PERFECT COMPETITION

Amit Prakash Jha

Perfect Competition

A perfectly competitive market is a hypothetical market where

competition is at its greatest possible level.

It is argued that perfect competition would produce the best

possible outcome for consumers, and society.
Perfect Competition

There are many sellers.

They are selling a homogenous (identical) product.

There are many buyers.

Perfect Competition

There is a perfect information.

There are no barriers to entry or exit.

No single entity can influence the market.

Perfect Competition

Firms are said to be price takers.

Participants are rational.

There are no externalities.

Perfect Competition

There is hardly a need for government regulation.

Remember

Profit maximizing condition:

Marginal Revenue is equal to Marginal Cost
The Perfectly Competitive Industry
.

Demand and Supply at Industry Level

P S

P* Equilibrium

Q* Q
Industry is Price Maker
Demand curve perceived by the firm in perfect competition

Price

P D

Quantity
Average Revenue Curve
.

Price
TR = P*Q
AR = TR/Q
AR = P

P D = AR = P

Quantity
Q
 Short run analysis
.

Price
MC
AC

P D = AR = MR = P

Quantity
Q
Short run analysis
Price
MC
AC

P D = AR = MR = P

Total Cost
Quantity
Q
Short run analysis
Price
MC
AC

P D = AR = MR = P

Total Revenue
Quantity
Q
Short run analysis
Price
MC
AC

P D = AR = MR = P
Economic Profit

Quantity
Q
 Short run analysis
.

Price Economic Profit = Total Revenue – Total Cost

MC
AC Cost includes the
opportunity cost

P D = AR = MR = P
Economic Profit

Quantity
Q
Analysis of a firm (in perfect competition) in the long
run
ATC
MC
Price

D = AR = MR = P

Quantity
A note on profit

• Economic Profit (abnormal profit) :– profit even after

subtracting opportunity cost
• Normal Profit :– profit that just compensates for the
opportunity cost
Shutdown Point

The shutdown rule: "in the short run a firm should continue to
operate if price exceeds average variable costs“

Illustration
Price = 11 Rs
Fixed Cost = 2 Rs
Variable cost = 10 Rs
Shutdown Point

The shutdown rule: "in the short run a firm should continue to
operate if price exceeds average variable costs“

Illustration
Price = 11 Rs
Fixed Cost = 2 Rs
Variable cost = 10 Rs
If I continue: Loss = 1 Re
If I shut down: Loss = 2 Rs (Hence, I should continue)
Shutdown Point

The shutdown rule: "in the short run a firm should continue to
operate if price exceeds average variable costs“

Illustration
Price = 9 Rs
Fixed Cost = 2 Rs
Variable cost = 10 Rs
Shutdown Point

The shutdown rule: "in the short run a firm should continue to
operate if price exceeds average variable costs“

Illustration
Price = 9 Rs
Fixed Cost = 2 Rs
Variable cost = 10 Rs
If I continue: Loss = 3 Rs
If I shut down: Loss = 2 Rs (Hence, I should shut down)
Shutdown Rule (Short Run)

The firm must shut down if the revenue is less than the variable
cost of production.

In short run, fixed cost may be interpreted as sunk cost.

Remember,
The concept of fixed cost is not exactly equivalent to sunk cost.
An example
Quantity Price Total Revenue Average Marginal
(Q) (P) (TR = P*Q) Revenue Revenue
(AR = TR/Q) (MR = ΔTR/ΔQ)
1 unit ₹6
2 6
3 6
4 6
5 6
6 6
7 6
8 6
An example
Quantity Price Total Revenue Average Marginal
(Q) (P) (TR = P*Q) Revenue Revenue
(AR = TR/Q) (MR = ΔTR/ΔQ)
1 unit ₹6 ₹6
2 6 12
3 6 18
4 6 24
5 6 30
6 6 36
7 6 42
8 6 48
An example
Quantity Price Total Revenue Average Marginal
(Q) (P) (TR = P*Q) Revenue Revenue
(AR = TR/Q) (MR = ΔTR/ΔQ)
1 unit ₹6 6 ₹6
2 6 12 6
3 6 18 6
4 6 24 6
5 6 30 6
6 6 36 6
7 6 42 6
8 6 48 6
An example
Quantity Price Total Revenue Average Marginal
(Q) (P) (TR = P*Q) Revenue Revenue
(AR = TR/Q) (MR = ΔTR/ΔQ)
1 unit ₹6 6 6
2 6 12 6 ₹6
3 6 18 6 6
4 6 24 6 6
5 6 30 6 6
6 6 36 6 6
7 6 42 6 6
8 6 48 6 6
An example
Quantity Price Total Cost Average Marginal
(Q) (P) Revenue (TC in ₹) Revenue Revenue
(TR = P*Q) (AR = TR/Q) (MR =
ΔTR/ΔQ)
0 unit -- -- 3
1 ₹6 6 5 6 6
2 6 12 8 6 6
3 6 18 12 6 6
4 6 24 17 6 6
5 6 30 23 6 6
6 6 36 30 6 6
7 6 42 38 6 6
8 6 48 47 6 6
An example
Quantity Price Total Cost Profit in ₹ Average Marginal
(Q) (P) Revenue (TC in ₹) (TR – TC) Revenue Revenue
(TR = P*Q) (AR = (MR =
TR/Q) ΔTR/ΔQ)
0 unit -- -- 3 -- --
1 ₹6 6 5 6 6
2 6 12 8 6 6
3 6 18 12 6 6
4 6 24 17 6 6
5 6 30 23 6 6
6 6 36 30 6 6
7 6 42 38 6 6
8 6 48 47 6 6
An example
Quantity Price Total Cost Profit in ₹ Average Marginal
(Q) (P) Revenue (TC in ₹) (TR – TC) Revenue Revenue
(TR = P*Q) (AR = (MR =
TR/Q) ΔTR/ΔQ)
0 unit -- -- 3 -- -- --

