CHAPTER 10

Perfect competition

Dr Jacques de Jongh
Jacques.dejongh@nwu.ac.za
(016) 910 3524
Learning outcomes
• State the assumptions of perfectly competitive firm
• Explain the demand curve of a perfect competition
• Explain why P=AR=MR for a perfect competitor
• Explain the theoretical differences between the four market structures
• Explain the equilibrium conditions for any firm
• Graphically illustrate the short-run profit maximising of a perfectly competitive firm (also
calculate and discuss it)
• Explain the short-run equilibrium position of a firm under a perfect competitive market
• Illustrate the lowest point at which a producer will continue production by means of
graphs
• Derive and explain the supply curve of a perfect competitive producer
• Illustrate and explain profit maximisation of the perfect competitor in the long-run
• Explain long-run equilibrium of a frim and the industry under perfect competition
Introduction
• Chapter 9 introduced production and cost theory, where costs are derived from
production.
• Cost theory is now combined with the analysis of revenue to create the theory of
the firm.
• More specifically, the theory of a firm aims to determine how much a firm will
produce and at what price it sells its output on the assumption that it wishes to
maximise its profits.
• Total profit = TR – TC, where TC includes implicit costs
• TR = Q x P and TC = AC x Q
• But how is the price determined? That depends on the market structure
 Perfect competition is the ideal situation. It serves as a
benchmark against which the other market structures can be
compared
TABLE 10-1: Summary of market structures (Textbook page 180[164])
Two decisions..

d we
ho u l e ?. .
S d u c
pr o u ch
m
how e ? . .
y es, oduc
If pr
t o

These decisions have to be taken by ALL firms

1) The equilibrium conditions (Applies to ALL firms, regardless of
the market structures in which they operate)
Shut-down
rule
Produce only
if
TR >= TVC
AR >= AVC 2
Profit
Rule
maximization
MR = MC
s
TR > TC
(greatest +
difference)
2) Perfect Competition
• Perfect competition occurs when none of the individual market
participants can influence the price of the product (demand & supply
determine price)
• Thus, firms in this market structure are known to be price takers
• NB! 7 assumptions
• Examples in real world markets are limited, but can include agriculture,
maize, meat and fish markets.
• International commodity markets where there are a number of buyers
and sellers selling and buying at the market price.
2.1) Assumptions / Requirements

2.1.1) Very Large Numbers

2.1.2) Homogenous / identical goods
2.1.3) No collusion

2.1.4) Free entry and exit from market

2.1.5) Full knowledge & information to all
participants

2.1.6) No government intervention

2.1.7) Full mobility of production factors
 2.2) The demand for the product of a perfectly
competitive firm

• The demand curve is perfectly elastic (horizontal) at the existing market

price (pg184-185)
• The producer cannot influence the market price (price taker) but can still
decide what quantity they will like to sell at that given price
• The horizontal demand curve implies that if the producer asks a higher
price, he/she will sell no products, because other producers supply the
same product more cheaply
• He/she would also not ask a lower price, because consumers are willing
to pay a higher price, which increases profits. At a lower price,
production costs will usually not be covered in the long run and the firm
would become bankrupt
Figure 10-2
P = AR = MR = D

Demand
curve

=D

Industry Individual Firm

(See page 185/box 10-2)

 How is MR = P???
R1179
Firm’s Firm’s TR
Demand Revenue 1048
Schedule Data
(Average
Revenue) 917
P QD TR MR

Price and Revenue

786
R131 0 R0
] R131 655
131 1 131
] 131
131 2 262
] 131
131 3 393 524
] 131
131 4 524
] 131
131 5 655 393
] 131
131 6 786
] 131 262
131 7 917
] 131 D = MR = AR
131 8 1048
131 9
] 131 131
1179
131 10 1310
] 131
2 4 6 8 10 12
Quantity Demanded (Sold)
2.3) The equilibrium of the firm under perfect competition

• The same as other market structures (Remember the profit

maximisation rule)
• Profit max. where:
o MR = MC, provided MC is rising and lies above minimum AVC
o Positive difference between TR and TC is at a maximum
 2.3.1) Marginal Revenue – Marginal Cost Approach

The relation between MR & MC contains NB information for the firm:

o MR > MC
• The firm is still making profit on the last unit produced, thus it can add to
its profit
• Expanding output/production
o MR = MC
• Profits are maximised
o MR < MC
• The firm will make a loss and therefore profits will decrease
• Output should be reduced
Example: Table 10-2 (Profit is maximised at the 4th unit where MR=MC)
 STUDY UNIT 5.2
CHAPTER 10[B]

