firm’s fixed cost amounts to R5. (The numbers have been kept small to keep the example as simple as
possible.) The firm’s daily output, revenue and cost are summarised in Table 10-2. The marginal revenue MR and
marginal cost MC of the firm are also shown graphically in Figure 10-3.
The marginal cost MC of the first unit produced is R4, indicated by point d in Figure 10-3. This is lower than the
marginal revenue of R10 (ie the price of the product). The production of the first unit thus adds R6 (ie R10 – R4) to
the profit of the firm. Likewise, the MC of the second unit (R6) is also lower than the MR of the second unit (R10).
The production of the second unit thus adds R4 (ie R10 – R6) to the profit of the firm. Point c in Figure 10-3 shows
that the production of the third unit costs R8. It can be sold for R10 and the firm will therefore add to its profit by
producing the third unit. The extra profit will be R2 (ie R10 – R8). For the fourth unit MC = MR (= P) = R10 and the
firm therefore makes no further profit. This serves as a signal that the point of maximum profit has been reached.
If the firm produces 5 units of the product, MC (indicated by e in Figure 10-3) will be R12, which is greater than
MR. The firm’s profit will thus decline by R2 (ie R10 – R12) if a fifth unit of the product is produced.
This example confirms the conclusion reached earlier, namely that a firm should expand its production as long
as MR > MC , up to the point where MR = MC (at which point profit will be maximised). If it continues producing
beyond that point, MR will be lower than MC and the firm’s profit will fall.

TABLE 10-2 Revenue and cost of a hypothetical firm

Quantity of Price per unit Total revenue Marginal revenue Total cost Marginal cost Total profit
the product (R) (R) (R) (R) (R) (R)
Q P TR MR TC MC TR–TC

0 10 0 5 –5
10 4
1 10 10 9 1
10 6
2 10 20 15 5
10 8
3 10 30 23 7
10 10
4 10 40 33 7
10 12
5 10 50 45 5

170 CHAPT E R 1 0 MA RKET STRUCTURE 1: OVERVI EW A ND PERFECT COM P E T I T I ON

 The firm’s profit position can be illustrated clearly by adding average cost AC to the diagram showing average
revenue AR, marginal revenue MR and marginal cost MC. Recall, from Chapter 9, that average cost AC consists
of average fixed cost AFC and average variable cost AVC. The firm’s profit per unit of output (or average profit)
is equal to the difference between average revenue AR and average cost AC
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AR is greater than AC the
firm is earning an economic profit. When AC is equal to AC the firm only earns a normal profit. Recall, from
Chapter 9, that normal profit is included in the firm’s cost.
Figure 10-4 shows the average revenue AR, marginal revenue MR, average cost AC and marginal cost MC of a firm
under perfect competition. AR and MR are both equal to the price P of the product and are represented by the same
horizontal line at the level of the market price (as shown in Figure 10-2). The cost structure of the firm is the same
as that explained in Chapter 9. In Figure 10-4 we show three different possibilities. The same set of unit cost curves
is used throughout, but we show three different market prices, and therefore three different AR and MR curves.
In Figure 10-4(a) the market price is P1. This is, of course, equal to the firm’s AR and MR. Profit is
maximised where MR (= P1, in this case) is equal to MC. This occurs at a quantity of Q1
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Q1 the firm’s
average revenue AR (= P1) is greater than its average total cost AC (which is indicated as C1 on the
vertical axis). The firm thus makes an economic profit (or supernormal profit) per unit of production of
P1 – C1. The firm’s total profit is given by the shaded area C1P1E1M, which is equal to the profit per unit of
output (P1 – C1) multiplied by the quantity produced (Q1

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obtained by subtracting the firm’s total cost from its total revenue. The firm’s total revenue is equal to the price
of the product P1 multiplied by the quantity produced (and sold) Q1. This is equal to the area 0P1E1Q1. Similarly,
the firm’s total cost is obtained by multiplying its average cost C1 by the quantity produced Q1. This is equal
to the area 0C1MQ1. The difference between these two areas is the shaded area C1P1E1M, which represents the
firm’s total economic profit.
In Figure 10-4(b) the market price (and therefore also the firm’s AR and MR) is P2. It is equal to MC at the point
where MC intersects AC (ie at the minimum point of AC). The corresponding level of output is Q2
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output AR is equal to AC (and TR = TC) and the firm therefore does not earn an economic profit. It does, however,

