Perfect Competition

Muhammad Shahadat Hossain Siddiquee, PhD

Professor of Economics
Department of Economics, University of Dhaka
Contact Email: [Link]@[Link]
Cell: +8801719397749
 Perfect Competition
• The concept of competition is used in
two ways in economics.
– Competition as a process is a rivalry among
firms.
– Competition as the perfectly competitive
market structure.
 Competition as a Process
• Competition involves one firm trying to
take away market share from another
firm.
• As a process, competition
pervades/saturates the economy.
 Competition as a Market
Structure
• It is possible to imagine something that
does not exist – a perfectly competitive
market in which the invisible hand works.
 Competition as a Market
Structure
• Competition is the end result of the
competitive process under highly
restrictive assumptions.
• A perfectly competitive market is one
in which economic forces operate
unimpeded.
 A Perfectly Competitive
Market
• A perfectly competitive market must
meet the following requirements:
– Both buyers and sellers are price
takers.
– The number of firms is large.
– There are no barriers to entry.
– The firms' products are identical.
– There is complete information.
– Firms are profit maximizers.
 The Necessary Conditions for
Perfect Competition
• Both buyers and sellers are price takers.
– A price taker is a firm or individual who
takes the market price as given.
– In most markets, households are price
takers – they accept the price offered in
stores.
 The Necessary Conditions for
Perfect Competition
• The number of firms is large.
– Large means that what one firm does has
no bearing on what other firms do.
– Any one firm's output is minuscule when
compared with the total market.
 The Necessary Conditions for
Perfect Competition
• There are no barriers to entry.
– Barriers to entry are social, political,
or economic impediments that prevent
other firms from entering the market.
– Barriers sometimes take the form of
patents granted to produce a certain
good.
 The Necessary Conditions for
Perfect Competition
• There are no barriers to entry.
– Technology may prevent some firms
from entering the market.
– Social forces such as bankers only
lending to certain people may create
barriers.
 The Necessary Conditions for
Perfect Competition
• The firms' products are identical.
– This requirement means that each firm's
output is indistinguishable from any
competitor's product.
 The Necessary Conditions for
Perfect Competition
• There is complete information.
– Firms and consumers know all there is to
know about the market – prices,
products, and available technology.
– Any technological advancement would be
instantly known to all in the market.
 The Necessary Conditions for
Perfect Competition
• Firms are profit maximizers.
– The goal of all firms in a perfectly
competitive market is profit and only
profit.
– Firm owners receive only profit as
compensation, not salaries.
 The Definition of Supply and
Perfect Competition
• If all the necessary conditions for
perfect competition exist, we can talk
formally about the supply of a produced
good.
• This follows from the definition of
supply.
 The Definition of Supply and
Perfect Competition
• Supply is a schedule of quantities of
goods that will be offered to the market
at various prices.
 The Definition of Supply and
Perfect Competition
• This definition requires the supplier to
be a price taker (the first condition for
perfect competition).
• Since most suppliers are price
makers, any analysis must be modified
accordingly.
 The Definition of Supply and
Perfect Competition
• Because of the definition of supply, if
any of the conditions are not met, the
formal definition of supply disappears.
 The Definition of Supply and
Perfect Competition
• That the number of suppliers be large
(the second condition), means that they
do not have the ability to collude.
 The Definition of Supply and
Perfect Competition
• Even if we cannot technically specify a
supply function, supply forces are still
strong and many of the insights of the
competitive model can be applied to firm
behavior in other market structures.
 Demand Curves for the Firm
and the Industry
• The demand curves facing the firm is
different from the industry demand
curve.
• A perfectly competitive firm’s demand
schedule is perfectly elastic even though
the demand curve for the market is
downward sloping.
 Demand Curves for the Firm
and the Industry
• This means that firms will increase their
output in response to an increase in
demand even though that will cause the
price to fall thus making all firms
collectively worse off.
Market Demand Versus Individual
Firm Demand Curve
Market Firm

Price Market supply Price

$10 $10
8 8 Individual firm
6 6 demand
4 Market 4
2 demand 2
0 0
1,000 3,000 Quantity 10 20 30 Quantity
 Profit-Maximizing Level of
Output
• The goal of the firm is to maximize
profits.
• When it decides what quantity to
produce it continually asks how changes
in quantity affect profit.
 Profit-Maximizing Level of
Output
• Since profit is the difference between
total revenue and total cost, what
happens to profit in response to a change
in output is determined by marginal
revenue (MR) and marginal cost (MC).

• A firm maximizes profit when MC = MR.

 Profit-Maximizing Level of
Output
• Marginal revenue (MR) – the change in
total revenue associated with a change in
quantity.
• Marginal cost (MC) -- the change in
total cost associated with a change in
quantity.
 Marginal Revenue
• Since a perfect competitor accepts the
market price as given, for a competitive
firm, marginal revenue is price (MR = P).
 Marginal Cost
• Initially, marginal cost falls and then
begins to rise.
• Marginal concepts are best defined
between the numbers.
 How to Maximize Profit
• To maximize profits, a firm should
produce where marginal cost equals
marginal revenue.
 How to Maximize Profit
• If marginal revenue does not equal
marginal cost, a firm can increase profit
by changing output.
• The supplier will continue to produce
as long as marginal cost is less than
marginal revenue (i.e., MC<MR).
 How to Maximize Profit
• The supplier will cut back on production
if marginal cost is greater than marginal
revenue (i.e., MC>MR).
• Thus, the profit-maximizing condition
of a competitive firm is MC = MR = P.
 Marginal Cost, Marginal
Revenue, and Price
MC
Price = MR Quantity Marginal Costs
Produced Cost
$35.00 0 60
35.00 1 $28.00
20.00 50
35.00 2 16.00
35.00 3 14.00 40 A C
35.00 4 P = D = MR
12.00 30 B
35.00 5 17.00 A
35.00 6 22.00 20
35.00 7 30.00
35.00 8 40.00 10
35.00 9 54.00
35.00 10 0
68.00 1 2 3 4 5 6 7 8 9 10 Quantity
The Marginal Cost Curve Is the
Supply Curve
• The marginal cost curve is the firm's
supply curve above the point where price
exceeds average variable cost.
• The MC curve tells the competitive firm
how much it should produce at a given
price.
The Marginal Cost Curve Is the
Firm’s Supply Curve
$70 Marginal cost
C
60
50
Cost, Price

