Lecture 7: Perfectly Competitive Markets

1. Features of competitive markets

2. Output decision in the short run
3. Output decision in the long run
4. Applications

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 Find Perfect Competition among the following:

1. Origin, AGL, Momentum, etc.

2. Beauty salons
3. Coles, Woolworths, IGA
4. Telstra, Optus, Vodafone, etc.
5. Kellogg’s, Uncle Toby’s, Nestle, etc.
6. Coca-cola, Pepsi, etc.
7. Water and Sewer (BCC)

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 What are the key characteristics of perfectly
competitive markets?

◼ Large number of buyers and sellers

◼ Homogeneous product
These two features imply that a competitive firm takes the
market price of output as given (outside of its control). At this
price, it can sell any amount of the good it wants to sell. At a
price higher than the market price, it would lose all its
customers. At a price below the market price it will needlessly
forgo profits since it can get as many consumers by pricing at
the market price. Put differently, a perfectly competitive firm
faces an infinitely elastic demand curve.
◼ Free entry and exit
◼ Equal access to resources
◼ Perfect information

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 Characteristics of perfectly competitive markets

◼ This implies that for a perfectly competitive firm the marginal

revenue equals the price of the product. (Why?)

◼ Also note that average revenue must by definition equal the price
of the product, since average revenue equals price times quantity
divided by quantity. This is true for all types of firms not just
competitive firms.

◼ However, MR = P is only true for competitive firms.

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Competitive markets in the short run

Consider the output decision in the short run. The firm wants to
choose output in a way that it maximizes its profit.

Figure 1 shows the marginal cost (MC), the average total cost
(AC) and the average variable cost (AVC) for a typical firm.

We also see a set of possible demand curves representing the

demand at different prices.

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Figure 1 Cost and demand for a competitive firm

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 Short run output decision

◼ When marginal cost (MC) < price (P), which is equal to

marginal revenue (MR), the firm will add to profits by producing
more.
◼ When MC > P, the firm by producing one unit less will save
costs to a greater extent than the loss in revenue.
◼ Therefore, the profit maximising quantity is found where the
horizontal price line intersects the marginal cost curve, i.e., when
P = MC = MR.

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 Short run output decision

◼ In some situations however, a firm will shut down and not

produce anything at all. (Note that a temporary shutdown
decision in the short run is different from a long run exit
decision).

◼ What determines the shut down decision? If a firm shuts down it

loses all revenue from the sale of its product. At the same time,
it saves the variable costs of production (but not the fixed costs).

◼ The firm shuts down if the revenue that it would get from
producing is less than the variable costs.
◼ Shut down if TR < TVC

=> Shut down if TR/Q < TVC/Q

=> Shut down if AR = P < AVC

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 Short run output decision

◼ Given the above analysis, what is the short run supply function
of the competitive firm?
◼ See figure 2. In the short run, the competitive firm’s supply
curve is its marginal cost curve above average variable costs. If
the price falls below AVC, it is better off producing nothing.

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Figure 2. A short-run supply curve for a competitive
firm (Derived from Figure 1)

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What is the short run market supply curve? It is simply a horizontal
summation of the marginal cost curves of all of the firms in the
industry. See figure 3 below.

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 Example:

◼ Suppose that a firm has a short run total cost curve given by
STC = 100 + 20Q + Q 2 where the fixed cost is 100 and total
variable cost is 20Q + Q 2 . The corresponding short run
marginal cost curve is SMC = 20 + 2Q

◼ What is the equation for the average variable cost?

◼ What is the minimum level of average variable cost?
◼ What is the firm’s short run supply curve?

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The equilibrium price and quantity are determined such that
aggregate supply = aggregate demand, as shown in Fig 4 below.

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As shown in Figure 5 below, it is possible, in the short run for
firms to be earning extra normal profits or normal profits (no
profit).

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 Example: The market consists of 600 identical firms, and the
market demand curve is given by Q=60-P.

◼ Each firm has a short run total cost curve STC = 0.1 + 150Q 2
◼ The corresponding short run marginal cost curve is: SMC =300Q
◼ The corresponding average variable cost curve AVC=150Q. The
minimum AVC then, is obviously zero.
◼ Find the short run equilibrium in this market.
Solution: Set P = SMC => P = 300Q => Q = P/300 is the supply
curve for the individual firm. Since short run equilibrium occurs
when market supply equals demand:
600(P/300) = 60 - P => P = 20. This means total supply equals 40,
with each firm producing 40/600=0.067 units.
◼ At the market equilibrium, do firms make positive economic profit?
Solution: Substitute for Q = 0.067 in the SAC = STC/Q =
(0.1/Q)+150Q =11.5
=> P > SAC. So each firm makes a profit.
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 Applications:
Policy analysis in the short run

Example 1: The market for illegal drugs

◼ Assume the market for illegal drugs is of the type we have been
studying – i.e it is perfectly competitive. It is characterized by a
supply curve for drugs similar to the one we just derived, and a
market demand curve that represents consumer preferences
studied earlier in Part 1 of this unit.
THINK POLICY!
◼ Suppose the government follows a policy that increases the
probability of the suppliers of drugs being caught and prosecuted.
This increases the costs of doing business for the drug dealers,
shifting the SMC and hence market supply curve to the left
(upwards).
Illegal drugs become more expensive (P ) and the equilibrium
quantity consumed falls (Q ). (See Figure 6).
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Figure 6. The market for illegal drugs

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 The market for illegal drugs

◼ Suppose the government targets consumers of drugs, rather than

the dealers. Figure 7 shows a shift in the demand curve curve
that is much bigger than the shift in supply. This is based on the
assumption that the dealers are part of organized crime groups
that are able to absorb the increased cost of doing business, and
the users are more likely to be deterred by prosecution and
punishment. The second policy is therefore more effective in
bringing down the consumption of drugs.