FIGURE 10-3 Marginal revenue and marginal cost of a firm operating in a perfectly competitive market

R
e MC
12
Profit
Marginal revenue, cost (rand per unit)

decreasing
d
10 MR = P MR = P
Profit
increasing c
8

b
6

a
4
Profit-maximising
level of output
2

Q
0
1 2 3 4 5

Quantity per period

Marginal revenue MR is equal to the price P of the product. Marginal cost MC increases as more units of the
product are produced. Profit is maximised where MR (or P) = MC, that is, at an output level of 4 units. At lower
levels of production, profit can be increased by expanding production. If more than 4 units of the product are
produced, profit starts falling.

C HA P TER 10 M A R K E T S T RUCT URE 1: OV E RV IE W AND PERFECT COMPETI TI ON 171

 BOX 10-3 MARGINAL COST AND PROFIT MAXIMISATION

In this box we explain why profits are only maximised along the rising part of the marginal cost curve MC. From
Chapter 9 we know that MC usually falls before it starts rising. We also know that under perfect competition,
marginal revenue MR is equal to the price P of the product. MR therefore stays constant at all levels of output.
It follows that MR can be equal to MC at two different levels of output, as in the figure below, and the question
arises as to what is signified at these two points (corresponding to quantities Q1 and Q2 in the figure). The
answer is that losses are maximised at a quantity such as Q1 (ie where MR = MC along the falling part of the
MC curve), while profits are maximised at a quantity such as Q2 (ie where MR = MC along the rising part of the
MC curve).
R
MC
Price, revenue and cost per unit

P MR

Q
0
Q1 Q2

Quantity (units) per period

The latter case (ie the position at Q2) is explained in detail in the text. All that remains is to show why losses are
maximised at a point such as Q1 and why we can therefore ignore the declining part of the marginal cost curve.
The answer is quite simple. At any point to the left of Q1, MC lies above MR. In other words each additional
unit of the product up to Q1 costs more to produce than the price at which it can be sold. At this stage the
firm’s AR is also less than its AC. Up to Q1 the firm therefore only makes losses. At quantities greater than Q1
marginal revenue MR is greater than marginal cost MC and the firm starts earning a profit on each additional
unit produced. The total loss of the firm thus starts to fall, and can turn into a total profit at some stage (ie
where AR becomes greater than AC). At Q2 the firm’s profit is maximised (or its losses minimised). It should
be clear therefore that the falling part of the MC curve can be disregarded when we analyse the equilibrium
position of the firm.

earn a normal profit, since all its costs, which include normal profit, are fully covered. Point E2 in Figure 10-4(b)
is usually called the break-even point.
In Figure 10-4(c) the market price (and therefore also the firm’s AR and MR) is equal to P3. MR or price is equal to
MC at a quantity of Q3
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Q3 the firm’s average revenue AR is lower than its average cost AC. It therefore makes an
economic loss per unit of output, equal to the difference between C3 and P3. The total economic loss is indicated by
the shaded area P3C3ME3. Whether or not the firm should continue production will depend on the level of AR (ie P3)
relative to the firm’s average variable cost AVC, which is not shown in the figure. If AR is greater than AVC, the firm
will be able to recoup some of its fixed costs and should therefore continue producing in the short run. However,
if AR is lower than AVC, the firm should close down in the short run, thereby restricting its losses to its fixed costs.

172 CHAPT E R 1 0 MA RKET STRUCTURE 1: OVERVI EW A ND PERFECT COM P E T I T I ON

FIGURE 10-4 Different possible short-run equilibrium positions of the firm under perfect competition

(a) Economic profit (b) Normal profit only (c) Economic loss
P MC P MC P MC

Unit revenue and cost

Unit revenue and cost

Unit revenue and cost

AC AC
E1 AC
P1 AR = MR

C1 E2 M
M P2 AR = MR AR C3
P3 AR = MR
E3

Quantity Quantity
0 Q1 0 Quantity
Q2 0 Q3

In the short run a firm’s economic profit may be positive, zero or negative. In (a) we show a situation in which the firm makes an
economic profit, equal to the shaded area. In (b) the firm just breaks even. It earns a normal profit but no economic profit. In (c) the
firm incurs an economic loss, equal to the shaded area. If the price P (= AR) lies above the minimum AVC (not shown in the figure)
the firm will continue production in the short run. If it lies below the minimum AVC, the firm will close down.

