CHAPTER FOUR

PERFECT COMPETITION
4.1. INTRODUCTION

Perfect competition is one of the several market models. Theoretically, perfect, unlike everyday
usage of the word, is characterized by a complete absence of rivalry (competition) among firms.
The model of Perfect competition cannot be realistically expected to exist in totality in everyday
life. It is highly theoretical, but the model provides a useful tool of economic analysis and helps
the economists to make sense of the real market situation. To start with the concept of perfect
competition, let us discuss the assumption / characteristics also known as the conditions for
perfect competition.

Assumptions
1. Many buyers and many sellers: this means that the numbers of buyers and sellers are so
large the share of each buyer in total demand and the share of each seller in total supply is
very small or insignificant. This implies no single buyer or no single seller can affect
market price by changing his/her demand or supply respectively. This is likely true in for
agricultural products.
2. Identical product: Identical commodities are produced by all firms in an industry in
terms of its technical characteristics and services associated with its sale and delivery
ruling out non-price competition. Hence, all the products offered by individual seller
(supplier) must be exactly the same so that buyers will be completely indifferent as from
which seller to buy.
3. Freedom of entry and exit: There is free entry to and exit from the industry. There is no
government interference in the form of price control and no restriction which would
prevent firms entering into the industry or leaving it. This means firms have freedom of
movement in and out of the industry.
4. Perfect knowledge: this means that all buyers and sellers have knowledge about prices,
quality, output levels and all market conditions both of the present and the future, and
information is free and costless. Thus, no consumer would pay more than the market
price and no supplier would be willing to sell for less than the market price. It follows
that there will only be one price prevailing throughout the market, at any moment of time.
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 This, however, does not mean that price is always the same but when it changes, it must
change for everyone at the same time. Thus, these assumptions will imply that the firms
are price takers so they are faced with perfectly elastic demand curve as shown in figure
4.1 b.
5. Profit maximization is the sole objective of firms in the industry (no other objectives
like welfare, etc.)
6. Perfect mobility of productive resources between or among firms.(Skills can be learned
and no factor monopolization and labor unionization.)

4.2. Demand and revenue curves of competitive firm

Under conditions (assumptions) of perfect completion, the interaction of the market supply and
market demand determines the market price for the industry, and each firm in the industry takes
the price as given. In figure 4.1 a, the determination of price by the market forces (market supply
and market demand) is shown. Figure 4.1 b reveals the fact that the prices P1 is externally
determined (by the two forces) and the firm in the industry sell its entire output at the same price.
If the firm tries to sell at a price above P1, it will sell nothing because all consumers know that
the same good can be obtained for P1 from other firms. The firm under perfect competition is
therefore, powerless to exert any influence on the price and is known as a ‘price taker’. In sum
while the industry demand curve is down ward sloping, the individual (firm’s) demand curve is
horizontal (see below).

The industry The firm TR

𝑃𝑥
DS

𝑃1 𝑃1 𝐷𝐷𝑥=MR=AR=P

O 𝑄1 𝑄𝑥 0 𝑄𝑥
(a) (b)
Figure 4.1: Price determination, demand and revenue curves of perfectly competitive firm

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Total revenue (TR) is the money value of the total quantity sold. It is the product of the price that
a firm charges and the quantity of output it sells at this price. The demand curve for a firm under
perfect competition, as mentioned earlier, is horizontal. It follows that an individual firm can
only make quantity adjustment at a fixed price, and its total revenue increases proportionally
with sales volume, implying that total revenue curve is straight line passing through the origin
(fig 4.1 b). The slope of TR line is known as marginal revenue (MR). MR is the extra revenue
obtained when quantity sold increased by one unit (i.e. = Δ𝑇𝑅
ΔQ
). Each time the firm sales a unit

of output, TR increases by a constant amount (MR) which is equal to the market price. Thus,
under perfect competition, price, MR and AR are equal (prove it mathematically).

