Perfect competition

1. E.Sunil Kumar, MBA, NET, Ph.D
Asso. Prof,
Dept of MBA,
Global Institute for Management

2. 1. PERFECT COMPETITION: A
MODEL
Learning Objectives
1. Explain what economists mean by
perfect competition.
2. Identify the basic assumptions of
the model of perfect competition
and explain why they imply price
taking behavior.
Market structure can range
from perfect competition and
one end of the continuum to
Market structure can range
from perfect competition and
one end of the continuum to
monopoly at the other.
monopoly at the other.
• Perfect competition is a model of the market
based on the assumption that a large number of
firms produce identical goods consumed by a large
number of buyers.

3. 1.1 Assumptions of the Model
• Price takers are individuals or firms who must take
the market price as given.
• Identical goods
• A large number of buyers and sellers
• Ease of entry and exit
• Complete information

4. 1.2 Perfect Competition and
the Real World
• The perfectly competitive model has strong
assumptions.
• When we use the model we assume market forces
determine prices.
• We can understand most markets by applying the
supply and demand model.
• With this framework we can see how competition
affect firms, consumer, and markets.

5. 2. OUTPUT DETERMINATION
IN THE SHORT RUN
Learning Objectives
1. Show graphically how an individual firm in a perfectly
competitive market can use total revenue and total cost curves
or marginal revenue and marginal cost curves to determine the
level of output that will maximize its economic profit.
2. Explain when a firm will shut down in the short run and when it
will operate even if it is incurring economic losses.
3. Derive the firm’s supply curve from the firm’s marginal cost
curve and the industry supply curve from the supply curves of
individual firms.

6. 2.1 Price and Revenue
S
D
• Total revenue is a firm’s output multiplied by the
price at which it sells that output.
EQUATION 2.1 TR = P´Q
TTRR = = $ $00.4.400**1100 = = $ $44

7. Total Revenue, Marginal
Revenue, and Average Revenue
Slope=0.4
Slope=0.2
TTRR, ,P P==$$00.6.600
TTRR, ,P P==$$00.4.400
TTRR, ,P P==$$00.2.200
0.60 = MR = AR = P
0.40 = MR = AR = P
0.20 = MR = AR =
P
Slope=0.6

8. Price, Marginal Revenue, and
Average Revenue
• Marginal revenue is the increase in total revenue from
a one-unit increase in quantity.
• Average revenue is total revenue divided by quantity.
AR = TR = P ´ Q
=
EQUATION 2.1 P
Q
Q
• Marginal revenue, price, and demand for the perfectly
competitive firm

9. Price, Marginal Revenue, and
Average Revenue
A perfectly competitive firm
faces a horizontal demand
A perfectly competitive firm
faces a horizontal demand
curve.
curve.

10. 2.2 Economic Profit in the
Short Run
Economic profit, which equals total
Economic profit, which equals total
revenue minus total costs, is
maximized at an output of 6,700
pounds of radishes per month
revenue minus total costs, is
maximized at an output of 6,700
pounds of radishes per month
1,500
6,700 $938
2,680
1,742
TTootatal lR Reevveennuuee
TTootatal lC Coosstt
The slope of a line drawn
tangent to the total cost
curve at 6,700 pounds is
equal to 0.4, which is also
equal to the slope of the
total revenue curve. The
slope of the total cost
curve is marginal cost;
the slope of the total
revenue curve is marginal
The slope of a line drawn
tangent to the total cost
curve at 6,700 pounds is
equal to 0.4, which is also
equal to the slope of the
total revenue curve. The
slope of the total cost
curve is marginal cost;
the slope of the total
revenue curve is marginal
revenue.
revenue.

11. 2.3 Applying the Marginal
Decision Rule
Producing to maximize
economic profit.
• Economic profit per unit is the difference between
price and average total cost.
PPrroofifti t= = $ $993388
6,700 $0.14
0.26
MC
MR
ATC
Producing to maximize
economic profit.

12. 2.4 Economic Losses in the
Short run
• Economic loss is the amount by which a firm’s total cost
exceeds its total revenue.
Producing to minimize
economic loss.
Producing to
maximize economic
profit.
TTootatal ll olossss = = $ $222222.2.200
4,444
0.23
.018
0.14
MC
MR1
ATC
AVC
MR2
Producing to minimize
economic loss.
0.18
A fall in
demand
A fall in
demand
2.1 10
Producing to
maximize economic
profit.

13. 2.4 Economic Losses in the
Short run
• The shutdown point is the minimum level of average
variable cost, which occurs at the intersection of the
marginal cost curve and the average variable cost curve.
minimize economic loss
1,700
0.14
MC
ATC
AVC
MR3
Shutting down to
Shutting down to
minimize economic loss

14. 2.5 Marginal Cost and Supply
MC
AVC
Industry
supply
14 17 19 280 330 380

15. 3. PERFECT COMPETITION IN
THE LONG RUN
Learning Objectives
1. Distinguish between economic profit and accounting profit.
2. Explain why in long-run equilibrium in a perfectly competitive
industry firms will earn zero economic profits.
3. Describe the three possible effects on the costs of the factors of
production that expansion or contraction of a perfectly
competitive industry may have and illustrate the resulting long-run
industry supply curve in each case.
4. Explain why under perfection competition output prices will
change by less than the change in production cost in the short
run, but by the full amount of the change in production cost in
the long run.
5. Explain the effect of a change in fixed cost on price and output
in the short run and in the long run under perfect competition.

16. 3.1 Economic Profit and
Economic Loss
• Economic versus accounting concepts of profit and loss
– Explicit costs are changes that must be paid for
factors of production such as labor and capital.
– Accounting profit is profit computed using only
explicit costs.
– Implicit cost is a cost that is included in the
economic concept of opportunity cost but that is not
an explicit cost.
• The long run and zero economic profits

17. Eliminating Economic Profits in
the Long Run
When firms enter supply shifts
right and MR shifts down
PPrroofifti t= = $ $993388
6,700
0.26
MC
MR1
ATC
When firms enter supply shifts
right and MR shifts down
$0.22 $0.22
MR2
13
S1
S2
D

18. Eliminating Economic Losses in
the Long Run
When firms exit supply shifts
left and MR shifts up
LLoossss
P2 P2
P1
MC
ATC
MR2
When firms exit supply shifts
left and MR shifts up
MR1
Q1
S2
S1
D
Q2
P1
C1
q1 q2

19. 3.1 Economic Profit and
Economic Loss
• Entry, Exit, and Production Costs
– Constant-cost industry are changes that must be
paid for factors of production such as labor and
capital.
– Increasing-cost industry is profit computed using
only explicit costs.
– Decreasing-cost industry is a cost that is included
in the economic concept of opportunity cost but that is
not an explicit cost.
– Long-run industry supply curve is a curve that
relates the price of a good or service to the quantity
produced after all long-run adjustments to a price
change have been completed.

20. 3.1 Economic Profit and
Economic Loss
SCC
SIC
SDC

21. 3.2 Changes in Demand and in
Production Cost
An increase in demand increases
profitability which leads to an
increase in supply.
B
$2.30
A
1.70 C
D2
D1
S2
S1
Q Q3 Q 2 1
$2.30
1.70
B?
A?
MC
ATC
MR2
MR1
qq 2 1
An increase in demand increases
profitability which leads to an
increase in supply.

22. 3.2 Changes in Demand and in
Production Cost