MICROECONOMICS

(ECO 110)

FALL 2017
FINAL REPORT
SUBMITTED TO: ANSAN RIZVI

GROUP MEMBERS:
RAJA TALHA HAMEED
JAWAD MEHDI
TAHA HASSAN
SAMIR RIZWAN
CONTENTS:

ACKNOWLEDGEMENT

1. INTRODUCTION
1.1. Price taking demanding and supplier
1.2. Homogenous product
1.3. Free mobility of resources
1.4. Perfect knowledge

2. LITERATURE REVIEW
2.1. Condition of perfect competition
2.2. Perfect competition and creativity of market
2.3. Perfect competition according to Enrico Barone
2.4. History of perfect competition

3. ANALYSIS
3.1. Competitive supply where marginal cost equals price
3.2. Total cost and the shutdown condition
3.3. Characteristics of Perfect competition
3.4. Short run & Long run

4. CONCLUSION AND RECOMMENDATION

5. REFERENCES
 ACKNOWLEDGEMENT

We would like to express our deepest sense of gratitude to our respected and learned guides, Sir
Ahsan Rizvi for their valuable help and guidance, we are thankful to her for the encouragement
she has given us in completing the project.

We are also grateful to respect Asif Shamim (Cluster head) for permitting
us to utilize all the necessary facilities of the institution.

We are also thankful to all other faculty and staff members of our
department for their kind co-operation and help.

Lastly, we would like to express our deep apperception towards our

classmates and our indebt to our parents for providing us the moral support and encouragement.
 PERFECT COMPETITION

INTRODUCTION:

In theoretical parlance the “perfect competition” describes a market situation in

which there is a complete absence of direct competition. Therefore, in the pure economic sense
there is no “rivalry” among suppliers in the market, and buyers do not recognize their
competitiveness vis-à-vis one another: the market is thus entirely impersonal. As theoretical
concept of economics, it is the diametrical opposite of the businessmen’s concept of competition.

An understanding of concepts of perfect completion (and equilibrium) in a perfectly

competitive market is facilitated by the following scenario (or parable).

“Consider the market for a given commodity and suppose that participants in this market
are divided into two groups: one group consists of consumers or demanders of the commodity
and the other group consists of producers or suppliers of the commodity. Exchange between
these groups is accomplished through an auctioneer in the following manner. The auctioneer
announces a price for the commodity, and each consumer decides how much of the commodity
he wishes to purchase at that price. Similarly, each producer decides how much of the
commodity he wishes to supply at the announced price. The auctioneer adds up the demands of
all the consumers and also adds up the supply offers of all the producers. If the aggregate
demand equals the aggregate supply, the announced price is said to be the equilibrium price, and
transactions are consummated at this price. If, at the currently announced price, the quantity that
consumers wish to purchase is not the same as the quantity that producers wish to supply, and
new price is announced by the auctioneer. This process is repeated until and equilibrium price is
found”.

As a corollary to the above the market for the following goods, (inter alia), may be
categorized as “perfectly competitive markets”.
 1. Toothpastes;
2. Toilet Soaps;
3. Shaving Razors / Safety Razors;
4. Match boxes;
5. Tissue papers; etc. (among a myriad of others).
Under perfect competition market scenario the principal area of competition

among the supplier of goods (or services) is thus “advertising”. The advertising of one firm will
state that its product is superior to those of its rivals (which it will virtually name). Firms will
also take innovative steps to lure customers by means of style features, method of packaging,
claims of durability, etc. in fact, firms compete in almost every conceivable way except by
means of price reduction.

Four important conditions / pre-requisites are used by the economists to define

perfect competition. These conditions are discussed hereunder in detail with the explanations that
how each one is related to the “auctioneer” parable.

1. Price taking demanders and suppliers: Under the perfect competition scenario
of the market the price is regarded as given by all the market participants whether thy
may be demanders for goods or supplier of goods. Though it is true that the overall
aggregate behavior of both the demanders and suppliers in Toto affects the price but the
market is of such sixe, peculiarities and dimensions that no economic agent takes the
effect of its behavior on price into account when making a consumption or production
decision.
The natural corollary of the above may leads us to the assumption by stipulating
that in a competitive market, every economic agent is so small, relative to the market as a
whole, that it cannot exert a significant influence on price.