1 ₹6 6 5 1 6 6

2 6 12 8 4 6 6

3 6 18 12 6 6 6

4 6 24 17 7 6 6

5 6 30 23 7 6 6

6 6 36 30 6 6 6

7 6 42 38 4 6 6

8 6 48 47 1 6 6
An example
Quantity Price Total Cost Profit in ₹ Average Marginal Marginal
(Q) (P) Revenue (TC in ₹) (TR – TC) Revenue Revenue Cost in ₹
(TR = (AR = (MR = (MC)
P*Q) TR/Q) ΔTR/ΔQ)
0 unit -- -- 3 -- -- --

1 ₹6 6 5 1 6 6

2 6 12 8 4 6 6

3 6 18 12 6 6 6

4 6 24 17 7 6 6

5 6 30 23 7 6 6

6 6 36 30 6 6 6

7 6 42 38 4 6 6

8 6 48 47 1 6 6
An example
Quantity Price Total Cost Profit in ₹ Average Marginal Marginal
(Q) (P) Revenue (TC in ₹) (TR – TC) Revenue Revenue Cost in ₹
(TR = (AR = (MR = (MC)
P*Q) TR/Q) ΔTR/ΔQ)
0 unit -- -- 3 -- -- -- --

1 ₹6 6 5 1 6 6 2

2 6 12 8 4 6 6 3

3 6 18 12 6 6 6 4

4 6 24 17 7 6 6 5

5 6 30 23 7 6 6 6

6 6 36 30 6 6 6 7

7 6 42 38 4 6 6 8

8 6 48 47 1 6 6 9
An example
Quantity Price Total Cost Profit in ₹ Average Marginal Marginal
(Q) (P) Revenue (TC in ₹) (TR – TC) Revenue Revenue Cost in ₹
(TR = (AR = (MR = (MC)
P*Q) TR/Q) ΔTR/ΔQ)
0 unit -- -- 3 -- -- -- --

1 ₹6 6 5 1 6 6 2

2 6 12 8 4 6 6 3

3 6 18 12 6 6 6 4

4 6 24 17 7 6 6 5

5 6 30 23 7 6 6 6

6 6 36 30 6 6 6 7

7 6 42 38 4 6 6 8

8 6 48 47 1 6 6 9
An example
Quantity Price Total Cost Profit in ₹ Average Marginal Marginal
(Q) (P) Revenue (TC in ₹) (TR – TC) Revenue Revenue Cost in ₹
(TR = (AR = (MR = (MC)
P*Q) TR/Q) ΔTR/ΔQ)
0 unit -- -- 3 -- -- -- --

1 ₹6 6 5 1 6 6 2

2 6 12 8 4 6 6 3

3 6 18 12 6 6 6 4

4 6 24 17 7 6 6 5

5 6 30 23 7 6 6 6

6 6 36 30 6 6 6 7

7 6 42 38 4 6 6 8

8 6 48 47 1 6 6 9
An example
Quantity Price Total Cost ATC or Profit in ₹ Average Marginal Marginal
(Q) (P) Revenue (TC in ₹) Average (TR – TC) Revenue Revenue Cost in ₹
(TR = Total (AR = (MR = (MC)
P*Q) Cost TR/Q) ΔTR/ΔQ)

0 unit -- -- 3 -- -- -- --

1 ₹6 6 5 1 6 6 2

2 6 12 8 4 6 6 3

3 6 18 12 6 6 6 4

4 6 24 17 7 6 6 5

5 6 30 23 7 6 6 6

6 6 36 30 6 6 6 7

7 6 42 38 4 6 6 8

8 6 48 47 1 6 6 9
An example
Quantity Price Total Cost ATC or Profit in ₹ Average Marginal Marginal
(Q) (P) Revenue (TC in ₹) Average (TR – TC) Revenue Revenue Cost in ₹
(TR = Total (AR = (MR = (MC)
P*Q) Cost TR/Q) ΔTR/ΔQ)
(TC/Q)

