The document discusses the concept of perfect competition. It defines perfect competition as a market with many small firms, homogeneous products, free entry and exit, and perfect information. Under perfect competition in the short run, firms are price takers and will produce at the price that maximizes their profits where marginal revenue equals marginal cost. In the long run, perfectly competitive firms will earn only normal profits as entry and exit will cause prices to adjust until average costs are equal to prices.

1. Chapter 9
Perfect Competition
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2. Market





Defined as the institutional relationship between
buyers and sellers.
Interaction between buyers and sellers of a good (or
service) at a mutually agreed upon price.
Such interaction may be at a particular place, or may
be over telephone, or even through the Internet!
Sellers and buyers may meet each other personally,
or may not ever see each other, as in E-commerce.
Thus market may be defined as a place, a function, a
process.
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3. Market Morphology

Markets may be characterized on the basis of following
parameters:



Nature of competition: number, size and distribution of sellers in any
market
Nature of product: whether the product is homogeneous or
differentiated
Number and size of buyers:




large number of buyers but small size of individual buyer, the market
will be evenly balanced between buyers and sellers.
small number of buyers but their size is large, the market is driven by
buyers’ preferences.
Freedom to enter into or exit from the market: absence or presence
of financial, legal and technological constraints
Broad structures:




Perfect Competition
Monopoly
Monopolistic competition
oligopoly
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4. Type of
market
Number
of firms
Nature of
product
Number
of
buyers
Freedom of
entry and
exit
Examples
Perfect
competition
Very
Large
Homogeneous
(undifferentiated)
Very
Large
Unrestricted
Agricultural
commodities,
shares,
unskilled
labour
Monopolistic
competition
Many
Differentiated
Many
Unrestricted
Retail stores,
detergents
Oligopoly
Few
Undifferentiated
or differentiated
Few
Restricted
Cars,
computers,
universities
Monopoly
Single
Unique
Many
Restricted
Indian
Railways,
Microsoft
Monopsony
Many
Undifferentiated
or differentiated
Single
Not
applicable
Indian
defence
industry
Market Morphology
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5. Perfect Competition

A market where infinite number of sellers sell homogeneous good
to infinite number of buyers and buyers, and sellers have perfect
knowledge of market conditions
Features
 Presence of large number of buyers and sellers
 Homogeneous product
 Freedom of entry and exit
 Perfect knowledge
 Perfectly elastic demand curve
 Perfect mobility of factors of production
 No governmental intervention
 Firm is a price taker
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6. Demand and Revenue of a Firm
Marginal Revenue (MR) =P……(1)
Firms are price takers and can supply as much as they want at the
existing price in the market, thus:
AR= MR= P…………(2)
TC
TR
Revenue,
Cost, Profit
B
Profit
A
Q1
Q*
Q2
Output
Maximum
Profit
Π
Q1
Q*
Q2
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Output

7. Market Demand Curve and Firm’s
Demand Curve




The market demand curve for the whole industry is a
standard downward sloping curve.
An individual buyer is able to get the maximum
amount of output at each existing price, at a given
time.
The demand curve for an individual firm is a horizontal
straight line showing that the firm can sell infinite
volume of output at the same price.
The market demand curve is the horizontal summation
of individual demand curves.
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8. Demand Curve for Firm
Price
INDUSTR
Market Y
D
Demand
Price
S
Market
Supply
FIR
M
E
P*
S
P=AR=MR
D
O
Q*
Output
O
Output
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9. 



Market equilibrium is at the point of intersection of the market
demand and market supply curves, i.e. at E where equilibrium
output for the industry is given at Q and price at P*.
Each perfectly competitive firm, being a price taker, takes the
equilibrium price from the market as given at P*.
It can sell not even a single unit of its product at even a slightly
higher price. It is not worthwhile for the firm to offer any quantity at a
lower price either, since it can sell as much as it wants at the
prevailing market price.
Hence TR of a firm would increase at a constant rate, i.e. MR would
be constant.



Average Revenue will be equal to Marginal Revenue.
Since a firm can sell all it wants at this price, it faces a perfectly
elastic demand curve for its product hence the demand curve is
straight horizontal line.
Hence the demand curve coincides with the AR and MR curves.
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10. Equilibrium of Firm

Two conditions must be fulfilled for a profit maximizing firm to reach
equilibrium:

dπ
First order condition: MR=MC or ( dQ = dR(Q) − dC (Q)
)
dQ
dQ

Second order condition: Slope of MR curve < MC curve (

The second order condition is a sufficient condition.

