Perfect Competition

Perfect Competition (PC) Perfectly Competitive Market:

A market structure characterized by complete ABSENCE OF RIVALRY among the individual firms.

Existence of a large number of firms in Industry implying no single firm has any power to influence the Market Price for its Product.

Exp: (Closest): Stock Market, Agriculture Market, Raw materials (Copper, Iron, Cotton, Sheet Steel)

Stock Market: Face value of share is fixed

Large number of sellers and buyers in the marketProduct (Share) is homogenous Mobilise REVENUE by selling more…..No Asymmetry of INFORMATION

Caution: Stock prices can be sometimes becomes grossly OVERVALUED/UNDER VALUED (BULL/ BEAR Market)]

No simple indicator to judge whether a market is highly competitive or not.

Is COMPETITION synonymous to RIVALRY?

Perfect Competition: NO RIVALRY AMONG THE FIRMS

Economist’s definition of Perfect Competition is DIAMETRICALLY OPPOSITE to COMPETITION used by a common man.

Layman: Competition means Rivalry

Economist’s definition of PC: Stresses on Impersonality of the Market, one person can not influence the Market.

Sell any quantity at the given price to maximize profit without

ADVERTISEMENT.

Behaviour versus Structure: Firms in Perfectly Competitive Markets do not compete with each other while firms that do compete with each other do not operate in Perfectly Competitive Market

Perfect Competition

Why to study Perfect Competition?

Offers a point of reference/standard

Useful for studying variety of Markets

One can measure the Economic Cost or inefficiency for departures from Perfect Competition.

Departure: Monopoly, Oligopoly, Monopolistic Competition

Assumptions of Perfect Competition Market….

• A market is said to be in perfect competition if

• it produces HOMOGENEOUS PRODUCT,

• Have Many BUYERS, each purchasing small quantity,

• Have Many SELLERS, each supplying a small quantity,

• Buyers and Sellers can ENTER & EXIT Market freely

Assumptions…..

• All buyers and sellers have EQUAL INFORMATION

• Profit Maximization is the GOAL of firm

• Perfect Mobility of Factors of Production

• No government Regulation

Assumptions of PC: Product Homogeneity… Commodity is homogenous/ identical/ perfectly standardized

Difficult to distinguish output of different firms

No scope for product differentiation implies individual firms do not have discretion in setting the PRICE.

Sellers are PRICE TAKERS.Demand Curve is INFINITELY ELASTIC (Horizontal straight line)FIRM can Sell any amount at the PREVAILING PRICE

Continues…Exp: Paddy sold by different farmers

Gold Mined in different countries are perfect substitutes

Mineral Water- Not Perfect Substitutes due to differences in Chemical Composition and brand

Rationale of this Assumption: Ensures prevalence of single Market price, consistent with demand and supply analysis

Heterogeneous products (such as brand names) can fetch higher prices. Why? The product is perceived as better quality

Assumptions of PC…Large Number of Buyers and Sellers.

Implication:Equilibrium price and quantity cannot be affected largely by one or few customers/sellers

Exp: Market for Gold and UraniumGold: Countless buyers and purchases of

each buyer is very small as compared to world stock

Assumptions….Free Entry & Free Exit of Buyers and Sellers

• Absence of Barrier to Entry & Exit from the Industry.• No barrier implies exodus of one or few

firms may NOT Provide ENOUGH POWER to the remaining firms to affect the price. Because there are LARGE NUMBER of firms.

NO SPECIAL COST for ENTERING (in case of profit opportunity) or Exiting the industry (in case of loss)

Implication: Buyer can switch form one Supplier to Another and Supplier can enter or exit the Market.

With the change in Price, buyers can switch over to other sellersEx: Pharmaceutical Industry –not perfectly competitive. (Investment in R &D or Substantial License fee to produce a drug restricts entry for

new firms)

Other Assumptions.. • Perfect Mobility of Factors of Production

– Factors of production are free to Move from one firm to another.

– Workers can LEAVE one job and take up other assignment to improve skill.

• Perfect competition in markets for FACTORS of PRODUCTION

• Buyers and Sellers have complete knowledge about conditions of the market.

Information is free and costless Firm is a Price Taker: Takes the market-determined price as the

price it will receive for its output. Given the price one can sell as much as it can.