0 unit -- -- 3 -- -- -- -- --

1 ₹6 6 5 5 1 6 6 2

2 6 12 8 4 4 6 6 3

3 6 18 12 4 6 6 6 4

4 6 24 17 4.25 7 6 6 5

5 6 30 23 4.60 7 6 6 6

6 6 36 30 5 6 6 6 7

7 6 42 38 5.43 4 6 6 8

8 6 48 47 5.88 1 6 6 9
An example
Quantity Price Total Cost ATC or Profit in ₹ Average Marginal Marginal
(Q) (P) Revenue (TC in ₹) Average (TR – TC) Revenue Revenue Cost in ₹
(TR = Total (AR = (MR = (MC)
P*Q) Cost TR/Q) ΔTR/ΔQ)
(TC/Q)

0 unit -- -- 3 -- -- -- -- --

1 ₹6 6 5 5 1 6 6 2

2 6 12 8 4 4 6 6 3

3 6 18 12 4 6 6 6 4

4 6 24 17 4.25 7 6 6 5

5 6 30 23 4.60 7 6 6 6

6 6 36 30 5 6 6 6 7

7 6 42 38 5.43 4 6 6 8

8 6 48 47 5.88 1 6 6 9
Total Revenue (TR = P*Q)
.
Price
MC
AC

P D = AR = MR = P

Total Revenue
Quantity
Q
An example
Quantity Price Total Cost ATC or Profit in ₹ Average Marginal Marginal
(Q) (P) Revenue (TC in ₹) Average (TR – TC) Revenue Revenue Cost in ₹
(TR = Total (AR = (MR = (MC)
P*Q) Cost TR/Q) ΔTR/ΔQ)
(TC/Q)

0 unit -- -- 3 -- -- -- -- --

1 ₹6 6 5 5 1 6 6 2

2 6 12 8 4 4 6 6 3

3 6 18 12 4 6 6 6 4

4 6 24 17 4.25 7 6 6 5

5 6 30 23 4.60 7 6 6 6

6 6 36 30 5 6 6 6 7

7 6 42 38 5.43 4 6 6 8

8 6 48 47 5.88 1 6 6 9
Total Revenue (TR = P*Q)
.
Price
MC
AC
Q

P D = AR = MR = P

AC

Total Cost
Quantity
Q
An example
Quantity Price Total Cost ATC or Profit in ₹ Average Marginal Marginal
(Q) (P) Revenue (TC in ₹) Average (TR – TC) Revenue Revenue Cost in ₹
(TR = Total (AR = (MR = (MC)
P*Q) Cost TR/Q) ΔTR/ΔQ)
(TC/Q)

0 unit -- -- 3 -- -- -- -- --

1 ₹6 6 5 5 1 6 6 2

2 6 12 8 4 4 6 6 3

3 6 18 12 4 6 6 6 4

4 6 24 17 4.25 7 6 6 5

5 6 30 23 4.60 7 6 6 6

6 6 36 30 5 6 6 6 7

7 6 42 38 5.43 4 6 6 8

8 6 48 47 5.88 1 6 6 9
Total Revenue (TR = P*Q)
Price
MC
AC
Q

P D = AR = MR = P
Profit = TR - TC

AC

Quantity
Q
Answer this
A perfectly competitive firm
1. Chooses its price to maximize profits
2. Sets its price to undercut other firms selling similar
products
3. Takes its price as given by market conditions
4. Picks the price that yields the largest market share
Answer
A perfectly competitive firm
1. Chooses its price to maximize profits
2. Sets its price to undercut other firms selling similar
products
3. Takes its price as given by market conditions
4. Picks the price that yields the largest market share
Now answer this
A competitive firm maximizes profit by choosing the
quantity at which
1. Average total cost is at its minimum
2. Marginal cost equals the price
3. Average total cost equals the price
4. Marginal cost equals average total cost
Answer
A competitive firm maximizes profit by choosing the
quantity at which
1. Average total cost is at its minimum
2. Marginal cost equals the price
3. Average total cost equals the price
4. Marginal cost equals average total cost
An important concept

First, recall that a firm will produce only if the price is above
the average variable cost
An important concept

Next, convince yourself that marginal cost curve is same as

the short run supply curve.
Now answer this
Answer
Answer this one
Answer
One more
In the long run equilibrium of a competitive market with
identical firms, what is the relationship between price (P),
marginal cost (MC), and average total cost (ATC)
1. P > MC and P > ATC
2. P > MC and P = ATC
3. P = MC and P > ATC
4. P = MC and P = ATC
Answer
In the long run equilibrium of a competitive market with
identical firms, what is the relationship between price (P),
marginal cost (MC), and average total cost (ATC)
1. P > MC and P > ATC
2. P > MC and P = ATC
3. P = MC and P > ATC
4. P = MC and P = ATC
And the last one
And the last one
An important short/long answer question

What are the main characteristics of a competitive firm?

Another important short/long answer question

Explain, using graph, how a competitive firm chooses the

level of output that maximizes profit.