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PERFECT COMPETITION
Lesson 9

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PERFECT COMPETITION

The Perfect Competition Market is an Ideal Market, depicting a Capitalist System. It is regarded as a bench mark against which the imperfections of other markets can be measured. The price is fixed by Market conditions of D and S, so that there is no exploitation of the consumer.
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Features of P.C
1.

Large number of buyers and sellers, no individual unit can influence the market price. Homogenous products: no difference in product between firms. Easy entry and exit: No barriers to new firms entering or leaving the industry. Perfect information or knowledge

2.

3.

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4.

Features of P.C
5. 6.

No transport costs, Firms are price takers they cannot influence the market price. The demand curve for a firm is perfectly elastic. Perfect mobility of factors, consumers and firms.
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7.

8.

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Market Price
R C MARKET OR INDUSTRY S R C FIR M

P AR=MR =d D

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Q q Kgs tonnes Market P fixed by Market D and S at P. Each firm in PC 5 sells at this price, and elasticity of demand for an individual firm is infinity.

Short Run equilibrium of a firm

Each firm in PC is rational, and wants to maximise its profits. The maximum profit is at the point where TR TC is maximum. This can be determined either by taking total cost and revenue curves, Or Average and Marginal curves.
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Short Run equilibrium of a firm in PC At a AC =

RC
Br po ea in ke t ve n

b AR=MR =d

profit

q1

q2

Loss

Los s

SM C

SAC

q Kgs

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AR. This is the Break even point, where profits =0. After this AC< AR, showing profits. At b AC=AR, after which AC > AR, loss. Between a and b the firm makes profits. What quantity 7 to produce to

Profit Maximisation

At what output does the firm make maximum profit? AR > AC to make profits. From Total Cost and Revenue analysis, we know that the maximum profit is where difference between TR and TC was maximum. Profit = TR TC, or (AR q) (AC q) 8

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Two conditions of Profit Maximisation

First or necessary condition of profit maximisation is at that level of output where :

Addition to TC= addition to TR. Or MC = MR.

Second or sufficient condition of profit maximisation is:

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If output is increased, the addition to TC > addition to TR.

Profit Maximisation
SM C e Abnorma l Profits c AR=MR =d SAC

0 q1 8/12/12 q3 q Kgs

At e, profit maximisation conditions are satisfied. MC = MR, and MC . Profit = TR TC. TR = AR q = 0Peq3. TC = AC q = 0acq3. As TR > TC, profits = aPec. This is the maximum profit that the firm can 10 earn, at price P,

RC

Conditions for Profit Maximisation

In the figure, MC = MR at points e and f. At f, the firm makes loss as AC > AR. If the firm increased Q its AC falls, and it enters the profit zone. So it is better to increase output. At e, the difference between AR and AC is the maximum. At this level, profit is maximised.
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At e MC is rising, and cuts MR from

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Loss Minimisation
SAC SM C f LOS S c e AR=MR =d RC AV C

SAC > AR, but AVC < AR, the firm tries to minimise loss. MC = MR, MC. Loss = pgfe. Should the firm continue production? If AR > AVC, then the firm can continue. TC = TVC + TFC. Here TVC = 0acq3, and TFC = agfc. TR is opeq3, which covers entire TVC, and some part of TFC = aPec. If the firm closes down, its 12 loss = TFC = agfc

g P a

TR > TVC 0 q3 8/12/12 q Kgs

Shut down Point

SAC RC SM C f LOSS = TFC e AR=MR =d TR=TVC 0 AV C

q3 8/12/12

q Kgs

If AVC = AR, then should the firm continue production? Should the firm continue production? Here AR = AVC, it covers variable costs. Loss = TFC = Pafe. If the firm shut down its production, its loss = TFC = Pafe. So it does not matter whether the firm produces output or not, its 13 total loss = TFC.

Long Run Equilibrium in P.C.

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Long Run equilibrium

In the long run new firms can enter the industry and loss making firms can leave the industry. Individual firms will expand output and encounter different returns to scale. In other words, the Long Run costs have to be taken into account to determine equilibrium.
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The same rules of Profit Maximisation

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Long Run equilibrium and Returns to Scale

RC LRMC LRAC S0 S1

P0 P1

e Short term profit AR=MR =d

P0

E F

P1 D0

0 q1 FIRM 8/12/12 q0 AR = LRAC, normal profit q Kgs Q0

Q1

MARKET

Q Tons 16

Long Run Equilibrium of PC Firm

Suppose firms in PC are making abnormal profits. This attracts new firms to the industry, and Market Supply now increases, shifts to the right. Assuming D is constant, leads to fall in P to P1, all firms in the market have to sell at this price.
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Long Run Equilibrium of PC Firm

Now the firm in PC has to fix lower P, and its profits fall. As long as P > AC, new firms will enter, and increase market S, reducing market P. This goes on until all profits are competed away. Then equilibrium is at the point where P = AC, no abnormal profits, 8/12/12 only normal profits.
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The Perfect Market

Why is this the Perfect Market?

o

There are no barriers to entry, new firms can enter freely. Homogenous product, so there are no false differentiated products. Uniform price Firms are Price takers they do not influence the price in any way.
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The Perfect Market

o

In the long run, firms make only normal profits, no exploitation of the consumer. P = LRAC , firms operate at minimum AC = efficient firm, full capacity use, no excess capacity P = AR = MR = LRAC = LRMC P = MC, also P = MU, so MU = MC, That is: addition to consumers utility of the marginal unit = addition to firms cost of production of marginal unit. 20

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Questions
1.

Short Answer Questions:

1.

Why is a PC firm a price taker? What is the shape of the demand curve for a PC firm, and why? State and explain the two conditions of profit maximisation. What is the meaning by Shut down point of a firm? Illustrate with a diagram. is the difference between
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2.

3.

4.

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2. Essay Questions:
1.

How does a firm in PC maximise profits in the short run? firm to

1. When is it better for a loss making PC

a) continue in production, and b) to close down? 3. How is long term equilibrium achieved in PC? What are its salient features?
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are the chief features of PC that

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