4.3. Equilibrium of firm

4.3.1. Short-run Equilibrium of the Firm and the Industry
The equilibrium output of the firm is the output that maximizes its total profit. Total profits equal
the difference between total revenues and total costs, i.e.
∏= TR – TC
∏= PQ – ATC (Q)
∏= Q (P –ATC)

A firm is said to be in equilibrium (maximizing profit) when it has no incentive either to expand
or to contract its output. A firm has no incentive to change its level of output only when its total
profit is the maximum. In a perfectly competitive market structure, price is given (firms are price
takers). Thus firms decide on the level of output (Q) they produce to attain their equilibrium
points. Two approaches are used in determining a firm’s equilibrium.

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1. The total approach (TR-TC Approach): total profits are maximized when the positive
difference between total revenues and costs is largest.
TR/TC STC TR
C

0 Qe Q
Figure 4.2: Short run equilibrium of firm (TR-TC approach)

To the left of point B and to the right of C, STC>TR so that the firm is in a loss (negative ∏).
Between B and C, however, the firm is enjoying a positive profit and it is maximized at the point
where the vertical difference between the TR and STC is largest (at Qe). Point B and point C are
the break-even points where the firm just covers its cost of production and operates at zero
economic profit.

2. The marginal approach: the perfectly competitive firm is a price taker and faces a perfectly

d𝑇𝑅
elastic demand curve. Since marginal revenue (MR) is
and price(P) is constant, then P =
dQ

MR.

𝑀𝑅 =dQ =dQ𝑃 =𝑃
d𝑇𝑅 𝑑 (𝑃Q) 𝑑Q
=dQ
Total profit is maximized when the slope of the TR and total cost curves are equal. That is,
when MR (P) = MC. The firm is at equilibrium at quantity level Q e (where MR = P = MC at
point E). To the left of E, MR > MC (i.e., benefits > costs) and it should increase production.
To the right of E, MC>MR and the firm should cut back its production. This particular figure
represents the case where the firm operates at a economic profit (= area of rectangle ABEM).
∏ = Q (P – ATC)
∏ = Qe (OA - OB) = (AB) (EM) = area of ABEM
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 P/MR MC
ATC
MC
AVC
AC

A I E P = MR = DD
B M

O Qe Q
Figure 4.3: Short run equilibrium of firm (Marginal approach)

It can be the case that competitive firms may operate at losses, at positive profits, or at a normal
(zero) profit. For instance, a firm operates at a loss if the demand curves (MR) lies below point
M. On the other hand, a firm gets only a normal (zero) profit if the demand curve passes through
M. In general,

If Then
P > AC Positive ( economic) profit
P = AC Normal ( zero ) profit, i.e., break-even point
AVC < P < AC Loss, but the firm continues to produce
P = AVC Shut-down point (indifferent to decide)
P < AVC Loss or no operation

N.B.: in the figure above, P(MR) = MC at two points, E and I. But the profit maximizing
level of output is that level of output which corresponds to E. Condition for profit
maximization is:
= 0
d∏

dQ
1. MR = MC this implies

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 < 0 or 𝑑
2 2 2
𝑑 ∏ TR TC
2. MC is rising: -𝑑 <0 or dMR
- dMC<0 or dMR
< dMC (slope of
dQ2 dQ dQ dQ dQ dQ
2 2
MR is less than slope of MC) dQ

The firm operates at different points at the marginal cost curve depending on the level of
price it faces. Thus, its supply curve is its MC curve but above the shut-down point. The
industry supply curve is the simple horizontal summation of the supply curves of the
individual firms. Thus, the industry is at equilibrium when the industry demand curve
intersects the industry supply curve.

S
P P
S

Pe E E*
P = MR Pe

O Qe Q O Qe Q
Panel A: For the firm Panel B: for the industry
Figure 4.4: Short-run equilibrium

Example: Suppose you are the manager of a watch-making firm operating in a competitive
market. Your cost of production is given by C = 100 + Q2, where Q is the level of output and C
is total cost. Given the price of watches is birr 60,
a) How many watches should you produce to maximize profit and find profit level be?
b) Check whether profit obtained in b is maximum profit or minimum loss?

