In This Lecture…

Concept of Perfect Competition Market

Features of Perfectly Competition Market

Conditions of Short-Run and Long-Run Competitive Equilibrium

Market Structure

The particular environment of a firm, the characteristics of which influence the firm’s pricing and output decisions.

The Theory of Perfect Competition

A theory of market structure based on four assumptions:

(1)There are many buyers and sellers (2)Each firm produces and sells a

homogeneous product. (3)Buyers and sellers have perfect

knowledge about the market i.e. all relevant information with respect to prices, product quality, sources of supply, and so on.

(4)There is free or easy entry and exit from the industry.

A Perfectly Competitive Firm is a Price Taker

A seller in perfect competition market does not have the ability to control the price of the product it sells; it takes the price determined in the market by the market demand and market supply forces.

In Perfect Competition market P=AR=MR=d

Market Demand Curve and FirmDemand Curve in Perfect

Competition

The market, composed of all buyers and sellers, establishes the equilibrium price. (a)

A single perfectly competitive firm then faces a horizontal (flat, perfectly elastic) demand curve. (b)

Quantity of Output the Perfectly

Competitive Firm Will Produce The firm’s demand

curve is horizontal at the equilibrium price. Its demand curve is its marginal revenue curve. The firm produces that quantity of output at which MR = MC.

Profit-Maximization Rule

Profit is maximized by producing the quantity of output at which MR = MC.

For Perfect Competition, profit is maximized when P = MR = MC*

* This condition is unique for perfect competition and does not hold for other market structures.

Resource Allocative Efficiency

Producing a good—any good—until price equals marginal cost ensures that all units of the good are produced that are of greater value to buyers than the alternative goods that might have been produced.

A firm that produces the quantity of output at which price equals marginal cost (P = MC) is said to exhibit resource allocative efficiency.

For a perfectly competitive firm, profit maximization and resource allocative efficiency are not at odds.

Profit Maximization and Loss Minimization for the Perfectly

Competitive Firm: Three Cases I

In Case 1, TR TC and the firm earns profits.

It continues to produce in the short run.

In Case 2, TR < TC and the firm takes a loss.

It shuts down in the short run because it minimizes its losses by doing so; it is better to lose $400 in fixed costs than to take a loss of $450.

Profit Maximization and Loss Minimization for the Perfectly

Competitive Firm: Three Cases II

In Case 3, TR < TC and the firm takes a loss.

It continues to produce in the short run because it minimizes its losses by doing so; it is better to lose $80 by producing than to lose $400 in fixed costs by not producing.

Profit Maximization and Loss Minimization for the Perfectly

Competitive Firm: Three Cases III

What Should a Perfectly Competitive Firm Do in the

Short Run?

The firm should produce in the short run as long as price (P) is above average variable cost (AVC).

It should shut down in the short run if price is below average variable cost.

The Perfectly Competitive Firm’s

Short-Run Supply Curve

The short-run supply curve is that portion of the firm’s marginal cost curve that lies above the average variable cost curve.

Long-Run Equilibrium

Long-run competitive equilibrium exists when:

there is no incentive for firms to enter or exit the industry,

there is no incentive for firms to produce more or less output, and

there is no incentive for firms to change plant size.

Productive Efficiency

The situation that exists when a firm produces its output at the lowest possible per-unit cost (lowest ATC).

The perfectly competitive firm does this in the long-run.

Long-Run Competitive Equilibrium

The condition where: P = MC = SRATC = LRATC. There are zero economic profits,

firms are producing the quantity of output at which price is equal to marginal cost, and no firm has an incentive to change its plant size.

Long-Run Competitive Equilibrium in the Market and the Firm

P = MC (the firm has no incentive to move away from the quantity of output at which this occurs, q1);

P = SRATC (there is no incentive for firms to enter or exit the industry); and

SRATC= LRATC (there is no incentive for the firm to change its plant size).

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