In short run an individual firm may either earn



Supernormal profit:
Normal profit:
Losses:
AR>AC
AR=AC
AR<AC
10
dMR dMC
−
dQ
dQ
<0)

11. Calculus Corner: Equilibrium of Firm

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Total cost function of a competitive firm selling its product at Rs.
640 per unit is TC=240Q–20Q2 + Q3. Find the profit maximizing
output and the value of maximum profit.
Solution:
TC = 240Q–20Q2 + Q3
MC = 240 – 40Q + 3Q2
For profit maximization MR = MC.
Since this firm is in perfect competition P=MR=AR= 640
Solving for Q we get Q= - 20/3 (rejected) and 20 (accepted)
The equation for total profit is: Π = R(Q)-C(Q)= P.Q – 240Q–20Q 2
+ Q3
Substituting Q =20 in this equation we get: Π =16,000
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12. Supernormal Profit

Pri
ce
MC
P
*A
A
C


E
AR=
MR
B


O
Q*
Quan
tity
Firm is in equilibrium at
OQ* output at market price
P*, where both the
conditions of equilibrium
are fulfilled.
TR= OP*EQ* (TR= AR.Q)
TC= OABQ* (TC=AC.Q)
Profit = (OP*EQ* - OABQ*)
= AP*EB
This is the supernormal
profit made by the firm in
the short run, because the
market price P* (AR) is
greater than average cost.
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13. Normal Profit

Pri
ce
MC
P
*
A
C
E
AR=
MR




O
Q*
Quan
tity
Not
all
firms
earn
supernormal profits in the
short run; some of them
may also earn normal
profits (when revenue is
equal to cost).
TR= OP*EQ*.
TC= OP*EQ*.
TR=TC;
Firm makes normal profit,
and actually ends up
producing at the break
even level of output.
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14. Subnormal Profit (or Loss)


Pri
ce

MC
A
P
*
O
B
A
C
AR=
MR
E
Q*

Quan
tity
TR= OP*EQ*
TC= OABQ*.
Profit (Loss)= P*ABE
= OP*EQ* - OABQ*
The firm incurs loss or
subnormal profit in the
short run because the
average cost of producing
this output is more than
the ruling market price
hence TR<TC.
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15. Shut Down of Production

FIRM
Pri
ce
P*
M
C
A
A
C

AV
C
AR=
MR



O
Q*
A firm incurring losses in the
short run will not withdraw from
the market, but will wait for
market conditions to improve in
the long run.
Firm would continue production
till price > average variable cost
(AVC).
If AVC > AR the firm would shut
down.
Point A denotes the shut down
point, where price P* = AVC.
Any fall in market price below P*
will cause the firm to shut down.
Quantity
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16. Market Supply Curve and Firm’s Supply
Curve





Condition I: If Price<minimum AVC, then shut down
For such price, the supply curve would coincide with the
vertical axis.
Condition II: If Price≥ minimum AVC, then choose any
output that would maximize profit.
For any price above minimum AVC, the firm would
choose an output level that would satisfy the conditions
of profit maximization.
The supply curve of the firm would be identical to the
short run marginal cost curve above the minimum point
of the AVC curve.
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17. Long Run Equilibrium


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In the long run perfectly competitive firms earn only normal profits.
AR=MR=MC=AC
The reason is the unrestricted entry into and exit of firms from the
industry in the long run.
When existing firms enjoy supernormal profits in the short run new
firms are attracted to the industry to gain profits.
The supply of the commodity in the market increases. Assuming no
change in the demand side, this lowers the price level.
When firms are making losses in the short run, some may be forced
to leave the industry in the long run.
Their exit from the industry causes a reduction in the supply of the
product and as a result the equilibrium price rises.
This process of adjustment continues up to the point where the price
line becomes tangential to the AC curve.
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18. Long Run Equilibrium
Pric
e
P1
LMC1
O
LM
C
E1
P*
LAC1
AR=M
R
E
Q1
Q*
LA
C
Quanti
ty
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19. Summary
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
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A market is a place / process of interaction between sellers and buyers that facilitates
exchange of goods and services at mutually agreed upon prices.
Perfect competition is defined as a market structure which has many sellers selling
homogeneous products at the market price.
The equilibrium price is determined by demand and supply in the market
Each firm sells a very small portion of the total industry output; hence it can not affect
the price in the market and has to accept the price given to it by the market. As such,
it is regarded as a “price taker”.
A firm faces a perfectly elastic demand curve; hence average revenue is constant
and is equal to marginal revenue.
Profit maximizing output is that where marginal cost is equal to marginal revenue
while marginal cost is increasing.
In the short run firms can earn supernormal profits, or normal profits, or even loss.
This depends on the position of the short run cost curves.
The supply curve of the firm would be identical to the short run marginal cost curve
above the minimum point of the AVC curve.
The industry supply curve is obtained by the horizontal summation of the supply
curves of all firms in the industry.
In the long run perfectly competitive firms earn only normal profits. If firms are making
supernormal profits in the short run, this would attract new firms and if firms are
incurring losses; some firms would exit the market, leaving existing firms with normal
profits in either case.
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