2. Homogenous products: Another important and closely related characteristic of the

perfectly competitive market is the homogeneity of the products being offered by the
producers / suppliers. It means that the product of any one seller must be identical to the
product of any other seller.
 3. Free mobility of resources: Another condition for labeling a market to be
perfectly competitive is that all resources (factors of production)are perfectly mobile. It
means that each factor can easily move in and out of the market very readily in response
to pecuniary signals.

The natural corollary of the above stated foundation is that it should meet

following further sub-requirements / pre-requisites:-

a). It means that the labor must be mobile, not only geographically but among
jobs as well. The latter phenomena thus implies that the requisite labor skills are few,
simple and can easily be learned.
b). The free mobility of resources also means that the ingredient inputs
(required to produce the goods or services) are not monopolized by an owner or producer.
c). Finally, it also means that new firms (or new capital) can enter and leave
an industry without extraordinary difficulty.

Nota Benes: As a practical point of view this (last) sub-condition is very difficult to realize in
practice.

4. Perfect Knowledge: For the fulfillment of this condition it is required that all the
market participants, whether they be producer (suppliers), consumers (demanders) and
resource owners must possess perfect knowledge if a market is to be categorized as be
perfectly competitive.
The natural consequence of the above is that if consumers are not fully

cognizant (aware) of prices, they might buy at higher prices when goods (with the same
characteristics and satisfying the same consumer needs are available at lower prices. Similarly, if
the laborers are not aware of the wage rates offered, they may not be able to sell their services to
the highest bidder. Finally, producers of goods must know their costs as well as price (of the
goods offered by them) in order to attain the most optimum rate of output.
NB: But above is just the beginning and tip of the iceberg. In its fullest economic sense, the
perfect knowledge requires complete knowledge of the future as well the present. In the absence
of this omniscience the perfect competition cannot prevail.

GIST (OF THE INTRODUCTORY SECTION):

“The Perfect Competition is an economic model of a market possessing the following

characteristics.

 Each market agent acts as if prices are given, i.e., each acts as a price-taker;
 The product is homogeneous;
 There is free mobility of all resources, including free entry and exit of business firms; and
 All the economic agents in the market possess compete and perfect knowledge

LITERATURE REVIEW:

The literary work on the concept implementation and practice on the perfect
competition are dealt with hereunder:

1. Conditions for perfect competition ~ CLIFF NOTES

 In these brief notes, the structure of the market under the perfect competition is is
discussed in a summarized form and have identified the ubiquitous four different
characteristics of The Perfectly Competitive market viz,
i. The number and size of the forms in the market.
ii. The ease with which forms may enter and exit the market.
iii. The degree to which firm’s products are differenciated and
iv. The amount of information available to the both buyers and sellers
regarding prices, product charachteristics and production.
2. Perfect competition and the creativity of the market ( By Louis Makowski & Joseph
M. Ostroy)
JOURNAL OF ECONOMIC LITERATURE, VOL XXXIX (JUNE 2001)

 Competition is a central idea in economics, its idealization as Perfect Competition

underlies much of traditional analysis. But contemporary research according to
the authors is largely directed elsewhere.
 According to the central idea by the scholars as propogated in their above named
research paper is that anything that has been so important and has survived for so
long is too valuable to be put aside. Every effort should be made to preserve its
centrality, even if that means reviving the way one thinks about the concept in the
light of the recent challenges.

3. Perfect Copetition according to Enrico Barone

 He was the Italian Economist (1859-1924) who is well known for elaborating the
theory of marginal productivity. Barone spoke of competition with the adjective
‘Perfect’ as far way back as in 1896, when dealing with the wquality between
marginal productivity and the price of each input: In particular, he writes, this
equality is realized only ina perfect competition regime. For him, the regime of
Perfect Competition suggests a system of market governance and ot the
behaviour of the actors in competitive markets. In short, it is a market structure.
 4. A note on the history of Perfect Competition: ( Paul J. McNutty )
~ Journal of Political Economy – Vol 75, No.4, Part I (Aug 1967) pp. 395-399

 In this research paper, Paul J. McNutty has deliberated upon the views of various
economists on the concept of Perfect Competition. He has quoted the work of
Prof. Stiglen. According to him Prof. Stiglen has opened theory of Perfect
Competition with Adam Smith’s treatement of the subject.
“We may reasonably refer”, He added, that the conditions of numerous
rivals and of independence of actors of these rivals were matters of direct
observation ( Stiglen, 1957, P2 ).
 The purpose of this note is to suggest:
i. That Adam Smith was lead to the concept of competition by his
acquaintance with the economic literature of his time; and
ii. That the Smittian concept of competition was of a fundamentally different
character than that which was later perfected by economic theorists.

