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1. Perfect Competition

2. 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 market
Product (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.

3. 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

4. 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

5. 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

6. Assumptions…..
• All buyers and sellers have EQUAL INFORMATION
• Profit Maximization is the GOAL of firm
• Perfect Mobility of Factors of Production
• No government Regulation

7. 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

8. 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

9. 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 Uranium
Gold: Countless buyers and purchases of
each buyer is very small as compared to
world stock

10. 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 sellers
Ex: Pharmaceutical Industry –not perfectly competitive.
(Investment in R &D or Substantial License fee to produce a drug restricts entry for
new firms)

11. 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.

12. Profit Maximization
The 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

13. 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……

14. Total Revenue: Competitive Firm
Rs25
Rs20
Rs15
Rs10
Rs 5
Rs
Quantity
Total Revenue
1 2 3 4 5
Marginal
Revenue

15. 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

16. 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

17. 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)

18. 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 Even
2 35 70 60 10
3 35 105 75 30
3.5 35 122.5 91 31.5 Profit Max
4 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

19. 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>MC
1.5 35 10 35 0 0 MR>MC
2 35 11 30 5 10 MR>MC
3 35 25 25 10 30 MR>MC
3.5 35 35 26 9 31.5 MC=MR
4 35 50 27.5 7.5 30 MR<MC
5 35 35 0 0
5.5 35 40 -5 -27.5
Source: Salvatore, Dominick (2003): Microeconomics, Theory & Applications
Oxford University Press

20. 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

21. The Competitive Firm
dRs4
Output
(bushels)
Price
Rs per
bushel
100 200
Firm Industry
D
Rs4
S
Price
Rs per
bushel
Output
(millions
of bushels)
100

22. 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 )(

23. 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)

24. q2
A Competitive Firm
10
20
30
40
Price
50
MC
AVC
ATC
0 1 2 3 4 5 6 7 8 9 10 11
Outputq*
AR=MR=P
A
q1 : MR > MC
q2: MC > MR
q*: MC = MR
q1
Lost Profit
for q2>q*Lost Profit
for q1<q*

25. A Competitive Firm – Positive Profits
10
20
30
40
Price
50
0 1 2 3 4 5 6 7 8 9 10 11
Outputq2
MC
AVC
ATC
q*
AR=MR=P
A
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

26. A Competitive Firm – Losses
Price
Output
MC
AVC
ATC
P = MRD
At q*: MR =
MC and P <
ATC
Losses =
(P- AC) x q*
or ABCD
q*
A
B
C

27. 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)

28. 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

29. A Competitive Firm’s
Short-Run Supply Curve
Price
($ per
unit)
Output
MC
AVC
ATC
P = AVC
P2
q2
The firm chooses the
output level where P = MR = MC,
as long as P > AVC.
P1
q1
S
Supply is MC
above AVC

30. A Competitive Firm’s
Short-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

31. •
Industry Supply in the Short Run
$ per
unit
SThe short-run
industry supply curve
is the horizontal
summation of the supply
curves of the firms.
Q
15 21
P1
P3
P2
1082 4 75

32. 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

33. q1
B
C
AD
In the short run, the
firm is faced with fixed
inputs. P = $40 > ATC.
Profit is equal to ABCD.
Output Choice in the Long Run
Price
Output
P = MR$40
SAC
SMC
q3q2
$30
LAC
LMC

34. Output Choice in the Long Run
Price
Output
q1
B
C
AD
P = MR$40
SAC
SMC
q3q2
$30
LAC
LMC
In the long run, the plant size will be
increased and output increased to q3.
Long-run profit, EFGD > short run
profit ABCD.
FG
E

35. 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

36. Long-Run Competitive Equilibrium – Profits
S1
Output Output
$ per
unit of
output
$ per
unit of
output
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-Increase
in Production-Market Supply Curve
Shifted to S2 (Output Rises)- Price falls
to $30 (equal to Average Cost of Production)

37. Long-Run Competitive Equilibrium – Losses
S2
Output Output
$ per
unit of
output
$ per
unit of
output
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. Price
Rise to reach break-even ($30)

38. Long-Run Competitive Equilibrium
1. All firms in industry are maximizing profits
– MR = MC
2. No firm has incentive to enter or exit
industry
– Earning zero economic profits
3. Market is in equilibrium
– QD = QS

39. MC2
q2
Input cost increases
and MC shifts to MC2
and q falls to q2.
MC1
q1
The Response of a Firm to
a Change in Input Price
Price
($ per
unit)
Output
$5
Savings to the firm
from reducing output

40. Thanks a lot