Perfect Competition

Dr. Divya Gupta

Economics I

Dr. Divya Gupta Perfect Competition Economics I 1 / 16

References

Neva Goodwin: Chapter 16

Mankiw: Chapter 14

Dr. Divya Gupta Perfect Competition Economics I 2 / 16

Discussion so far

In our discussion of the Producer’s Theory so far, we have seen the

different types of costs that a typical firm faces.
Note that these costs, and subsequently the cost curves, are common
to all types of firms, regardless of the market structure they operate
in.
Further, we know that firms in neoclasscial producer’s theory are
profit maximisers.
This profit can be defined as: π = TR − TC , where π are profits, TR
is total revenue (= P x Q) and TC is total cost.
Since the structure of TC is the same for each firm, across market
types, the choice of profit maximising output, thus, depends on their
total revenues, or more specifically the price (P) that they can charge.
This ‘P’ that a typical firm charges to maximises its profits differs
across market structures.
Dr. Divya Gupta Perfect Competition Economics I 3 / 16
Perfectly Competitive Market

Competitive markets also known as perfectly competitive markets are

those markets which have the following characteristics:
Large number of buyers.
Large number of sellers.
All the sellers are selling exactly the same product /good/ service (i.e.
homogeneous goods and services)
Because of large number of buyers and sellers, no single buyer or
seller can influence price level.
Therefore, each firm and buyer acts as a ‘price taker’.
There is free entry and exit of firms.

Dr. Divya Gupta Perfect Competition Economics I 4 / 16

Concept of Revenue: TR and MR

Total Revenue (TR) is the total earnings of the firm, defined as Total
Revenue = Price (P) x Quantity (Q).
Average revenue (AR) is the revenue earned per unit sold, defined as
AR = TR
Q .
PxQ
Therefore, by construction, AR = Q = P, always.
Marginal Revenue (MR) is the extra/additional revenue earned by
selling an additional unit of a commodity, defined as MR = ∆TR
∆Q .
Since for a firm under perfect competition, the price is given by the
market - say P*, the firm can sell any quantity at this price.
Therefore, for every additional unit of a commodity sold, the
additional revenue earned by the firm is exactly P*.
Hence, for firms under perfect competition, P* = AR = MR.

Dr. Divya Gupta Perfect Competition Economics I 5 / 16

Profit Maximisation Condition

As discussed earlier, firms in any market tend to maximise π = TR − TC .

This equation for profit is mathematically maximised at a unique point/
unique level of output, at which MR = MC.
Intuitively, this profit-maximising condition asserts that firms “think at the
margin”.
That is, when they increase the output, Q, by one unit, their revenue rises
by MR and cost rises by MC.
Thus, the increase in Q will increase π, if MR > MC.
However, if an increase in Q results in MR < MC, then reducing Q will raise
profit.
This adjustment goes on until the two become equal. MR=MC gives the
profit maximizing output.
In case of perfectly competitive firms, since P = MR, therefore,
profit maximising condition becomes P = MC.

Dr. Divya Gupta Perfect Competition Economics I 6 / 16

Profit Maximisation under Perfect Competition
For a perfectly competitive firm, the choice of profit maximising output can,
thus, be depicted as shown below.

As shown, at Q1 , MR1 > MC1 , therefore, the firm will increase output.
At Q2 , MC2 > MR2 , therefore, the firm will reduce output.
Finally, the firm will stop at Qmax , where MR = MC = P, thus making
Qmax as the profit maximising output.
Note that since under perfect competition, a firm takes the price as given,
this price is constant at P, hence making the AR and MR curves as the same
horizontal line.
Dr. Divya Gupta Perfect Competition Economics I 7 / 16
Firm’s Supply Curve under perfect competition
Based on previous discussion, it can be inferred that:
Firms under perfect competition takes the price as given.
Then, at this price, the firm chooses that level of output at which the
price-line intersects the MC curve, i.e. when P = MC.
Therefore, a firm’s MC curve can be said to be it’s supply curve, as shown in
diagram below:

Thus, as price increases from P1 to P2 , the profit maximising output

increases from Q1 to Q2 .
Note that this is the upward sloping supply curve that was, until now,
assumed to be given for free and competitive markets (recall discussions of
module 2).
Dr. Divya Gupta Perfect Competition Economics I 8 / 16
Short-run v/s long-run supply decision
Shut-down decision v/s exit decision

Generally speaking, the upward sloping part of the MC curve is said to be a

perfectly competitive firm’s supply curve.
However, which portion of MC curve acts as a firm’s supply curve depends
on short-run vis-a-vis long-run.
Before we go into the details of these decisions, recall that in short-run,
there are two types of costs - fixed costs and variable costs; whereas in the
long-run, all costs are variable costs - as all inputs are variable.
Further, in the short-run, fixed costs are also termed as ‘sunk costs’, because
once incurred, they become sunk regardless of whether the firm produces
anything or not.
On the contrary, variable costs are paid only when the firm produces any
output.
Thus, when making production decisions, in the short-run, firms would want
to earn revenues such that it covers at least their variable costs - even if
fixed costs (and hence, total costs) are not recovered.
However, in the long-run, firms would want to earn revenues to cover all of
their costs.
Dr. Divya Gupta Perfect Competition Economics I 9 / 16
Short-run v/s long-run supply decision (contd.)
Shut-down decision v/s exit decision

