Market: Perfect Competition

Agenda for discussion

Market structure Perfect Competition Market Demand and Market Supply The Competitive Firms Demand Curve Equilibrium of the industry in the perfect competition Equilibrium of the firm: Profit Maximization The Shutdown Point

Market structure
The characteristics of a market that influence how trading takes place
1. How many buyers and sellers? 2. Products: standardized or significantly different? 3. Barriers to entry/exit ?

Market structure
Types of markets
Perfect competition Monopoly Monopolistic competition Oligopoly

Perfect Competition: Characteristics

Many buyers and sellers
no individual decision maker can significantly affect the price of the product

Standardized product
buyers do not perceive differences between the products

Sellers can easily enter/exit the market

no significant barriers to discourage new entrants

Perfect Competition: Characteristics

Each firm attempts to maximize profits Each firm is a price taker

its actions have no effect on the market price

Information is perfect Transactions are costless

Market Demand curve of the Industry

To derive the market demand curve, we sum the quantities demanded at every price
px Individual 1s demand curve px Individual 2s demand curve px Market demand curve

px*

x1
x1*

x2 x
x2*

X x
X*

x1* + x2* = X*

Market Supply Curve of the industry

To derive the market supply curve, we sum the quantities supplied at every price
P Firm As supply curve sA P sB P Firm Bs supply curve Market supply curve S

P1

q1A

quantity

q1B

quantity

Q1

Quantity

q1A + q1B = Q1

Equilibrium of Industry under perfect competition

Sl. No. Price ( in Rs.) Market Market Supply Demand (Pen) = total (Pen) = total of of individual individual demand demand 2500 2400 2200 400 500 600 Equilibrium Or Disequilibrium

1 2 3

5 10 15

Disequilibrium Disequilibrium Disequilibrium

4
5 6 7

20
25 30 35

2000
1800 1500 1200

1000
1300 1500 1800

Disequilibrium
Disequilibrium Equilibrium Disequilibrium

8
9 10 11 12

40
45 50 55 60

1000
800 500 400 100

2000
2500 2800 3000 3500

Disequilibrium
Disequilibrium Disequilibrium Disequilibrium Disequilibrium

Perfect Competition
Individual Demand Curve Quantity Demanded at Different Prices Quantity Supplied at Different Prices Individual Supply Curve

Added together Market Demand Curve Quantity Demanded by All Consumers at Different Prices

Added together Quantity Supplied by All Firms at Different Prices Market Supply Curve

Market Equilibrium
P S D

Quantity Demanded by Each Consumer

Quantity Supplied by Each Firm

Equilibrium of the firm: Break even point Total Cost and Total Revenue

Total Revenue
Total Cost

The amount that the firm receives for the sale of its output. The amount that the firm pays to buy inputs.

Profit is the firms total revenue minus its total cost.

Profit = Total revenue - Total cost

Equilibrium of the firm: Break even point Total Cost and Total Revenue
Quantity Price Total Revenue 400 800 1200 1600 2000 Total Cost Break even point

1 2 3 4 5

400 400 400 400 400

550 1000 1200 1500 1700 Break even point

6
7 8

400
400 400

2400
2800 3200

1850
1950 2500 Maximum Profit

Equilibrium of the firm: Break even point Total Cost and Total Revenue
Price, TR And TC 2,800 1,950 Break Even point A

TR

TC Profit = TR-TC Maximum Profit = 850

550

Slope = 400

10 Quantity

Equilibrium of the firm: Marginal Cost and Marginal Revenue

Total Profit = TR TC Equilibrium of the firm : MR=MC

The Competitive Firms Demand Curve

1. The intersection of the market supply and the market demand curve Price Market S Price 3. The typical firm can sell all it wants at the market price Firm

400 D

Rs400

Demand Curve Facing the Firm

Output 2. determines the equilibrium market price

Output 4. so it faces a horizontal demand curve.