The situations illustrated in Figure 10-4 are also summarised in Figure 10-5 in the next section.
The equilibrium condition of the firm under perfect competition may be summarised as follows: Profit is
maximised (or loss minimised) when a firm produces an output where marginal revenue equals
marginal cost, provided marginal cost is rising and lies above minimum average variable cost.

10.6 The supply curve of the firm and the market supply curve
In the previous section we explained that a firm maximises its profits where marginal revenue (MR) is equal to
marginal cost (MC), provided that average revenue AR (ie the price of the product) is sufficient to cover average
variable cost (AVC). Under perfect competition, price P is equal to marginal revenue MR and average revenue
AR. The firm will therefore produce the quantity where P is equal to MC, provided that this occurs where P is
equal to, or greater than, AVC. The rising part of the firm’s MC curve above the minimum of AVC can thus be
regarded as the firm’s supply curve. In Figure 10-5 this is illustrated by the part of the MC curve above point b.
We show various quantities that will be supplied at different prices, and we also show the close-down point b
and the break-even point d.
The market supply curve is obtained by adding the supply curves of the individual firms horizontally. In Chapter
4 we simply assumed that the firm’s supply curve and the market supply curve slope upward from left to right. In
the present chapter we have explained why this is the case. The supply curves slope upward because the marginal
cost curves slope upward, that is, because marginal cost increases as output increases. (The marginal cost curves,
in turn, slope upward because the marginal product curves slope downward – on account of the law of diminishing
returns.)
We are now also in a better position to explain changes in supply, which are illustrated by shifts of the market
supply curve. In Chapter 4 we mentioned, for example, that supply will change if the number of firms change
or if the prices of the factors of production (eg labour) change. Since the market supply curve is the sum of the
individual supply curves, an increase in the number of firms will shift the market supply curve to the right, and
a reduction in the number of firms will move the market supply curve to the left, ceteris paribus. If the price of a
variable input (such as labour) changes, both marginal cost MC and average variable cost AVC will change. For
example, if the price of labour (ie the wage rate) increases, MC and AVC will move upward and the market supply
curve will also move upward (ie to the left), indicating a fall in supply (of each individual firm and in the market).

C HA P TER 10 M A R K E T S T RUCT URE 1: OV E RV IE W AND PERFECT COMPETI TI ON 173

 FIGURE 10-5 The supply curve of the firm
10.7 Long-run equilibrium of the firm and
the industry under perfect competition R MC
Break-even
So far we have examined only the position of an individual firm point
in the short run. We turn now to the long run and examine, in e AC

Revenue and cost (rand)

P1
addition, the position of the industry (ie the collection of firms AVC
that supply a specific product in the market). In the long run, two P2
d
things can change. First, new firms can enter the industry and c
P3
existing firms can leave. Second, all factors of production become b
P4
variable (recall the definition and analysis of the long run in the a
previous chapter) and existing firms earning economic profit in P5

the short run may decide to expand their plant sizes to realise
economies of scale. These two changes are now examined. Close-down
point
Initially, we ignore changes in plant size and costs and focus only Q
0
on the impact of entry and exit on the long-run equilibrium of the Q4 Q3 Q2 Q1
firm and the industry. After we have explained this, we use long- Quantity per period
run cost curves to extend the analysis.