40 A
30
20 B

10
0 1 2 3 4 5 6 7 8 9 10 Quantity
 Firms Maximize Total Profit
• When we speak of maximizing profit, we
refer to maximizing total profit, not
profit per unit.
• Firms do not care about profit per unit;
as long as an increase in output will
increase total profits, a profit-
maximizing firm should increase output.
 Profit Maximization Using
Total Revenue and Total Cost
• Profit is maximized where the vertical
distance between total revenue and total
cost is greatest.
• At that output, MR (the slope of the
total revenue curve) and MC (the slope
of the total cost curve) are equal.
 Profit Determination Using
Total Cost and Revenue Curves
TC TR
$385 Loss
Total cost, revenue

350
315 Maximum profit =$81 Profit
280
245
210 $130
175
140
105
70
35 Loss
0
1 2 3 4 5 6 7 8 9 Quantity
 Total Profit at the Profit-
Maximizing Level of Output
• While the P = MR = MC condition tells us
how much output a competitive firm
should produce to maximize profit, it
does not tell us the profit the firm
makes.
 Determining Profit and Loss
From a Table of Costs
• Profit can be calculated from a table of
costs and revenues.
• Profit is determined by total revenue
minus total cost.
 Determining Profit and Loss
From a Table of Costs
• The profit-maximizing position is not
necessarily a position that minimizes
either average variable cost or
average total cost.
• It is only the position that
maximizes total profit.
 Costs Relevant to a Firm
Profit Maximization for a Competitive Firm
P = MR Output Total Cost Marginal Average Total Profit
Cost Total Cost Revenue TR-TC
— 0 40.00 — — 0 –40.00
35.00 1 68.00 28.00 68.00 35.00 –33.00
35.00 2 88.00 20.00 44.00 70.00 –18.00
35.00 3 104.00 16.00 34.67 105.00 1.00
35.00 4 118.00 14.00 29.50 140.00 22.00
35.00 5 130.00 12.00 26.00 175.00 45.00
35.00 6 147.00 17.00 24.50 210.00 63.00
 Costs Relevant to a Firm
Profit Maximization for a Competitive Firm
P = MR Output Total Cost Marginal Average Total Profit
Cost Total Cost Revenue TR-TC
35.00 4 118.00 14.00 29.50 140.00 22.00
35.00 5 130.00 12.00 26.00 175.00 45.00
35.00 6 147.00 17.00 24.50 210.00 63.00
35.00 7 169.00 22.00 24.14 245.00 76.00
35.00 8 199.00 30.00 24.88 280.00 81.00
35.00 9 239.00 40.00 26.56 315.00 76.00
35.00 10 293.00 54.00 29.30 350.00 57.00
 Determining Profit and Loss
From a Graph
• Find output where MC = MR.
• The intersection of MC = MR (P)
determines the quantity the firm will
produce if it wishes to maximize profits.
 Determining Profit and Loss
From a Graph
• Find profit per unit where MC = MR.
• To determine maximum profit, you
must first determine what output the
firm will choose to produce.
• See where MC equals MR, and then
drop a line down to the ATC curve.
• This is the profit per unit.
 Determining Profits Graphically
Price MC Price MC Price MC
65 65 65
60 60 60
55 55 55
50 50 50 ATC
45 45 ATC 45
40 D A P = MR 40 40 Loss P = MR
35 35 35
Profit P = MR
30 B ATC 30 30 AVC
25 C AVC 25 AVC 25
20 E 20 20
15 15 15
10 10 10
5 5 5
0 0 0
1 2 3 4 5 6 7 8 9 10 12 1 2 3 4 5 6 7 8 9 10 12 1 2 3 4 5 6 7 8 910 12
Quantity Quantity Quantity
(a) Profit case (b) Zero profit case (c) Loss case

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000

 Zero Profit or Loss Where
MC=MR
• Firms can also earn zero profit or even a
loss where MC = MR.
• Even though economic profit is zero, all
resources, including entrepreneurs, are
being paid their opportunity costs.
 Zero Profit or Loss Where
MC=MR
• In all three cases (profit, loss, zero
profit), determining the profit-
maximizing output level does not depend
on fixed cost or average total cost, by
only where marginal cost equals price.
 The Shutdown Point
• The firm will shut down if it cannot cover
average variable costs.
– A firm should continue to produce as long as
price is greater than average variable cost.
– Once price falls below that point it makes
sense to shut down temporarily and save the
variable costs.
 The Shutdown Point
• The shutdown point is the point at which
the firm will gain more by shutting down
than it will by staying in business.
 The Shutdown Point
• As long as total revenue is more than
total variable cost, temporarily
producing at a loss is the firm’s best
strategy since it is taking less of a loss
than it would by shutting down.
Perfect Competition
THE END…