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Figure 7. The decision about who to prosecute

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 Example 2: The incidence of a tax

◼ Another way the government can affect the workings of a market

is by imposing a tax on the producers of the good produced in
that market. Will the consumers bear the burden of this tax, or
the producers?

◼ Figures 8-10 illustrate the situation with different assumptions

about the elasticity of demand. When the demand is perfectly
inelastic, the tax is paid entirely by the consumer. When it is
perfectly elastic, the burden falls entirely on the producer. In the
intermediate situation, it falls partly on the consumer, and partly
on the producer.

◼ Note: A tax policy was not feasible in the illegal market for
drugs!
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Figure 8. The incidence of a tax and the elasticity of
demand

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Figure 9. The incidence of a tax and the elasticity
of demand

p a +

pa

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Figure 10. The incidence of a tax and the elasticity
of demand

pc

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 Competitive markets in the LONG RUN

◼ The short run equilibrium we looked at allowed for the existence

of firms that were earning positive (above normal) profits. In the
long run this cannot happen since other firms will enter the
market or the existing firms will increase their capacity. This
will cause an increase in the market supply and decrease in the
equilibrium price, till the point that there are no super-normal
profits.

◼ In Figure 11, we see the long run average and marginal costs for
a competitive firm along with a series of short run curves. The
short run cost curves are associated with different (fixed) levels
of capital.

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Figure 11. The adjustment to a long-run
equilibrium

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 The adjustment to a long-run equilibrium
◼ Assume, to start with the price is p1 and the short run cost
structure of all firms is given by the one associated with K 1 .
◼ Since firms are earning profits more firms will enter the industry
and the price will fall to p1.
◼ If the firms are able to adjust their capacity to K1, they will
survive and still earn profits. Otherwise they have to shut down.
◼ More firms will enter till the price falls to p * .
◼ Firms will then adjust their capacity to K * (OPTIMAL SCALE).
◼ The market price (P*) will equal the firms’ marginal cost (LRMC
= SRMCK*) and also the lowest point of the long run average cost
curve (LRAC = SRACK*).
◼ Firms shut down completely (exits the industry) if P <
min(LRAC). This is known as the break-even price. => Supply
falls until P = P*.
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 Example:

◼ A competitive market has an unlimited number of potential

suppliers producing the same output, and each supplier has a
long run average cost function of AC = Q − 4Q + 6 , and a long
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run marginal cost function of MC = 3Q − 8Q + 6 .

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◼ Find the equilibrium quantity Q produced by each firm in the

long run.
◼ Find the long run equilibrium price.

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 Dynamic changes in market equilibria: FACTOR –
PRICE EFFECTS
◼ Since firms can enter and exit a market in the long run but not the
short run, changes in demand have different effects over different
time horizons. Suppose a market begins in long run equilibrium
and for some reason the demand for the product rises.
◼ Factor/input prices can remain constant, increase or decrease due
to a change in the demand for the product.
◼ Examples:
◼ Increasing: The cost curves shift upwards as the industry demand
expands. E.g., expanding farming industry raises price of land,
jewellery industry increases price of precious stones.
◼ Decreasing: The cost curves shift downwards as the industry demand
expands. E.g., expanding computer industries reduces cost of machine
parts, softwares, etc. due to economies of scale in input production.
◼ Constant: The cost curves don’t change as the industry demand
expands/contracts.

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Figure 12. The short-run response to a change in
demand

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 Dynamic changes in market equilibria: Constant-
cost industries
◼ As shown in Figure 12, the short run response to this change is a
rise in the price of the good. Assuming that the industry is
characterized by constant costs, costs do not change as new firms
enter the industry. This means that entry will occur and the short
run supply will shift (to the right) until price falls back to the long
run equilibrium (lowest point of the LRAC, where no firm earns
extra normal profits).

◼ The long run supply curve is therefore flat: the quantity produced
by larger number of firms in the new equilibrium has increased
even though price falls back to its original level. See Figure 13.

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Figure 13. The long-run response to a change in
demand for Constant-cost industries

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 Dynamic changes in market equilibria: increasing
cost and decreasing cost industries.

◼ In the case of increasing costs, entry occurs to the point where the
new price equals the lowest point on the new and higher long run
average cost, and the long run supply curve is upward sloping. See
Figure 14.

◼ Likewise, for a decreasing cost industry it can be downward

sloping. See Figure 15.

◼ Note: The firm’s supply could increase or decrease in each case

depending on how the cost curves shift. In Figures 12 and 13, firm
supply does not change, only industry supply changes due to entry
of firms.

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Figure 14. Increasing-cost industries

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Figure 15. Decreasing-cost industries

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