CHAPTER 7

Perfect competition

KEY POINTS

Market structures
Characteristics of perfect competition
Perfectly competitive firm as a price taker
Profit maximisation condition
Short-run profit and losses
Shutdown rule
Long-run equilibrium
Three types of long-run supply curves

MARKET STRUCTURES
Market structure classifies some of the key
traits of a market, including:
the number of firms
the similarity of the products sold
the ease of entry into and exit from the market.

This chapter is concerned with how the

perfectly competitive market determines prices,
output and profits.

MARKET STRUCTURES

PERFECT COMPETITION

LARGE NUMBER OF SMALL FIRMS

A perfectly competitive market is made
up of thousands of small firms.
Firms act independently.
As no firm produces a significant share
of total output, no firm can, by itself,
affect the market price firms in this
market are known as price takers.

HOMOGENEOUS PRODUCT
Homogeneous products mean products
from one firm cannot be distinguished
from another.
Buyers are indifferent as to whose
product they buy.
Goods or services of all the firms are
identical.

VERY EASY ENTRY AND EXIT

New firm face no barriers to its entry into that
market.
In perfectly competitive markets there are no
barriers to entry or exit into the market.

IS THIS A REAL-WORLD MARKET?

No real-world market exactly fits the
perfect competition assumptions.
But some markets do approximate the
model fairly closely.
Examples: farm product markets, the
interstate road transport market, lawnmowing or cleaning markets.

PROMOTING COMPETITION AND

FAIR TRADING IN AUSTRALIA
The Australian Competition and Consumer
Commission (ACCC) promotes competition,
fair trade and consumer protection in Australia.
In New Zealand the Commerce Commission
has similar objectives.
Government competition policies aim to
encourage industries to become more efficient
by behaving as if they were competitive.

THE PERFECTLY COMPETITIVE

FIRM AS A PRICE TAKER
A price taker is a seller that has no control over
the price of the product it sells.
Costs are the only thing that it can control.

THE INDIVIDUAL FIRMS

DEMAND CURVE
Consequently the individual firm has a
horizontal (perfectly elastic) demand curve.
Being only one of many small firms, it would
sell nothing if it set the price above the
prevailing market price.
It would not drop its price because it can sell all
it wants to at the prevailing price.

THE MARKET PRICE AND

DEMAND FOR THE PERFECTLY
COMPETITIVE FIRM

SHORT-RUN PROFIT MAXIMISATION

Question: Since the perfectly competitive
firm has no control over price, what does
the firm control?

Answer: The quantity of output to produce

that maximises profit.

PROFIT MAXIMISATION
CONDITION

TOTAL REVENUETOTAL COST

METHOD
Exhibit 7.3 shows a hypothetical data of a
perfectly competitive firm.
From the table, the TR-TC method shows the
firm facing a:
loss if it produces between 0 and 2 units per hour
rising profit between 3 and 9 units of output per hour
profit falls after that.

TOTAL
REVENUE
TOTAL COST
METHOD

TOTAL REVENUETOTAL COST

METHOD
Exhibit 7.4 illustrates graphically that
maximum profit occurs where the vertical
distance between the total revenue and
total cost curves is at a maximum.

TOTAL REVENUETOTAL COST

METHOD

MARGINAL REVENUE EQUALS

MARGINAL COST METHOD
Marginal revenue is the change in total
revenue from the sale of one additional
unit of output.
Marginal cost is the change in total cost
from the production of one extra unit of
output.

MARGINAL REVENUE EQUALS

MARGINAL COST METHOD
The firm maximises profit by producing
the output where marginal revenue
equals marginal cost (MR=MC).
Exhibit 7.5 shows how use of the
marginal revenue curve equals marginal
cost rule leads to profit maximisation.

MARGINAL REVENUE EQUALS

MARGINAL COST METHOD

MARGINAL REVENUE EQUALS

MARGINAL COST METHOD
From Exhibit 7.5, between eight and nine units of
output, the MC curve is below the MR curve ($59 < $70
as shown in Exhibit 7.3). Profit rises as we increase
output because a rise in output adds more to revenue
than it does to cost.

MARGINAL REVENUE EQUALS

MARGINAL COST METHOD
From Exhibit 7.5, beyond nine units of output, the MC
curve is above the MR curve and the profit curve falls.
Between nine and ten units of output, MC is $75 and
MR is $70. (Profit falls)

MARGINAL REVENUE EQUALS

MARGINAL COST METHOD
Thus, if the firm produce nine units of output,
the MR curve equals the MC curve and profit is
maximised.
To maximise profits, the firm should produce at
the point where MR = MC.

SHORT-RUN PROFIT
If P > ATC, and the
firm is producing a
level of output
where MR = MC,
the firm is
maximising profits
in the short run.

SHORT-RUN LOSS
If P < ATC, and the
firm is producing a
level of output
where MR = MC,
the firm is
minimising losses
in the short run.

SHUTDOWN RULE
If P < AVC, the
revenue from
each unit
produced fails to
cover the variable
cost/s of
production.
The firm should
shutdown.

FIRMS SHORT-RUN
SUPPLY CURVE
The perfect
competitors supply
curve is equal to
the firms MC curve
above the
minimum point of
the AVC curve.

INDUSTRYS SHORT-RUN
SUPPLY CURVE

SHORT-RUN EQUILIBRIUM

LONG-RUN EQUILIBRIUM

LONG-RUN EQUILIBRIUM
Long-run equilibrium occurs at the
market price that enables firms to make
a normal profit.

LONG-RUN EQUILIBRIUM

THREE TYPES OF LONG-RUN

SUPPLY CURVES

CONSTANT-COST INDUSTRY

DECREASING-COST INDUSTRY

INCREASING-COST INDUSTRY