The impact of entry and exit on the equilibrium The rising portion of the firm’s marginal cost curve
above the minimum of its average variable cost curve
of the firm and the industry at point b is the firm’s supply curve. If the price is P5,
In the previous two sections we saw that an individual firm can the firm will not produce at all. If the price is P4, the firm
be in equilibrium in the short run where it makes an economic will be at its close-down point (b) and it is immaterial
profit or an economic loss. These positions, however, are if it shuts down or continues production. If the price
not sustainable in the long run under conditions of perfect is P3, the firm will minimise its economic losses by
producing a quantity Q 3, corresponding to point c. If
competition. When firms are making economic profits, this will
the price is P2, the firm will make normal profit (ie it will
induce new firms to enter the industry and when this happens,
break even) at point d, which corresponds to a quantity
the market (or industry) supply will increase, thus reducing the Q 2. If the price is P1, the firm will maximise economic
market price, ceteris paribus. Similarly, firms making economic profit at point e, that is, it will produce a quantity Q 1.
losses will leave the industry in the long run, thus reducing the
market (or industry) supply and raising the market price, ceteris
paribus . The industr y will be in equilibrium in the long
run only if all the firms are making normal profits. Only then will there be no inducement for new firms
to enter the industry, or for existing firms to leave the industry. With complete freedom of entry and exit, there
will always be some movement (ie disequilibrium) in the industry when firms are making economic profits or
losses. Disequilibrium, and the process whereby equilibrium is reached, can be explained with the aid of a series
of diagrams.
We start, in Figure 10-6, by showing the long-run equilibrium of the firm and the industry. In Figure
10-6(a) we show that the individual firm is making only a normal profit. It is therefore covering all its costs (including
normal profit). The firm is doing just as well as it could if its resources were employed elsewhere. There is thus no
incentive for existing firms to leave the industry or for new firms to enter the industry. In Figure 10-6(b) we show
the market demand and supply of the product, which determines the market price (and therefore the AR and MR
of the individual firm). The vertical axes in (a) and (b) are exactly the same – both measure the price per unit of
the product. The horizontal axes both measure quantities, but the horizontal scales are different since each firm
supplies only a small, insignificant part of the whole market. In the figure this is indicated by using units on the
horizontal axis in (a) and thousands of units on the horizontal axis in (b). (The reason why the price is labelled P2
will become obvious as we proceed.)
In Figure 10-7 we show a situation in which the individual firm initially earns an economic profit. The initial
demand and supply curves in (b) are D1 and S1 respectively, and the market price is P1. The individual firm in (a)
makes an economic profit at E1 (ie at price P1). However, because the existing firms are making economic profits,
new firms enter the industry, and the market (or industry) supply curve shifts to the right. This process will
continue until the new supply curve is S2, and the market price is P2 (corresponding to the equilibrium point E2).
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E2 (ie at a price of P2) the individual firm earns only a normal profit and there is no reason for more new firms
to enter the industry. The industry and each individual firm is in equilibrium at a price of P2. This corresponds to
the equilibrium at price P2 in Figure 10-6.

174 CHAPT E R 1 0 MA RKET STRUCTURE 1: OVERVI EW A ND PERFECT COM P E T I T I ON

 FIGURE 10-6 The firm and industry in long-run equilibrium

(a) The firm (b) The industry

P MC P

AC S
Price per unit

P2 AR = MR = P2

D
0 Q Q
0
Q2
Quantity (units) Quantity (thousands of units)

Equilibrium occurs when the price determined in the market (P2 in (b)) is just sufficient for the individual
firm to earn a normal profit. This is shown in (a) where MR = MC and AR = AC at the same quantity (Q 2).

FIGURE 10-7 The individual firm and the industry when the firm initially earns an economic profit

(a) The firm (b) The industry

P MC P
S1

S2
AC
E1
Price per unit

E1
P1 AR1 = MR1 = P1

P2 AR2 = MR2 = P2 E2
E2

D1
Q Q
0 0
Quantity (units) Quantity (thousands of units)

The original demand and supply curves in (b) are D 1 and S 1, yielding a price of P1. At P1 the
individual firm earns an economic profit where MR 1 = MC, since AR > AC at that point (E 1). At
E 1 the industry is in disequilibrium. The economic profits attract new firms to the industry, thus
shifting the supply curve in (b) to S 2 in the long run. The price falls to P2, where industry equilibrium
is established, since the individual firm is only earning a normal profit and there is no incentive for
firms to enter or leave the industry.

C HA P TER 10 M A R K E T S T RUCT URE 1: OV E RV IE W AND PERFECT COMPETI TI ON 175

 In Figure 10-8 we start off with a situation where the individual firm is making an economic loss. The initial
demand and supply curves in (b) are D1 and S1 respectively, and the initial market price is P1
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firm makes an economic loss where MR1 = MC at E1. This loss, however, cannot be sustained in the long run and
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left. The process will continue until the new supply curve is S2 and the market price is P2 (corresponding to the
equilibrium point E2

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for more firms to leave the industry (or for new firms to enter the industry). The industry and each individual firm
is in equilibrium at a price of P2. This corresponds to the equilibrium at price P2 in Figures 10-6 and 10-7.