ANALYSIS:

Because competitive forms cannot affect the price, the price for each unit
sold is the extra revenue that the firm will earn. For example, at a market price of $40 per unit,
the competitive firm can sell all it wants at $40. If it decides to sell 101 units rather than 100
units, its revenue goes up by exactly $40.

Here are the points to remember:

1. Under perfect competition, there are many small firms, each producing an identical
product and each too small to affect the market price.
2. The perfect competitor faces a completely horizontal demand curve.
3. The extra revenue gained from each extra unit sold is therefore the market price.
COMPETITIVE SUPPLY WHERE MARGINAL COST EQUALS PRICE:

Suppose you are operating Bob’s oil operations and are responsible for
setting the profit-maximizing output. How would you go about this task? Examine the given
table. This table adds a further assumption that the market price of oil is $40 per unit.

TABLE- Profit Is Maximized at Production Level Where Marginal Cost Equals Price

This table shows that the maximum profit comes at

the output where price equals MC. If output is raised
above q = 4000, the additional revenue of $40 per
unit is less than the marginal cost, so profit is
lowered.
 Firm’s Supply Curve Is Its Rising Marginal Cost Curve

For a profit maximizing competitive form, the

upward sloping marginal cost (MC) curve is the
firm’s supply curve. For market price at d’d’, the
form will supply output at the intersection point at A.
Explain why intersection points at B and C represent
equilbria for prices at d and d” respectively.

TOTAL COST AND THE SHUTDOWN CONDITION:

 Our general rule for firm supply open one possibility~that the price ill be so low
that the firm will want to shut down. Isn’t it possiblt that at the P = MC equilbrium. Bob may be
loosing a truckful of money and would want to shutdown in the short run when it can no longer
cover its variabble costs.

For example, suppose the firm were faced with a market price of $85, shown by the horizontal
d”d” line in the figure above in “The Firm’s Supply Curve”. At that price, MC equals price at
point C, a point at which the price is actually less than the average cost of production. Would the
firm want to keep producing even though it was incurring a loss?

The surprising answer is that the firm should not necessarily shutdown if it is losing money. The
firm should minimize its losses, which is the same thing as maximizing profits. Producing at
point C would result in a loss of only $20,000, whereas shutting down wouls involve losing
$55,000 (which is the fixed cost). The firm should therefore continue to produce.

The critically low market price at which revenues just equal variable costs (or, equivalently, at
which losses exactly equal fixed costs) is called the shutdown point.

Shutdown Rule: The shutdown price where revenues just cover variable costs or where losses
are equal to fixed costs. When price falls below average variable costs, the firms will maximize
profits (minimze its losses) by shutting down.

The figure below shows the shutdown and zero-profit points for a firm. The zero-profit point
comes where price is equal to AC, while the shutdown point comes where price is equal to AVC.
Therefore, the fir’s supply curve is the solid line in thee given figure. It first goes up the vertical
axis to the price corresponding to the shutdown point; next jumps to the shutdown point at M,
where P equals the level of AVC; and thrn continues up the MC curve for prices above the
shutdown price.

Zero-Profit and Shutdown Prices

Firm’s Supply Curve Travels down the MC Curve to the
Shutdown Point

The firm’s supply curve corresponds to its MC curve

as long as revenues exceed variable costs. Once price
falls below P, the shutdown point, losses are greater
than fixed costs, and the firm shuts down. Hence the
solid curve is the firm’s supply curve.
CHARACTERISTICS OF PERFECT COMPETITION

 A large number of small firms

 Perfect resource mobility or the freedom of entry into and exit out of the industry
 Perfect knowledge of prices and technology

Price Taker
Firms In perfect competition are price taker. A price taker is a firm that cannot influence the
market price because its production is an insignificant part of the total market.

Imagine that you are a farmer who plants fruits in Pakistan & you have thousands of acres of
land on which you have planted the seeds. But compared to the millions of acres in India and
others. Nothing makes your fruit better than any other farmer and all the buyers of fruit knows
the prices on which they can do the business.

If market price is $10 per box, then that is the highest price that you can get from fruits. If you
offer $10.20 then no one will buy from you and if you offer $9.80 then your fruits will be sold
out in seconds therefore you have to sell fruits on rate of $10 which is the market price .