Profit Maximization
Price

(MR=MC)

Profit maximization MR=MC 400

MC

d = MR

10 Output

Profit Maximization
Total Profit = TR TC MR>MC increase output Maximize profit: MR=MC Measuring Total Profit
Profit per unit = P ATC

If P > ATC the firm earns profit If P < ATC the firm suffers a loss

Equilibrium of firm under perfect competition

Firm attains equilibrium by maximizing profit Profit = Revenue cost ( = R - C) ..(1) R and C are functions of the level of output Q. So appropriate condition for max value of profit
d /dq = 0 (necessary condition) d2 /dq2 < 0 (sufficient condition)

From (1) above d /dq = d/dq (R - C) = 0

= dR/dQ dC/dQ = 0 . i.e., MR MC = 0 or MC = MR (2)

Equilibrium of firm under perfect competition Under perfect competition the competitive seller is a price taker and not a maker as in the case of monopoly. Hence as the in the definition R = pq, the price p is a constant for the competitive seller. Therefore
dR/dQ = P = PQ i.e. MR = AR.. (3)

Now from (2) and (3) the necessary condition for equilibrium of firm under perfect competition can be restated as MC = MR = AR .(4)

Measuring Profit or Loss

Total profit = profit per unit *Q ATC Profit per unit=revenue per unit - cost per unit Profit per unit (`Rs.100) MC d = MR MR=MC Q=7

Price

400 300

Output

Measuring Economic Profit or Loss

Price Total loss = loss per unit *Q Loss per unit= cost per unit - revenue per unit Loss per Unit(100) MR=MC Q=5 300 200

MC
ATC d = MR Output

The Firms Short-Run Supply Curve

The firm takes the market price as given decides how much output to produce at that price Profit-maximizing output level: P=MC As price of output changes, firm will slide along its MC curve in deciding how much to produce

The Shutdown Point

Price at which a firm is indifferent between producing and shutting down If P>AVC produce If P<AVC shut down Firms supply curve
Is its MC curve for all prices above AVC

Short-Run Equilibrium
Competitive firms can earn economic

profit, or suffer an economic loss

The market sums buying and selling preferences of individual consumers and producers, and determines market price Each buyer and seller Takes market price as given Is able to buy or sell the desired quantity

Short-Run Equilibrium in Perfect Competition

1. When the demand curve is D1 and market equilibrium is here . . . Price 3.50 Market S 2. the typical firm operates here, earning economic profit in the short run. Firm Price MC ATC 3.50 Loss per unit at p =2 2.00 d1 d2 Profit per unit at p = 3.50 4,000 7,000

2.00

D1

D2
400,000 700,000

Output

Output

3. If the demand curve shifts to D2 and the market equilibrium moves here . . .

4. the typical firm operates here and suffers a short-run loss.

Competitive Markets in the Long Run

New firms can enter the market Existing firms can exit the market Profit and loss in the long run
Economic profit - outsiders enter the market Economic losses - firms exit the market

From SR Profit to LR Equilibrium

Economic profit attracts new entrants Market supply curve - shifts rightward Market price - falls Demand curve facing each firm - shifts downward Each firm - decreases output

Positive economic profit attracts new entrants until economic profit = 0

Long-Run Equilibrium
Market Price A 4.50 S1 With initial supply curve S1, market price is 4.50 Firm Price so each firm earns an economic profit. 4.50

MC A d ATC 1

900,000

Output

9,000

Output

From Short-Run Profit to Long-Run Equilibrium

Market Price A 4.50 4.50 S1 S2 Price

Firm

MC A d ATC 1 E

2.50

E D

2.50

d2

900,000 1,200,000
Profit attracts entry, shifting the supply curve rightward

Output

5,000

9,000

Output

until market price falls to Rs. 2.50 and each firm earns zero economic profit.

From SR Loss to LR Equilibrium

Economic losses - firms exit the market Market supply curve - shift leftward Market price - rises Demand curve facing each firm - shifts upward

Economic loses firms exit until economic loss = 0 In the LR, firms earn normal profit zero economic profit

Perfect Competition and Plant Size

In LR equilibrium, every firm will select
Plant size Output level

And
Operate at minimum point of LRATC curve

Perfect Competition and Plant Size

1. With its current plant and ATC curve the firm earns zero economic profit. Price MC1 P1 P* LRATC 3. As all firms increase plant size and output, market price falls to its lowest possible level . . . Price LRATC

ATC1
d1 = MR1

MC2 ATC
E

d2 = MR2

q1

Output

q*

Output

2. The firm could earn positive profit with a larger plant, producing here

4. and all firms earn zero economic profit and produce at minimum LRATC.

A Summary of the Competitive Firm in the LR

In long-run equilibrium, the competitive firm produces Q where: MC=minimum ATC=minimum LRATC=P Consumers are getting the best deal they could possibly get

Example
The long run cost function of a representative firm in an industry C = q3 10q2 + 50q. Determine the equilibrium price, aggregate quantity supplied and the number of firms in the industry when demand law for the product is D = 100 2p.

Example
The long run cost function of a firm is C = q3 8q2 + 20q. Prove that MC = AC at the minimum point of AC.