Lecture 7 – Perfectly Competitive Market

When we know the cost curve of the firm, we can turn to the fundamental problem: how
much should be produced? The answer to this question depends, among the others, on the
market structure. We will see how a perfectly competitive firm chooses the level of output
that maximises its profit. We will next examine how the firm’s output choice changes as the
cost of production changes. In this way we will show how to derive the firm’s supply curve.

Model of a perfectly competitive market

The model of perfect competition rests on three assumptions: price taking, product
homogeneity, and free entry and exit.

Price taking – many firms compete in the market, and therefore each firm faces a significant
number of direct competitors for its products. As a result, there is very little room to negotiate
with the firm’s customers. If the firm does not offer a competitive price – the price which is
determined on the market – the customers will go and purchase products elsewhere.
Additionally, the firm realises that it sells a very small portion of total market output and that
its decisions have no impact on market price. Thus each firm takes the market price as
given – it is a price taker. The assumption of price taking applies also to consumers. In a
perfectly competitive market, each consumer buys such a small portion of total output that he
or she has no impact on the market price.

Product homogeneity – price-taking behaviour is typical for markets where firms produce
identical, or nearly identical, products. When the products of all the firms in the market
are perfect substitutes – they are homogenous – no firm can raise the price of its product
above the price of other firms without loosing its customers. Most agricultural products
are homogenous. Because product quality is similar among farms in a given region, buyers of
–for example – potatoes do not ask which individual farm produced the product. Similarly,
raw materials like oil, copper iron and so on are fairly homogenous.

Free entry and exit – there are no special costs that make it difficult for a new firm either to
enter an industry and produce or to exit it if it is not able to make a profit. As a result, buyers

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can easily switch from one supplier to another, and suppliers can easily enter or exit a
market. The assumption of free entry and exit is important for competition to be effective. It
means that consumers can easily switch to a rival firm if a current supplier raises the price.
For a firm, this means that it can freely enter an industry if it sees a profit opportunity and exit
if it looses money.

Profit maximisation

Demand and revenues for a competitive firm

Because each firm in a competitive industry sells only a small fraction of the entire industry
sales, how much output the firm decides to sell will have no effect on the market price of
the product. As the firm is a price-taker, the demand curve facing an individual
competitive firm is given by a horizontal line (Figure 1). The curve is horizontal because
the firm’s sales will have no effect on price. For example, when a farmer decides how much
corn to plant in a given year, he can take the market price of corn as given because that price
will not be affected by his decision how much to produce. Even if the farmer increases his
output by 10 or 20 tons of corn, this will have almost no effect on the market because the
whole industry output is much higher, say 100 million tons.

This also means that when an individual firm faces a horizontal demand curve, it can sell
an additional unit of output without lowering the price. Therefore total revenue (TR=pQ)
increases proportionally to the increase in output, as the price remains constant. The total
revenue curve is an upward sloping, straight line. As a result, the firm’s total revenue (TR)
increases by an amount equal to price: one ton of corn sold for 400 zl yields additional
revenue of 400 zl. Thus, marginal revenue (∆TR/∆Q) is constant at 400 zl. At the same
time, average revenue (TR/Q) received by the firm is also constant and equal to 400 zl as
every ton of corn will be sold at 400 zl. Therefore, the demand curve facing an individual
firm in a competitive market is both its average revenue curve and its marginal revenue
curve. Along this demand curve, marginal revenue, average revenue, and price are all
equal.

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 Table 1. Demand and revenues for a competitive firm

Q p TR = p⋅Q AR = TR/Q MR = ∆TR/∆Q

0 400 0 - -
1 400 400 400 400
2 400 800 400 400
3 400 1200 400 400
4 400 1600 400 400
5 400 2000 400 400

Figure 1. Demand and revenue curves for a competitive firm

Choosing output in the short run

Total profit of any firm is a difference between total revenue and total cost. To maximise
profit, the firm selects the output for which the difference between revenue and cost is the
greatest. Profit, Π = TR-TC is maximised at the point at which an additional increase of
output leaves profit unchanged (∆Π/∆Q = 0). Then

∆Π/∆Q = ∆TR/∆Q - ∆TC/∆Q = 0

As ∆TR/∆Q is marginal revenue MR, while ∆TC/∆Q is marginal cost MC, then

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 MR - MC = 0

and finally
MC=MR

Because the demand curve facing an individual firm is horizontal, so that marginal revenue
equals to price (MR = p), the general rule for profit maximisation that applies to any firm, can
be simplified. A perfectly competitive firm should chooses its output so that marginal
cost equals price

MC = p

In the short run, a firm operates with a fixed amount of capital and must choose the level of its
variable inputs (labour in our example) to maximise profit. Table 2 shows the firm’s short run
decisions.