WHY IT MATTERS?
A price taker is the opposite of a price maker. That is, they are not guaranteed profit makers, and
they may even choose to make more product even if it's not profitable to do so, just so they can
maintain market share or achieve other objectives. Thus, investors who can distinguish price
takers from price makers can more easily identify steady profit producers. Price takers are
generally not leaders in their industries.
 SHORT RUN AND LONG RUN IN PERFECTLY COMPETITIVE
MARKETS:

Short Run:
Hence Price Taker
In the diagram below, the firm is making supernormal profits. The total cost to the firm is in
blue, and the profit is in the red. We can intuitively tell it makes profit because its average costs
are lower than the average revenue. To calculate the cost, see where the quantity hits the average
cost line, and then draw a horizontal line to the Y axis. Whatever area is above the cost is the
profit or the loss.
Since we assume that all individual firms are profit maximizers, we take MC = MR for profit
maximization. If a company is loss-making, the rule still applies, so the loss is minimized.
Similarly, the least Total Cost is taken to maximize profit or minimize loss.

Short run Equilibrium:

In the short run, the rate of output per period of time can be increased or decreased by increasing
or decreasing the use of variable inputs. The individual firm can adjust its rate of output over a
wide range subject only to the limitations imposed by its fixed inputs (generally, plant and
equipment). Since each firm adjusts until it reaches a profit-maximizing rate of output, the
market or industry also adjusts until it reaches a point of short-run equilibrium.

Super Normal Profits

Long Run:

In the long run time frame a firm can vary both the quantity of labor and the quantity of capital,
so in the long run, all the firm’s cost are variable. The behavior of long run depend on the firm’s
production function, which is the relationship between the maximum output attainable and the
quantities of both labor and capital.

Long run in perfect competition:

Entry and Exit:

In perfect competition long run entry arise when new firms come join the market and market
increases. As new firms enter, they add to the demand for the factors of production used by the
field. If the field is a significant user of those factors, the increase in demand could push up the
market price of factors of production for all firms in the field if that take place, then entry into
field will boost average costs at the same time as it puts downward pressure on price so when
firm enters a market supply increases and market supply curve shifts rightward. The increases in
supply reduce the market price and after some time eliminates economic profit. When economic
profit reaches zero, entry stops. Exit arises when existing firm leave a market and market
decreases. Firm exit a market when they lead economic losses. When firm exit a market, supply
decreases and market supply curve shifts leftward. The market price get up and economic loss
decreases and after some time economic loss eliminates and exits stops Entry and exit affects
long run in perfect competition as entry and exit changes supply curve which drive the market
price, the quantity produced by each firm, and its economic profit or loss.

Long run equilibrium:

The long run equilibrium of a perfectly competitive market occurs when marginal revenue equals
marginal costs, which is also equal to average total costs. It happens when economic profit and
economic loss have eliminated and entry and exit of firm in market have stopped.
In a perfectly competitive market, demand is perfectly elastic. This means the demand curve is a
horizontal line. In equilibrium condition firm can’t attain economic profit, it can only breakeven
and market is productively and allocative efficient.

CONCLUSION
In ideal opposition, many group sell equal merchandise to many shoppers, there
are not any limits to entry, seller and consumers are well informed about price. A wonderfully
opposition company is a free taker and the firm marginal revenue continually identical to the
marketplace rate.
The firm produces the output at which marginal price same marginal cost. In short run
equilibrium, a company could make some economic earnings, incur a monetary loss,
or ruin even. If the rate is much less than minimum average variable fee the firm temporarily
shuts down. At rate under minimum average variable price, a company deliver curve
run alongside the y-axis, at rate above minimal common variable value, a firm deliver curve is its
marginal price curve.
The marketplace deliver curve indicates the sum of the quantities furnished via every firm at
every charge. Marketplace demand and marketplace deliver decide price. A firm may make a
superb financial profit, some zero-economic earning or incur a loss.
A everlasting increase is call for leads to larger marketplace output and a larger variety of
corporation. An everlasting decrease in demands leads to a smaller market outputs and smaller
range of companies. New technologies lower the amount of production, growth supply and in
long term decrease the fee and boom the quantity.
Assets are used effectively while we produce item and service in the amount that human value
most highly. Ideal competition achieves a green allocation. In long run equilibrium buyer pay the
lost feasible rate and marginal social value and blessing same marginal social price.

RECOMMENDATIONS:
We recommend that perfect competition in the long run is better, because
economic profit induces entry and economic loss induces exit. Entry increase supply and lowers
price and profits. Exit decrease supply and raise price and profit. In long run economic profit is
zero, there is no entry or exit.
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