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Perfect Competition Chapter 8
A Perfectly Competitive Market
A perfectly competitive market is one in which economic forces operate unimpeded.
A Perfectly Competitive Market
For a market to be perfectly competitive, six conditions must be met:
1. Both buyers and sellers are price takers – a price
taker is a firm or individual who takes the market
price as determined by market supply and demand.
Since a competitive firm takes the market price as
given and beyond its control, its only decision is
how much output to produce and sell
2. The number of firms is large – any one firm’s output
compared to the market output has no influence on
other firms
14-3
A Perfectly Competitive Market
3. There are no barriers to entry – barriers to entry are
social, political, or economic impediments that prevent
firms from entering a market e.g. Patents, technology,
lenders
4. Firms’ products are identical – this requirement means
that each firm’s output is indistinguishable from any
other firm’s output
5. There is complete information – all consumers know all
about the market such as prices, products, available
technology and profit levels
6. Selling firms are profit-maximizing entrepreneurial
firms – firms must seek maximum profit
14-4
The Definition of Supply and Perfect Competition
These strong six conditions are
seldom met simultaneously, but are
necessary for a perfectly competitive
market to exist
14-5
Demand Curves for the Firm and the Industry
The demand curves facing the firm is different from the
industry demand curve.
Individual 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.
Supply
Demand
1,000 3,000
Price
$10
8
6
4
2
0 Quantity
Market Firm
Individual firm demand
Market Demand Versus Individual Firm Demand Curve
10 20 30
Price
$10
8
6
4
2
0 Quantity
Price Equilibrium
Profit Maximisation
•The goal of every firm is to maximize profits.
•Profit is the difference between total revenue (money in)
and total cost (money out).
•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.
•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.
Profit Maximisation
•A perfect competitor accepts the market price as given
(price taker).
•As a result, marginal revenue equals price (MR = P).
•Initially, marginal cost falls and then begins to rise.
Profit Maximization: MC = MR •To maximize profits, a firm should produce where
marginal cost equals marginal revenue.
Profit Maximisation
•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.
•The supplier will cut back on production if marginal cost
is greater than marginal revenue.
•Thus, the profit-maximizing condition of a competitive
firm is MC = MR = P.
Profit Maximisation
Again! MC=MR
Profit is maximized when MC=MR.
If the cost of producing one more unit is less than
the revenue it generates, then a profit is available
If the cost of producing one more unit is more
than the revenue it generates, then increasing
production reduces profit.
P = D = MR
Costs
1 2 3 4 5 6 7 8 9 10 Quantity
60
50
40
30
20
10
0
B
MC
Marginal Cost, Marginal Revenue, and Price
0 1 2 3 4 5 6 7 8 9
10
$28.00 20.00 16.00 14.00 12.00 17.00 22.00 30.00 40.00 54.00 68.00
Price = MR Quantity
Produced
Marginal
Cost
$35.00 35.00 35.00 35.00 35.00 35.00 35.00 35.00 35.00 35.00 35.00
Profit
Maximisation
Measuring Profit
€1.00 €0.80-
Profit per apple(€0.20) D = MR = AR
MC
AC
Economic Profit
Apples per Day
Euros
100 200 300 400 500 600 700 800
Moving from Short Run to Long Run: Entry of new firms
Firms enter the market for a number of reasons
As perfect knowledge exists, everybody knows
the profits that are made.
Profit is attractive and will therefore bring new
firms.
There are no barriers to entry.
Moving from Short Run to Long Run: Entry of new firms
As we enter long-run, much will change: •As number of firms increases, market supply curve will shift rightward causing several things to happen:
1. Market price begins to fall.
2. As market price falls, demand curve facing each firm shifts downward
3. Each firm—striving as always to maximize profit—will slide down its marginal cost curve, decreasing output
Moving from Short Run to Long Run: Entry of new firms
S1
d1 AC
MC
€1.00
With initial supply curve S1, market price is €1.00… €1.00
900,000 9,000
So each firm earns an economic profit.
A
Price per apple
Market
Apples per Year
Euros
Firm
Apples per Year
D
S1
d1 AC
MC
€1.00
Profit attracts entry, shifting the supply curve rightward…
€1.00
900,000 9,000 5,000
...until market price falls to €0.25 and each firm earns zero economic profit.
S2
d1
A A
€0.25 €0.25 E E
Market Firm
Price per apple
Apples per Year
Euros
Apples per Year
D
1,200,000
Moving from Short Run to Long Run: Entry of new firms
Moving from Short Run to Long Run: Entry of new firms
MC
AC
D = MR = AR
€1.00
€0.80 Loss per apple (€0.20)
Economic Loss
Apples per Day
Euros
100 200 300 400 500 600 700 800
From Short-Run Loss to Long-Run Equilibrium
What if we begin to make a loss?
In a competitive market, economic losses continue to cause
exit until losses are reduced to zero
When there are no significant barriers to exit, economic loss
will eventually drive firms from the industry, raising market
price until typical firm breaks even again
Supply curve in Perfect Competition
The Supply Curve is the quantity of a good that a firm will
produce at each price.
In Perfect Competition, a firm always produces where MC=AR
The SR supply curve is that part of the MC curve above AVC
curve (See P.112)
The LR supply curve is that part of the MC curve above AC
curve (See P.113)
Advantages of Perfect Competition
1. Consumer not exploited – Consumer buys at the lowest
price. This is the lowest price that the seller is willing to
make the product.
2. No waste of resources such as advertising.
3. Efficiency is encourages as any firm that cannot produce at
the lowest point on the AC goes out of business.
4. Consumer guaranteed to get the same quality and price for
the product…everywhere!
Disadvantages of Perfect Competition
1. No choice as goods are identical.
2. No economies of scale as most businesses are small
compared to market total. Therefore, higher prices for
consumers.
3. Firms only one step away from going out of business which
may discourage entrepreneurs from entering the market.
Is Perfect Competition realistic?
ANSWER = NO...BUT WHY?
1. There are barriers in every industry (e.g. setting up an
airline)
2. Goods are not identical (e.g. Coca Cola and Pepsi, Mac
lipstick and L’oreal lipstick)
3. Goods are not always the same price (e.g. petrol)
4. Many business’ in order to get established and become
popular will lower prices and undercut competition.
Perfect Competition is the economic equivalent of World
Peace. It doesn’t exist but is an ideal on which we can
compare the real world to.
