ECO1010.

1110 –
PRICE TAKING AND PERFECT COMPETITION

Geraint Van der Rede

Geraint.vanderrede@uct.ac.za
 Learning outcomes

• Once you have studied this chapter you should be able to:
• explain the equilibrium conditions for any firm
• list the conditions which must be met for perfect competition to exist
• explain the demand curve facing the firm under perfect competition
• explain the short-run equilibrium of the firm under perfect competition
 SOME REVISION FROM UNIT 7

We have a function for profit: 𝜋 = 𝑇𝑅 − 𝑇𝐶

Having done basic calculus, we know that when we decide to maximise a function, we need to solve for the
condition where the first derivative is equal to 0.
𝑑𝜋 𝑑 𝑑𝑇𝑅 𝑑𝑇𝐶
So … 𝑑𝑄 = 𝑑𝑄 𝑇𝑅 − 𝑇𝐶 = − =0
𝑑𝑄 𝑑𝑄

But, remember that the slope of our TR function is marginal revenue, and the derivative of the total cost
function is marginal cost. So, we get that 𝑀𝑅 − 𝑀𝐶 = 0

𝑀𝑅 = 𝑀𝐶

3
 PROFIT MAXIMIZATION

Profit-maximization can also be

described in terms of revenue and
costs.
Marginal revenue (MR) =
change in revenue from selling an
additional unit (net effect of
decreasing price and increasing
quantity sold)
Firm maximizes profits by
choosing point where
MR = MC
 PRICE TAKING FIRMS

• In Unit 7, we assumed that there were a few firms and they produced
differentiated products. Due to this differentiation, firms could not simply jump
from firm to firm trying to find the lowest priced item. Product differentiation
meant that the firms could choose the price.
• In this unit, we think about firms producing homogenous products. Due to
firms selling basically the same good, there is no incentive for firm A to charge
a price above firm B. Why would a customer more for the same product??
• What is the prevailing price in the market? Well, earlier in the chapter we
introduced the market demand and the market supply. These two curves
combine to give us an equilibrium price.
 Figure 8.5. The profit-maximizing price and quantity for a bakery.

€7 The point of highest profit in the

feasible set is point A, where the
€80 isoprofit curve is tangent to
the feasible set. You should make 120
€6
loaves per day, and sell them at the
market price, €2.35 each. You will
make €80 of profit per day in
€5 addition to normal profits.
Price, P; Cost

€4
Marginal cost curve
Isoprofit curve: €200
€3
A Isoprofit curve: €80
P* Firm’s demand curve
€2 Zero-economic-profit
curve (AC curve)

€1
Feasible set
Equilibrium @ P = MC
€0
0 20 40 60 80 100 120 140 160 180 Earlier we said it was at MR = MC
Quantity Q: number of loaves
 IS IT P = MC OR MR = MC?
• Well, when a firm chooses the price it sells at there is a trade-off between the quantity sold and the
price the product is sold at.
• An Example…
• Suppose you could sell 10 pens for R10 each. TR would be R100 = 10 * R10
• If you chose to sell 11 pens, you couldn’t sell the first 10 for R10 and then drop the price for
the 11th.
• You would have to drop the price for all sales.
• Let’s assume this price drop is from R10 to R9.50.
• TR – 11 * R9.50 = R104.50
• In this case, P = R9.50 but the actual MR (difference between TR10 and TR11 )is R4.50.

• If a firm cannot choose the price and must charge the same amount for all goods, then additional
sales are not coupled with a price decrease. So if you choose to sell 10 units for R10 (TR=R100),
and another customer strolls in to buy a pen, they pay R10 and the price matches the marginal
revenue.
• So it’s always MR=MC maximise profit. But when a firm is a price-taker, P is the same as MR.
Disequilibrium Adjustment
 What happens when the price changes?
The firm accept the price and sets P = MC
€7 €7
Marginal cost curve

Isoprofit curve: €200 €6

€6
Isoprofit curve: €80
€5 Zero-economic-profit €5
Supply
curve (AC curve)
MC curve
Price, P; Cost

€4 €4

Price, P; Cost
€3 €3

€2 €2

€1 €1

€0 €0
0 40 80 120 160 200 0 40 80 120 160 200
Quantity Q: number of loaves Quantity, Q: number of loaves
 Perfect competition

Requirements

• Large number of buyers and sellers – no-one can influence market price
• No collusion – sellers act independently (anyway not possible because of
number of sellers
• Homogeneous product
• Freedom of exit and entry
• Perfect knowledge
• No government intervention
• All factors of production are perfectly mobile
Profit or Loss under Perfect Competition
 AN EXAMPLE – PROFIT-MAXIMISATION -
ALGEBRAICALLY

Suppose a firm sells goods according to the market demand schedule 𝑃 = 120 − 2𝑄 and that the market supply
is represented by 𝑃 = 30 + 𝑄.
produce according to a total cost schedule given by 𝑇𝐶 = 20 + 15𝑄 2 .
1. Calculate the prevailing price in this market
120 − 2𝑄 = 30 + 𝑄
90 = 3𝑄
𝑄 = 30 (𝑇ℎ𝑖𝑠 𝑖𝑠 𝑡ℎ𝑒 𝑡𝑜𝑡𝑎𝑙 𝑜𝑢𝑡𝑝𝑢𝑡 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑚𝑎𝑟𝑘𝑒𝑡)
∴ 𝑃 = 120 − 2 30 = 𝑅60
2. Calculate the quantity sold by the firm is the marginal cost of production is MC = 30Q.
60 = 30𝑄
∴𝑄=2
 THE EXAMPLE - GRAPHICALLY

MC = 30Q
120
Market Supply

60 P = MR

20 Market Demand

Market 2 Firm