Perfect Competition

All Rights ReservedMicroeconomics© Oxford University Press Malaysia, 2008

9– 1


9– 22MICROECONOMICS

Perfect Competition

9CHAPTER


9– 3

DEFINITION AND CHARACTERISTICS OF A

PERFECTLY COMPETITIVE MARKET

Definition

A market in which there are many buyers and sellers, the products are homogeneous and sellers can easily enter and exit from the market.

MICROECONOMICS 3

Characteristics• Large number of buyers and sellers – firms

are price takers.


9– 4

Homogenous or standardized product – the buyers do not differentiate the products of one seller to another seller.

Free of entry and exit into the market.Role of non-price competition is insignificant.Perfect knowledge of the market – all the sellers and

buyers in perfect competition market will have perfect knowledge of that market.

DEFINITION AND CHARACTERISTICS OF A PERFECTLY COMPETITIVE

MARKET (CON’T)


9– 5

PRICE DETERMINATION IN A PERFECTLY COMPETITIVE FIRM

Market

The price is determined by the intersection of the market supply curve and the market demand curve.Price

QuantityQ*

RM10

DD

SS

Since firms are price takers, they face a horizontal demand curve. Demand curve in perfect competition is horizontal or perfectly elastic. Therefore, Price = MR = AR.

P = MR = ARRM10

Quantity

Price

Firm


9– 6

PROFIT MAXIMIZATION IN A PERFECTLY COMPETITIVE FIRM

Using Table:Profit maximization is determined by scanning through the profit at each level, and the level which gives the highest profit is the profit maximizing output.

(1)Quantity

(per kg per dAy)

(2)Price

(per kg per dAy)

(3)Total

Revenue(TR)

(4)Total Cost

(TC)

5)Profit/Lloss

0

10

20

30

40

50

60

70

10

10

10

10

10

10

10

10

0

100

200

300

400

500

600

700

60

140

210

290

390

500

630

800

-60

-40

-10

10

10

0

-30

-100

1. Using Total approach

TOTAL REVENUE – TOTAL COST APPROACH


9– 7

TR, TC

Quantity

40

TR

Highest vertical difference

TC


Using Graph:TR curve is a straight line through the origin.The maximum profit is where the vertical difference is the highest.


9– 8


2. Using Marginal approachMARGINAL REVENUE – MARGINAL COST APPROACH

Using Table:The profit maximizing output level is obtained following the MR = MC rule.

0

10

20

30

40

50

60

70

10

10

10

10

10

10

10

10

0

100

200

300

400

500

600

700

-

10

10

10

10

10

10

10

-

8

7

8

10

11

13

17

(1)Quantity

(per kg per day)

(2)Price

(per kg per day)

(3)Total

Revenue(TR)

(4)Marginal Revenue

(MR)

(5)Total Cost(TC)

(6)Marginal

Cost (TC)

(7)Profit/Lloss

-60

-40

-10

10

10

0

-30

-100

60

140

210

290

390

500

630

800


9– 9

MR, MC

Quantity

MC

MRRM10

40


Using Graph:TR curve is a straight line through the origin. The maximum profit is where the vertical difference is the highest.


9– 10

The demand function for a product sold by a perfect competitor is given as

QD = 20 – P

and the marginal cost is MC = −10 + 3Q.

Calculate profit maximizing price and quantity.

PROFIT MAXIMIZATION USING THE EQUATION METHOD


9– 11

Solution For profit maximization to take place,

we use the MR = MC rule.

Firstly, we need to derive the demand curve.Given Q = 20 − P

P = 20 − Q MR = 20 − Q (since in perfect competitive firm, P = MR = AR)

PROFIT MAXIMIZATION USING THE EQUATION METHOD (CON’T)


9– 12

MR = MC20 − Q = −10 + 3Q4Q = 30Q = 7.5

Substitute Q = 7.5 into P = 20 − Q

P = 20 − 7.5P = 12.5

PROFIT MAXIMIZATION USING THE EQUATION METHOD (CON’T)


9– 13

SHORT-RUN SUPPLY CURVE

Point a is not considered a supply curve since at any point below the minimum of AVC, the firm would shut down its operation and the quantity supplied would be zero.

