Perfect Competition

Ch. 20, Economics 9th Ed, R.A. Arnold

Introduction

In Microeconomics one of our interests is the decision-

making of business firms.
A firms decision making (pricing and output decisions)
will depend upon the characteristics of the market in
which it sells its products.
In Ch 20 we look at the perfectly competitive market
(where perfect competition happens) and how it affects
the pricing and output decisions of a firm in this market.
A firm or seller in this market is called the perfectly
The Perfectly Competitive Market
The Perfectly Competitive Market has the following characteristics:
1) There are many sellers (firms) and many buyers, and each is only a small
part of the market. They act independently of one another. And hence none
can influence the price in the market.
2) Each firm produces and sells a homogenous product. Each firm sells a
product that is indistinguishable from all other firms products in a given
industry (e.g. Rice, sugar, eggs, other agricultural products). Hence buyers are
indifferent to the sellers (it doesnt matter to them from which seller they buy
the good).
3) Buyers and sellers have ALL relevant information about price, product
quality, sources of supply and so forth.
4) Firms have easy entry and exit . There are no barriers to entry and exit from
the industry.
As a consequence of the first three assumptions, a seller
(firm) in the perfectly competitive market (a perfectly
competitive firm) is a price taker, which means it sells all
of its product at the price determined in the market.
Why?
Due to (1) the firm cannot influence the price. It cannot
charge a higher price due to assumptions (2) and (3).
And there is no incentive to charge a lower price since
they can sell all their products at the market price (there
are many buyers). Hence a firm in a perfectly competitive
market or the perfectly competitive firm is a price-
taker.
So, the demand curve of the firm is a horizontal line
drawn at the price given by the market. The graphical
The Marginal Revenue (MR) Curve of a Perfectly
Competitive Firm is the Same as Its Demand Curve

The title of the slide says it all. Although we should

understand why.
Remember: The marginal revenue (MR) is the additional
revenue a firm earns from selling one additional unit of
output. If a firm sells an additional output at $5 what is
the additional revenue the firm earns?
Revenue = price x quantity. Here, quantity = 1, P = $5.
So the marginal/additional revenue (MR) = 5 x 1 = $5 =
P. Hence, P = MR for a perfectly competitive firm. And
the MR curve is a horizontal line drawn at the market
given price but so is the demand curve (d), hence they
What level of output does the
perfectly competitive firm produce?
Remember: the objective of any firm is to maximize profit. Therefore,
the perfectly competitive firm produces the output at which the
marginal revenue = marginal cost, MR = MC. Since, P = MR in perfect
competition, profit maximization occurs when: P = MR = MC. Therefore,
P = MC.
Resource Allocative Efficiency: The situation when firms produce the
quantity of output at which price equals marginal cost, P = MC. Note:
the perfectly competitive firm produces the output at which P = MC and
hence it is resource allocative efficient.
This means that all units of a good are produced that are of greater
value to buyers than alternative goods that might have been produced
using the same resources.
Case 1, 2 and 3 (p. 466 7, 9 th Ed)
Case 1, 2 & 3: study the production of a perfectly competitive firm in the
short-run (You should study them from the textbook. Here we look at the
summary of the discussions)
Case 1: If, Price (P) > Average total cost (ATC) > Average variable cost, then
the firm will produce
Case 2: If, P < average variable cost (AVC) then the firm will shut down
Case 3: If, P > AVC but P < ATC then the firm will produce
So we can conclude if P > AVC then the firm continues production in
short-run, if P < AVC it shuts down, in the short run. Here, P = MC.
Therefore, the firm only produces (supplies) when MC > AVC. The supply
curve of the perfectly competitive curve is that portion of the MC curve that
lies above the AVC curve.
Perfect Competition in the Long Run
The following are the conditions of the long run equilibrium in a perfectly

competitive market (a.k.a Lon-Run Competitive Equilibirum Conditions):

1)Normal or Zero Economic Profit i.e. P = SRATC (price = short run

average total cost). Hence existing firms do not exit the industry and new

firms do not enter the industry. So, supply doesnt change.

2)Individual firms are producing the profit maximizing output: P = MR

= MC. Hence no incentive for individual firms to change the quantity

supplied (output). So total output (sum of the individual firms output) in

the industry does not change as well.

The last three conditions ensure that the supply is constant (the supply
curve does not shift). But we have not specified any conditions that will
keep the demand constant. So the demand curve might shift (due to
factors discussed in Ch. 3) and this will cause the perfectly competitive
market to move out of equilibrium. How will it go back to equilibrium?
Lets assume, the perfectly competitive market is in equilibrium (figure
next page). P = SRATC: All firms earn zero profit. Then, the number of
buyers increases so demand curve shifts right (figure 1 next page). The
equilibrium price increases. New price > SRATC. So there is positive
economic profit in the short run which attracts new firms/sellers (they
enter the market easily, since there are no barriers to entry). The
supply in market increases , the supply curve shifts right (fig 6) and the
price decreases until P = SRATC: Zero economic profit (fig 7). New firms
stop entering the market and the market moves back to a new
equilibrium.
The Perfectly Competitive Firm and
Productive Efficiency (p. 473 9th ed.)
Productive Efficiency: Occurs when a firm produces its output at
the lowest possible cost per-unit cost (lowest average total cost).

This is desirable for any society since it means the firm is

efficiently using the limited resources of the society (i.e.
obtaining the maximum output using the given resources).

In the LR a perfectly competitive firm is productive

efficient (i.e. P=MC=SRATC=LRATC is only possible if the firms
are productive efficient). A benefit of perfect competition.