Profit MaximizationThe goal of a competitive firm

is to maximize profit.Profit = TR -TC

Do firms Maximize Profit?– Managers in firms may be concerned

with other objectives• Revenue maximization• Dividend maximization• Short-run profit maximization (due to

bonus or promotion incentive)– Could be at expense of long run profits

Profit Maximization

• Implications of non-profit objective– Over the long run, investors would not support the company– Without profits, survival is unlikely in competitive industries

• Managers freedom to pursue goals other than long-run profit maximization is somewhat constrained……

Total Revenue: Competitive Firm

Rs25

Rs20

Rs15

Rs10

Rs 5

Rs

Quantity

Total Revenue

1 2 3 4 5

MarginalRevenue

Profit Maximization – Short Run

0

Cost,Revenue,

Profit($s per

year)

Output

C(q)

R(q)A

B

(q)q0 q*

Profits are maximized where MR (slope at A) and MC (slope at B) are equal

Profits are maximized where R(q) – C(q) is maximized

Marginal Revenue, Marginal Cost, and Profit Maximization

• If the producer attempts to INCREASE PRICE, SALES Decline to ZERO

• Refer GRAPH: Profit is negative to begin with, since revenue is not large enough to cover fixed and variable costs

• As output rises, REVENUE rises faster than COSTs, implying increase in profit

• Profit increases until it is Maximized at q*

• Profit is maximized where MR = MC or where slopes of the R(q) and C(q) curves are equal

Equilibrium Condition• (i) MC=MR

(Produce output at which MR is equal to MC)

• (ii) Slope of MC > Slope of MR

(MC must cut MR from below or slope of MC must be steeper than that of MR)

Profit Maximization in Perfect Competition

Quantity Price Total Total Total  

of Output ($) Revenue ($) Cost ($) Profits ($)  

0 35 0 30 -30  

1 35 35 50 -15  

1.5 35 52.5 52.5 0 Break Even2 35 70 60 10  

3 35 105 75 30  

3.5 35 122.5 91 31.5 Profit Max4 35 140 110 30  

5 35 175 175 0  

5.5 35 192.5 220 -27.5  

Source: Salvatore, Dominick (2003): Microeconomics, Theory & Applications

Oxford University Press

Profit Maximization for the Perfectly Competitive Firm

Quantity Price MC ATC Profit Total Relationship

of Output (=MR) ($) ($) per Unit Profits

between MC & MR

1 35 12.5 50 -15 -15 MR>MC1.5 35 10 35 0 0 MR>MC2 35 11 30 5 10 MR>MC3 35 25 25 10 30 MR>MC

3.5 35 35 26 9 31.5 MC=MR4 35 50 27.5 7.5 30 MR<MC5 35 35 0 0  

5.5 35   40 -5 -27.5  

Source: Salvatore, Dominick (2003): Microeconomics, Theory & Applications

Oxford University Press

The Competitive Firm & Industry

• Demand curve faced by an individual firm is a horizontal line– Firm’s sales have no effect on market price

• Demand curve faced by whole market is downward sloping– Shows amount of goods all consumers will

purchase at different prices

The Competitive Firm

dRs4

Output (bushels)

PriceRs per bushel

100 200

Firm Industry

D

Rs4

S

PriceRs per bushel

Output (millions of bushels)

100

The Competitive Firm• The competitive firm’s

demand– Individual producer sells all

units for $4 regardless of that producer’s level of output

– MR = P with the horizontal demand curve

– For a perfectly competitive firm, profit maximizing output occurs when

ARPMRqMC )(

Choosing the Output: Short Run

• The point where MR = MC, the profit maximizing output is chosen– MR = MC at quantity, q*, of 8– At a quantity less than 8, MR > MC, so more profit can

be gained by increasing output– At a quantity greater than 8, MC > MR, increasing

output will decrease profits

• Summary of Production Decisions– Profit is maximized when MC = MR– If P > ATC the firm is making profits– If P < ATC the firm is making losses-Shut Down Point

(Average Variable cost of producing the output should not exceed the price at which it is sold)

q2

A Competitive Firm

10

20

30

40

Price50

MC

AVC

ATC

0 1 2 3 4 5 6 7 8 9 10 11Outputq*

AR=MR=PA

q1 : MR > MCq2: MC > MRq*: MC = MR

q1

Lost Profit for q2>q*Lost Profit

for q1<q*

A Competitive Firm – Positive Profits

10

20

30

40

Price50

0 1 2 3 4 5 6 7 8 9 10 11Outputq2

MC

AVC

ATC

q*

AR=MR=PA

q1

D

C B Profits are determined

by output per unit times quantity

Profit per unit = P-AC(q) = A to B

Total Profit = ABCD

A Competitive Firm – Losses

Price

Output

MC

AVC

ATC

P = MRD

At q*: MR = MC and P < ATCLosses = (P- AC) x q* or ABCD

q*

A

BC

Scrap or store: What do Airlines do in a down turn?