The figure shows the AC, AVC and MC. There are five different market prices. The horizontal demand curve at each price is shown.

MC

P = MR = AR

AC

P2 = MR2 = AR2

AVC

P1 = MR1 = AR1

P3 = MR3 = AR3

P4 = MR4 = AR4a

b

d

e

The portion of marginal cost curve which lies above the average variable cost curve is the firm’s supply curve.

c

Price (RM)

Quantity40 60

20

5

10

Supply curve of a competitive firm is the upward portion of MC above minimum of AVC as shown by points b, c, d and e.


9– 14

A competitive firm earns economic profit

Economic profit or supernormal profit is the profit earned by a competitive firm when TR>TC.

PROFIT

At output Q* respectively the firm earns economic profit or supernormal profit equal to the area shaded.

MC

The marginal cost curve intersects the demand curve at point B. A competitive firm maximizes its profit when MR = MC.

The firm’s demand curve is horizontal at the price of RM20 where AR = MR.

PROFIT MAXIMIZATION IN THE SHORT RUN

Price (RM)

Quantity

The profit maximizing price and output is P* and Q*.P = MR = AR

ATC

Q*

P*20

B


9– 15

A competitive firm at breakeven



The profit maximizing price and output is P* and Q*, respectively.

At output Q*, the firm is at breakeven and earns normal profit.

Normal profit or breakeven profit is necessary for a firm to stay in business (TR =TC).

Price (RM)

Quantity

P = MR = AR

MC

ATC

Q*

P*B

20

PROFIT MAXIMIZATION IN THE SHORT RUN (CON’T)


9– 16

A competitive firm suffers economic losses

ATC

Economic losses or subnormal profit is the losses incurred by a competitive firm when TR<TC.

LOSSESAt output Q*, the firm suffers economic losses or subnormal profit equal to the area shaded.

MC


B

Price (RM)

QuantityQ*

P*20

P = MR = AR



The profit maximizing price and output is P* and Q* respectively.


9– 17

SHUT DOWN PRICE

Price (RM)

Quantity

P = MR = AR

MC

ATC

Q*

B

20

5

If price falls below RM5, the firm would incur more operating losses than fixed cost and the firm must shut down.

At the price of RM5, the losses incurred by the firm is equal to the fixed cost.

AVC

A firm can continue production until the price is equal to minimum average variable cost (AVC).

A firm will continue its operations even if it suffers losses.


LOSSESTOTAL FIXED COST

Shut down point is at the point where the price equals to minimum AVC.


9– 18

20

Market Firm

Price (RM)

QuantityQ*

DD

SS

SS1

15

P = MR = AR

Quantity

20

60

PROFITP1 = MR1 = AR1

MC

AC

The economic profit attracts newcomers to the industry. As a result, many firms will enter the market and this will lead to an increase in supply.

Price is determined by the intersection of the market supply curve and the market demand curve.

Supply curve will shift to the right and equilibrium market price will fall to RM15.

Firms that earn supernormal profits in short run will only be able to earn normal or zero profits in long run due to entry of newcomers.

The competitive firm sells 60 kg of chicken and earns an economic profit shown by the shaded area.


EFFECT OF ENTRY

Price (RM)

15


9– 19

10

Market FirmQuantity

Q*

DD

SS

SS1

15

The losses in short run forces those sellers who cannot cover their AVC or TVC to leave the market. As many firms exit the market, this will lead to a decrease in the market supply. The competitive

firm sells 60 kg of chicken and suffers losses shown by the shaded area.

Firms that suffer losses in short run can still continue their operation. As in long run they are able to earn normal or zero profits due to exit of the firms.

PROFIT MAXIMIZATION IN THE LONG RUN

EFFECT OF EXIT

Price (RM) Price (RM)

P = MR = AR

Quantity

20

60

P1 = MR1 = AR1

MC

AC

15

LOSSES

Supply curve will shift to left and equilibrium market price will rise to RM15

Perfect Competition

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