In the short run, firms want to cover at least their variable costs, i.e,
TR > TVC ; dividing by Q, we get P > AVC .
Thus, if P < AVC , then, the firm will decide to shut-down the business
temporarily, as not even variable costs are being covered by the revenues
earned by the firm.
In the long-run, however, firms want to cover all their costs, i.e. TR > TC ,
or P > ATC .
Thus, if P < ATC , then, in the long-run, firms will decide to exit the
market.
Similarly, in the long-run, a prospective entrant compares the benefits of
entering the market (i.e. the TR it will earn) with the costs (TC), and,
enters if the benefits exceed the costs.
Hence, a new firm will enter the market if it is profitable to do so, i.e. if
TR > TC , or P > ATC .

Dr. Divya Gupta Perfect Competition Economics I 10 / 16

Supply curve in short-run v/s long-run
Summarising the discussion so far:
The supply curve of a firm in competitive market is the upward sloping
portion of the MC curve. However:
The short-run supply curve is that portion of the MC curve which lies
above the AVC curve (as shown in figure 1 below), i.e. when P > AVC .
The long-run supply curve is that portion of the MC curve which lies
above the ATC curve (as shown in figure 2 below), i.e. when P > ATC .

Figure 1: Short-run supply curve Figure 2: Long-run supply curve

Dr. Divya Gupta Perfect Competition Economics I 11 / 16

Measuring profits/losses
A firm’s decision to enter or exit the market in the long-run is based on how
profitable or not it is for them to do so.
Mathematically, we have defined those conditions to be P > ATC for entry, i.e.
when it is profitable; and P < ATC for exit, i.e. when it leads to losses.
Graphically, profits/losses of a firm can be depicted as shown below:

As shown, the length of the red line along y-axis is P, and the length of red/black
lines along x-axis is Q (in both graphs). Therefore, the area of the rectangle
formed by red lines = P x Q = Total Revenue.
Likewise, the length of black line along y-axis is ATC. Therefore, the area of
rectangle formed by black lines = P x ATC = Total Cost.
In figure (a), shaded region of profit is area of red rectangle (TR) minus that of
black (TC); and in figure (b), shaded region of loss is area of black rectangle
(TC) minus that of red (TR).
Dr. Divya Gupta Perfect Competition Economics I 12 / 16
Zero Economic Profits in Long-run
Due to free entry and exit of firms in a competitive market, each firm makes ‘zero
economic profits’ in the long-run. Three questions arise on this:
1 First and foremost, why would firms want to stay in business, if they make zero
economic profits?
Answer: Recall the difference between economic profits and accounting profits.
Since economic profits account for implicit costs as well, therefore, even if
economic profits are ‘zero’, accounting profits are ‘positive’.
2 Second, can firms reach still make profits or losses in the short-run?
Answer: Yes. Recall that the firms decide to shut-down in the short-run only if
P < AVC . Therefore, it is possible that even if P > AVC and hence firm continues
production, P < ATC , such that firm is making losses in the short-run. Similarly,
firms can also make profits in the short-run, when P > ATC .
3 If firms make profits/losses in the short-run, how do they reach zero economic
profits in the long-run?
Answer: Through free entry/exit of other firms. Recall that firms in perfect
competition take the price as given. Thus, profits/losses in the short-run will
induce entry/exit, respectively, in the long-run, driving the market price down or
up, in a way that individual firm’s profits are reduced to zero. This is discussed in
detail in the next few slides.
Dr. Divya Gupta Perfect Competition Economics I 13 / 16
Long-run entry: Zero Economic Profits
Suppose the market for a commodity starts at a long-run equilibrium. As shown in
the graph below, the equilibrium price in this market is given by P1 , which the firm
takes as given and decides to produce the quantity at which this P1 line intersects
the MC curve.

Now suppose, due to some exogenous factor, the demand for the commodity
increases, which shifts the demand curve to the right, from D1 to D2 , as shown in
figure below.
This increases the equilibrium price from P1 to P2 , hence, facilitating the firm to
now make profits - as indicated by the shaded region.

Dr. Divya Gupta Perfect Competition Economics I 14 / 16

Long-run entry: Zero Economic Profits (contd.)

Since firms in this market are making profits, this induces entry in the
long-run, into this competitive market, thus, shifting the supply curve
to the right from S1 to S2 .
Due to the parallel shift of supply curve, the price is now brought
down (by market forces) from P2 to P1 , as shown in the graph below.

At P1 , the firm’s positive economic profits are all absorbed by the

higher number of firms in the market.
Finally, in the long-run, each firm is back to making ‘zero economic
profits’.
Dr. Divya Gupta Perfect Competition Economics I 15 / 16
 ALL THE BEST!

Dr. Divya Gupta Perfect Competition Economics I 16 / 16