To summarise: economic profits in a competitive industry are a signal for the entry of new firms; the industry
will expand, pushing the price down until the economic profits fall to zero (ie only normal profits are earned).
Economic losses in a competitive industry are a signal for the exit of loss-making firms; the industry will contract,
driving the market price up until the remaining firms are covering their total costs (ie until normal profits are
earned).

The impact of changes in the scale of production on the equilibrium of the firm and
the industry
Until now we have assumed that the existing firms’ scale of production remains unchanged. In the long
run, however, all factors of production are variable and existing firms can therefore change their scale of
production. If an existing firm is earning an economic profit and it can realise economies of scale (ie if average
cost can be reduced), it will expand its scale of production. This is illustrated in Figure 10-9. Initially, the firm
is producing at scale 1, with short-run marginal cost SRMC1 and short-run average cost SRAC1. The market
price is P1 and the firm maximises economic profit (indicated by the shaded area) by producing Q1 units of
the product. In the long run all the factors of production are variable and the firm can realise economies of
scale (ie reduce average costs) by expanding to scale 2, indicated by the new short-run marginal and average
costs, SRMC2 and SRAC2 respectively. The firm expands since it will increase profits at the original market
price (P1) if its average costs are reduced. However, the existence of positive economic profits in the industry
attracts new entrants (as explained earlier) and also gives other existing firms an incentive to expand the

FIGURE 10-8 The individual firm and the industry when the firm initially makes an economic loss

(a) The firm (b) The industry

P MC P

S2
AC S1
Price per unit

E2 E2
P2 AR2 = MR2 = P2

P1 AR1 = MR1 = P1 E1
E1

D1
Q Q
0 0

Quantity (units) Quantity (thousands of units)

The original demand and supply curves in (b) are D 1 and S 1, yielding a price of P1. At P1 the individual firm cannot
cover all its costs and makes an economic loss where MR1 = MC (since AR < AC at E 1). At E 1 the industry is in
disequilibrium. The economic losses force firms to leave the industry in the long run, thus shifting the supply
curve in (b) to the left, to S 2. The price rises to P2, where equilibrium is established for the industry. The individual
firm earns a normal profit and there is no incentive for firms to leave or enter the industry.

176 CHAPT E R 1 0 MA RKET STRUCTURE 1: OVERVI EW A ND PERFECT COM P E T I T I ON

FIGURE 10-9 Increasing the firm’s scale of production
to realise economies of scale

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The firm initially produces at scale 1 when the market price
is P1. A quantity of Q 1 is produced and economic profit
(indicated by the shaded area) is earned. In the long run,
when all inputs are variable, the firm expands its plant size
and produces at lower unit costs at scale 2. However, due
to similar expansions at other existing firms and the entry of
new firms, industry supply increases and the market price
drops to P2. In the long run, equilibrium is achieved at a
quantity Q 2 where P = SRMC 2 = SRAC 2 = LRAC. The firm
earns only normal profit in the long run.
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and the expansion of existing firms result in an increase
in the supply of the product, which can be illustrated by
a rightward shift of the supply curve. This increase in
supply (not shown in the diagram) drives the price of the
product down to P2 and in the end all remaining firms in
the industry (such as the one in Figure 10-9) again just
earn a normal profit (ie zero economic profit).
In the long run, therefore, existing firms will continue
to expand as long as there are economies of scale to be
realised (ie as long as average costs can be reduced), and
new firms will continue to enter the industry as long as
positive economic profits are being earned. This process
will continue until only normal profits are earned. In the
long run, the firm is thus in equilibrium where P = SRMC
= SRAC = LRAC, as at price P2 and quantity Q2 in Figure

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where P = SRMC = SRAC = LRAC will economic profit be
zero and will the industry be in equilibrium.
Throughout the analysis in this chapter we have assumed
that the demand for the product remains unchanged. If the
demand should change (illustrated by a shift of the demand
curve), the price of the product will change and this, in turn,
will set a whole chain of actions and reactions in motion.
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book, but you will encounter it in intermediate courses in
microeconomics.

10.8 Perfect competition as a benchmark

In Section 10.3 we mentioned that one of the reasons why perfect competition is studied is that it represents a
standard or norm against which the functioning of all other types of market can be compared. Two of the important
criteria in this regard are allocative efficiency and productive efficiency.