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4.3.2. Derivation of the supply curve of a firm and industry
We have already discussed that the interaction of market supply and market demand determines
equilibrium price and the firms, of course, accepts it. Accepting the externally determined price,
the firm under perfect competition attempts to set its output at the point where MR=MC. Each
time the market supply or demand changes, the equilibrium price and output change (recall from
theory of demand and supply). Now, our aim is to determine how much will be supplied for sale
by an individual firm at each price level. To do this, we have to examine the firm’s MC, AVC
and AC curves (figure 4.5a). Since for the firm MR=P, it tries to adjust its output so as to equate
p and MC. For example, when price is P3 the firm supplies q3 quantity of output. If a price rises
to P4, MR (corresponding to P4) will be greater than MC (corresponding to P3). So the firm find
it profitable to supply additional units so long as MR>MC. Since the decision to produce one
extra unit depends on the MC, the firm moves along the rising portion of the MC curve and
continue to supply more. As soon as MC=MR, it stops supplying more, and so on.

On the other hand, if price fall to P 2, MR will be less than MC. The firm, in trying to maximize
profit reduces output to q2. At this point (B), however, P=MC=AC so that the firm will be only
making normal profits. If price fall to P2, the firm will be making loss because P<AC. In the short
run, the firm will continue to supply even when P<AVC (point A). Any output corresponding to
the price between point A and B on the MC curve incurs loss, but it still represents the “most
profitable” output in the sense that it represents the output at which the loss is minimized.

If price is less than P1 = AVC, the firm’s revenue is not enough to cover its variable cost. Point
A, therefore, is a shut-down point. It is not profitable to produce below the point where P<AVC.
This is because, in the short run, a firm’s fixed cost can be covered and profits made when
market conditions become favorable and price increases. Therefore, the short run supply curve of
the competitive firm is that part of MC curve which lies above AVC 4.5 b). In the long run,
however, all costs have to be covered and hence the long run supply curve is the MC curve
above the interaction with the AC curve (above point B).

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 P5 MC
d5 = MR5 d4 = MR4
AC
P4 d3 = MR3
AC
d2 = MR2
P3

P2 B

P1 A d1 = MR1

P5 Supply

P4

P3

P2

P1

O q1 q2 q3 q4 q5 Q O q1 q2 q3 q4 q5 Q
Figure 4.5: Derivation of supply curve of competitive firm

4.3.3. LONG RUN EQUILIBRIUM OF THE FIRM AND INDUSTRY

In the short run firms may make excess profit, normal profit or losses. In the long run, however,
firms that make losses and cannot readjust their plant will close down. On the other hand, those
that make excess profit will expand their capacity, while excess profits will also attract new firms
into the industry. Entry, exit and readjustment of the remaining firms in the industry will lead to
the long run equilibrium in which firms will just be earning normal profit and there will be no
entry or exit from the industry. When long-run equilibrium is achieved, product prices will be
exactly equal to, and production will occur at each firm’s point of minimum ATC. This is
illustrated below for a constant cost industry (the case where the expansion of the industry
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through entry of new firms will have no effect up on resource prices and, therefore, up on
production costs) and a respective firm.

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 S0
LMC
ATC
P
S1
P0 P0 = MR0 P0

P1 P1 = MR1 P1

D0
O Q O Q
Firm Industry
Figure 4.7: Long run equilibrium of competitive firm

In the long run, all factors of production and all costs are variable. Therefore, the firm will
remain in the business in the long run only if TR≥ 𝑇𝐶. That is, the firms will be just earning
normal profit. If they are making excess profit, the new firms will be attracted into the industry.
As a result, the quantity supplied in the market will be increased by the increased production of
expanding old firms and the newly established ones. Then the supply curve in the market will
shift to the right from (S0) to (S1) which will lead to fall in price (downward shift in the
individual demand curve as price is equal to the demand curve in competitive firms) until it
reaches P1 where firms and industry are at equilibrium and upward shift of cost curves due to the
increase of price of factors as firms expand. These changes will continue until the LAC curve is
tangent to the demand curve defined by the market price. If firm make losses in the long run,
they will leave the industry, price will rise and costs may fall as the industry contracts, until the
remaining firm in the industry cover their total costs. This all lead to the long run equilibrium of
firm and industry. Hence, the best (optimal) level of output for competitive firms in the long run
is given by the point where (1). P= MR= SMC=SAC=LAC =LMC and MC is rising and
(2). Supply curve crosses demand for the industry.
In sum, in the long-run, all firms in a perfectly competitive industry (market) enjoy only normal
profit (zero profit) or at the break-even where TR = TC.

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