Perfect Competition
 Figure 10-3
• (lower prices) i.e. At points (a), (b) & (c):
o MR is greater than MC, but profit is still not
maximised.
Therefore a firm can still add to its profit by expanding until no
extra profit is made on the last unit produced
• (market price) i.e. At point (d):
o MR = MC (Maximum profit).
o Profits are greater than profits attained at point a to c.
• (higher prices) i.e. At point (e):
o MC > MR.
o Profits are lower and therefore the firm must reduce
its output back to the profit maximizing position (i.e.
point d).
2.3.2) Total Revenue - Total Cost Approach

Price = R131
(1) (2) (3) (4) (5) (6)
Total Product Total Fixed Total Variable Total Cost Total Revenue Profit (+)
(Output) (Q) Cost (TFC) Cost (TVC) (TC) (TR) or Loss (-)

0 R100 R0 R100 R0 R-100

1 100 90 190 131 -59
2 100 170 270 262 -8
3 100 240 340 393 +53
4 100 300 400 524 +124
5 100 370 470 655 +185
6 100 450 550 786 +236
7 100 540 640 917 +277
8 100 650 750 1048 +298
9 100 780 880 1179 +299
10 100 930 1030 1310 +280
Do You
Now SeeGraph
Let’s Profit The
Maximization?
Results…
2.3.3) Three possible short-run equilibrium positions of a perfectly
competitive firm

Economic profit, Break even or Economic loss

Figure 10-4

NB! For as long as AR is greater than

AC, the firm is earning an economic
profit.
 Remember P = MR = AR

 Profit is maximised where MR =

MC (at E1)

 This occurs at Q1 where the

firm's AR > AC

 The firm thus makes economic

profit equal to shaded area
 The firm break evens (i.e.
earns only normal profit)

 AR = AC
 At Q3, AR < AC and therefore the firm
incurs economic loss (shaded area)

NB – Whether or not the firm should continue

production will depend on the level of P (=AR)
relative to the firm's AVC:

o Price P (=AR) lies above the minimum

AVC (not shown in the figure)  Continue
production in the short run since the firm
can still cover its average variable cost such
as wages.

o If price P (=AR) lies below the minimum

AVC, The firm will shut down since it cant
pay the variable costs like wages from the
sale of its product. (You can’t expect
workers to work without pay!)
SUMMARY: Box 10-1 pg. 167

P=AR>AC

P=AR>AVC

P=AR<AC

P=AR<AVC
2.4) The supply curve of a perfectly competitive firm

• The supply curve is the rising section of the MC

curve above the minimum of the AVC curve (above
the shut-down point)
• Shows various Q that will be supplied at different
prices
• Remember P = AR = MR
• P5 – the firm would not produce at all (price is below
AVC)
• P4 – the firm will be at its shut-down point (If price P
is below)
• P3 – the firm minimise its economic loss by producing
a quantity Q3—point c
• P2 – the firm is making normal profit (breakeven)
• P1 – maximise economic profit at point e
 3) Long-run equilibrium of the firm and the industry
under perfect competition

• All PFs variable

• New firms can enter/existing firms can exit

• Abnormal Profit (Fig 10-7)

• more firms enter market
• Market SUPPLY shifts right
• Price decreases, reduces profit

• Economic Loss (Fig 10-8)

• Firms exit market
• Market SUPPLY decreases
• Price increases … normal Profit

• The industry will therefore be in equilibrium in the long run only if all the firms are
making normal profits
3.1) The firm and industry in long-run equilibrium
Normal Profit
MR = MC and
AR = AC at
the same
quantity

The reason why

price is labelled P2
will become clear
as we proceed
3.1.1) The individual firm and the industry when the firm initially earns economic
profit
3.1.1) The individual firm and the industry when the firm initially earns economic
profit
3.1.2) The individual firm and the industry when the firm initially makes an
economic loss
3.1.2) The individual firm and the industry when the firm initially makes an
economic loss
 SUMMARY – CHAPTER 10[11]
• 2 Rules (valid for all market structures)
• Price taker (PC) …
o Price set by MARKET
o DEMAND is horizontal at Pm
o 7 Prerequisites for PC
o Profit Max @ MR = MC OR where the difference between TR and TC is the greatest
• SR (Short Run)
• Economic Profit (P/AR > AC)
• Normal Profit (P/AR = AC)
• Economic Loss (P/AR < AC)
• LR (Long Run)
• ONLY normal profit
• Firms can exit/enter
• Profit Max @ P = SRMC = SRAC = LRAC