Allocative efficiency
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least one person better off without making someone else worse off. On the other hand, an allocation of resources
is inefficient if it possible to make at least one person better off without making someone else worse off. In such
a case the welfare of society can be improved by reallocating the resources.
This notion of allocative efficiency is called Pareto efficiency or Pareto optimality, after the Italian
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price of each product is equal to its marginal cost in the long run. Marginal cost (MC) is the opportunity
cost of producing an extra unit of output. Price (P), on the other hand, is the opportunity cost of consuming
an extra unit of the product – it reflects the consumers’ sacrifice required to obtain the extra unit. Society’s
welfare is maximised when the marginal cost of each product is equal to its price (ie when MC = P) and AC ≤
MC in the long run. If price is greater than marginal cost, society places a higher value on an additional unit
of the product than the resources required to produce it, and society’s welfare can be improved by producing
more of the product (and less of other products). Conversely, if price is lower than marginal cost, society
places a lower value on an additional unit of output than the cost of producing it. Society’s welfare can then be
improved by producing less of the product (and more of other products).

C HA P TER 10 M A R K E T S T RUCT URE 1: OV E RV IE W AND PERFECT COMPETI TI ON 177

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MR = MC, that is, where marginal cost (MC) is
equal to price (P). Under perfect competition there is equilibrium when MR = P = MC and the first condition
for allocative efficiency is thus met. Moreover, perfectly competitive firms will only produce in the long run if
AR (= P = MR) ≥ AC. It therefore also follows that AC ) MC in the long run. The second condition for allocative
efficiency is therefore also met.
Note that for a perfectly competitive firm, profit maximisation and allocative efficiency are not at odds. The
perfectly competitive firm seeks to maximise profits by producing the quantity of output at which MR = MC, and
because for the firm P = MR, it automatically achieves allocative efficiency (P = MC) when it maximises profit (MR
= MC). However, as we shall see in the next chapter, profit maximisation and allocative efficiency might be at odds
in other market structures.

Productive efficiency
Productive efficiency in an industry occurs when all the firms in the industry produce where their long-run
average or unit costs (AC) are at a minimum
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seen in the previous section, perfectly competitive firms are only in equilibrium in the long run where average
cost is at a minimum. Perfectly competitive firms thus satisfy the condition for productive efficiency. However,
as we shall see in the next chapter, firms in other market structures are not necessarily productively efficient.

10.9 Concluding remarks

Perfect competition is intuitively attractive. It disciplines all the participants and satisfies the conditions for allocative
and productive efficiency. In the impersonal world of perfect competition market forces call the tune and neither
private firms nor public officials wield economic power. The market mechanism, acting like Adam Smith’s invisible
hand, determines the allocation of resources among competing uses. Perfectly competitive markets clearly have
remarkable and desirable properties and are undoubtedly efficient.
But are such markets fair? Do they necessarily produce the greatest happiness for the greatest number of people?
Unfortunately not. To participate in the market, one needs purchasing power – only money votes count – and
people are not equally endowed with purchasing power. Some are very poor through no fault of their own and
some are very rich through no virtue of their own. In a society in which the distribution of income and wealth is
highly unequal, perfect competition will maintain and aggravate the inequalities. A perfectly competitive system
might be very efficient but it only benefits those who are in a position to compete. Societies do not live on efficiency
alone. Equity is also important and societies often decide to take steps to improve the equity or fairness of the
distribution of income and wealth.

IMPORTANT CONCEPTS

Market structure Demand curve for the product of the Marginal cost (MC)
Perfect competition firm Total profit
Monopoly Total revenue (TR) Normal profit
Monopolistic competition Marginal revenue (MR) Economic profit
Oligopoly Average revenue (AR) Break-even point
Homogeneous (identical) products) Shut-down rule Supply curve of the firm
Heterogeneous products Profit-maximising rule Industry (or market) supply
Entry and exit Total cost (TC) Industry equilibrium
Collusion Average cost (AC) Allocative efficiency
Price taker Average variable cost (AVC) Productive efficiency

178 CHAPT E R 1 0 MA RKET STRUCTURE 1: OVERVI EW A ND PERFECT COM P E T I T I ON