Table 2. Profit maximisation in a competitive firm

Q p TR FC VC TC Π MC MR
1 6 6 10 5 15 -9 5 6
2 6 12 10 9 19 -7 4 6
3 6 18 10 10 20 -2 1 6
4 6 24 10 13 23 1 3 6
5 6 30 10 17 27 3 4 6
6 6 36 10 23 33 3 6 6
7 6 42 10 30 40 2 7 6
8 6 48 10 39 49 -1 9 6
9 6 54 10 49 59 -5 10 6
10 6 60 10 60 70 - 10 11 6

Note that the firm takes price as fixed. Therefore total revenue increases proportionately to the
increase in output. The firm maximises total profit according to the MC = p rule. In our case,
the profit maximising level of output equals to 6. For this output, marginal cost equals
the price of the product. This means that the firm should not change the level of output.
Lower output would mean that marginal revenue (equal to price) is higher than marginal cost,
so the firm can get additional profit increasing output. On the other hand, higher output would
indicate that the firm produces too much, because it does not earn profit on the latest products

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(for example, production of the eighth unit of output is sold at 6 zl, but the marginal cost of
this unit is equal to 9 zl; so, the firm faces a loss on this unit equal to 3 zl).

Figure 2. competitive firm making a positive profit

Figure 2.

Figure 2 shows the firm’s profit maximising level of output. The average and marginal
revenue curves are a horizontal line equal to price. The cost curves are drawn so that the firm
can earn profit easily. Profit is maximised at point A, where price is equal to marginal
cost. Note that p and MC curves cross also at lower output. At this output, however, profit is
not maximised. Why? Because an increase in output increases profit (marginal cost curve is
below price). So, profit is maximised when price equals marginal cost at a point at which
the marginal cost curve is rising. Point E presents the level of output which is produced at
zero profit, as average cost is equal to average revenue. The same refers to point F. Positive
profit is earned for output greater than Q1 and lower than Q2. Remember, that at Qr profit is
maximised.

A firm may not be able to earn profit in the short run. Figure 3 presents two different cases.
The graph in the middle shows that due to higher average cost the firm is not able to earn
profit. At the profit maximising output Qr the average revenue (equal to price) is equal to

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average cost. The profit is just zero. The figure on the right presents the case of negative
profit. At the profit maximising output Qr the average revenue (equal to price) is less than
average cost. Therefore, the firm produces with a loss.

Figure 3. Competitive firm incurring zero profit and losses

Why does not a firm that earns a loss leave an industry entirely? A firm may operate at a loss
in the short run because it expects to earn profit in the future, when the price of product
increases or the cost of production falls, and because shutting down and starting up again
would be costly. In fact, a firm has two choices in the short run: it can produce some
output or it can shut down production temporarily. It will compare the profitability of
producing with the profitability of shutting down and will choose the preferred output. If the
price of product is greater than average cost of production, the firm makes positive
profits and will choose to produce.

But suppose that the price is lower than average cost, like in Figure 4. If it continues to
produce, the firm minimizes its losses at output Qr. The firm should therefore consider
shutting down. If it does, it earn no revenue, but it will have to bear the fixed cost of
production (because the fixed cost exists even if the firm does not produce). If the firm

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continues to produce, the price covers the variable cost of production and a part of the fixed
cost. Therefore, it pays for the firm to continue production, as the loss will be smaller than in
the case of shutting down.

The price equal to the variable cost means that in both cases (shutting down or keeping
production) the loss of the firm would be equal to the fixed cost. So, the firm should shut
down when the price is lower than average variable cost. Such a price does not cover the
fixed cost and covers only a part of the variable cost of production. If the firm decided to
produce, its loss would be greater (equal to the fixed cost and to a part of the variable cost)
than in the case of shutting down (the loss equal to the fixed cost). Therefore, the firm should
stay in business as long as the price of its product is greater than the average variable
cost of production.

Figure 4. Shut down rule

The competitive firm’s short run supply curve

A supply curve for a firm tells us how much output it will produce at every possible price. We
have seen that competitive firms will increase output to the point at which price is equal to
marginal cost but will shut down if price is lower than average variable cost of production.

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Therefore, the firm’s supply curve is the portion of the marginal cost curve that lies above the
average variable cost curve.
Figure 5 illustrates the short-run supply curve for the competitive curve. For any price greater
that c1(equal to the minimum average variable cost), the profit maximising output can be read
directly from the graph. At price c1 the quantity supplied will be Q1. At price c2 the quantity
supplied will be Q2. So the entire short-run supply curve consists of the bold portion of the
marginal cost curve above the point of minimum average variable cost (above price c1).

Figure 5. Short run supply curve for a competitive firm