• Terrorist Attack: Sept. 11, 2001 on WTC• Sharp downturn in Demand for Air travel• Airlines reduced number of flights• (Two-thirds of 2000 planes grounded after attack will not return to the skies)• (few were parked in desert in the Southwest of the US).

• Airlines failed to sell unwanted planes (second hand value very low, parked planes are older model)

• (Aircraft would be worth about $1m each as scrap… A new aircraft cost up to $ 80m.)• Decision to be taken: Whether plane should be sold, put back into service or broken up for

the value of spare parts.• Depends on AVERAGE VARIABLE COST:

– Whether AVC of Running (& restoring) an old plane will be less than the AVC of running other Planes in the fleet, which in turn remains less than the average Total Cost of buying new planes.

Source: Dominic O’ Connell, Sunday Times, Business Section, March 24, 2002, P.3(quoted in LIPSEY and CHRYSTAL: Economics)

Competitive Firm – Short Run Supply• Supply curve tells how much output will be produced at

different prices• Competitive firms determine quantity to produce where P =

MC– Firm shuts down when P < AVC

• Competitive firms’ supply curve is portion of the marginal cost curve above the AVC curve

A Competitive Firm’sShort-Run Supply Curve

Price($ per

unit)

Output

MC

AVC

ATC

P = AVC

P2

q2

The firm chooses theoutput level where P = MR = MC,

as long as P > AVC.

P1

q1

S

Supply is MC above AVC

A Competitive Firm’sShort-Run Supply Curve

• Why Supply is upward Sloping ?• MC rises due to Diminishing Returns• Higher price compensates for the higher cost of additional

output (due to diminishing returns) • Higher Price increases total profit (because it applies to all units

not to bulk amount)

• Market Supply Curve• Shows the amount of product the whole market will

produce at given prices• Is the sum of all the individual producers in the market

• MC3

Industry Supply in the Short Run

$ perunit

MC1

SThe short-runindustry supply curve

is the horizontalsummation of the supply

curves of the firms.

Q

MC2

15 21

P1

P3

P2

1082 4 75

Choosing Output in the Long Run

• In the short run, a firm faces a horizontal demand curve– Take market price as given

• The short-run average cost curve (SAC) and short-run marginal cost curve (SMC) are low enough for firm to make positive profits (ABCD)

• The long-run average cost curve (LRAC)– Economies of scale to q2

– Diseconomies of scale after q2

q1

BC

AD

In the short run, thefirm is faced with fixedinputs. P = $40 > ATC.

Profit is equal to ABCD.

Output Choice in the Long Run

Price

Output

P = MR$40

SACSMC

q3q2

$30

LAC

LMC

Output Choice in the Long Run

Price

Outputq1

BC

ADP = MR$40

SACSMC

q3q2

$30

LAC

LMCIn the long run, the plant size will be increased and output increased to q3.

Long-run profit, EFGD > short runprofit ABCD.

FG

E

Long-Run Competitive Equilibrium

• Entry and Exit– The long-run response to short-run profits is to

increase output and profits– Profits will ATTRACT other PRODUCERS– More producers INCREASES INDUSTRY SUPPLY,

which LOWERS the market PRICE– This continues until there are no more profits to

be gained in the market – zero economic profits

Long-Run Competitive Equilibrium – Profits

S1

Output Output

$ per unit ofoutput

$ per unit ofoutput

LAC

LMC

D

S2

$40 P1

Q1

Firm Industry

Q2

P2

q2

$30

•Profit attracts firms•Supply increases until profit = 0

Initial Long Run Eq. price $ 40 implying positive profit.New Firms Enter Industry-Increasein Production-Market Supply Curve Shifted to S2 (Output Rises)- Price falls to $30 (equal to Average Cost of Production)

Long-Run Competitive Equilibrium – Losses

S2

Output Output

$ per unit ofoutput

$ per unit ofoutput

LAC

LMC

D

S1

P2

Q2

Firm Industry

Q1

P1

q2

$20

$30

•Losses cause firms to leave•Supply decreases until profit = 0

Let Market Price falls to $20 But Min. LAC=$30. Firm Lose Money-Exit Industry.Outcome-Decrease Production.Shift in Supp Curve S2. PriceRise to reach break-even ($30)

Long-Run Competitive Equilibrium1. All firms in industry are maximizing profits

– MR = MC2. No firm has incentive to enter or exit

industry– Earning zero economic profits

3. Market is in equilibrium– QD = QS

MC2

q2

Input cost increases and MC shifts to MC2

and q falls to q2.

MC1

q1

The Response of a Firm toa Change in Input Price

Price($ per

unit)

Output

$5

Savings to the firmfrom reducing output

Thanks a lot