Perfect Competition Asst. Prof. Dr. Serdar AYAN

Types of Markets u u Pure Competition or Perfect Competition u u Monopoly u u Duopoly u u Oligopoly u u Monopolistic Competition

Perfect Competition

Assumptions of Perfect Competition u u Many independent firms u u Each seller is small relative to the whole market u u Homogeneous (identical) product u u Easy entry and exit u u Perfect Information

Price Taking The perfectly competitive firm is said to be a price-taker, because it takes the market price as given and has no control over the price. Why?...

If the firm tried to charge a higher price, it would lose all its business. Customers could go elsewhere to buy the same product for less. Since the firm is very small, it can sell as much as it wants at the market price. So there’s no reason to charge a lower price.

The demand curve for the product of the perfectly competitive firm shows how much can be sold at specific prices. Let’s see what it would like to… The firm can sell as little or as much as it wants at the market price. Suppose, for example, the market price is 5TL.

price 10 quantity 5TL The firm can sell 10 units for 5TL.

price 20 quantity 5TL The firm can sell 20 units for 5TL.

price 30 quantity 5TL The firm can sell 30 units for 5TL.

price 40 quantity 5TL The firm can sell 40 units for 5TL.

price 50 quantity 5TL The firm can sell 50 units for 5TL.

price quantity 5TL So all these points are on the demand curve for the firm’s product.

price quantity 5TL Connecting these points, we have the demand curve for the firm’s product. demand

price quantity market price The demand curve for the perfectly competitive firm’s product is a horizontal line at the market price. demand

Recall: Total Revenue Total Revenue = Price x Quantity TR = P x Q

Recall: Marginal Revenue (MR) Marginal Revenue is the additional revenue earned from selling one additional unit of output. MR =  TR /  Q

Comment For ease of writing, instead of writing the “perfectly competitive” firm we will frequently write the “p.c.” firm.

The MR Curve for the p.c. Firm For the p.c. firm, MR is equal to the market price. So MR is a horizontal line at the level of that price. The demand curve for the p.c. firm is also a horizontal line at the level of the market price. So, for the p.c. firm, the demand curve and the MR curve are the same horizontal line.

price quantity market price The demand curve (D) and the MR curve for the perfectly competitive firm’s product. D = MR

Optimal Output Level Recall: To maximize profit, the firm will produce at the output level where MR = MC. So the firm will produce where the MR and MC curves intersect.

TL Quantity Draw your axes; label them quantity and TL.

Draw your ATC, AVC, and MC curves. (Make sure MC intersects ATC and AVC at the minimum.) TL Quantity MC ATCAVC

Draw the D = MR curve horizontal at the market price. TL Quantity MC ATCAVC D = MR

If the market price is P 1, the quantity produced will be Q 1. TL Quantity MC ATCAVC D = MR P1P1 Q1Q1

If the market price is P 2, the quantity produced will be Q 2. TL Quantity MC ATC AVC D = MR P2P2 Q2Q2

If the market price is P 3, the quantity produced will be Q 3. TL Quantity MC ATCAVC D = MR P3P3 Q3Q3

If the market price is P 4, the quantity produced will be Q 4. TL Quantity MC ATCAVC D = MR P4P4 Q4Q4

If the market price is P 5, the quantity produced will be Q 5. TL Quantity MC ATCAVC D = MR P5P5 Q5Q5

Shutdown Point Price P 5 was the minimum of the AVC curve (the shutdown point). If the price fell any lower than P 5 the firm would produce no output.

The p.c. firm’s short run supply curve The firm’s supply curve shows the quantity the firm will produce at each price. The P, Q values we have shown, therefore, are points on the firm’s supply curve. But those points are all on the firm’s MC curve. So, the firm’s supply curve is the part of the MC curve that is above the minimum of the AVC curve.

The p.c. firm’s short run supply curve TL Quantity MC ATC AVC Supply

The market short run supply curve To determine the total amount that all the firms will produce at each price, we simply add up the amounts that each of the firms will produce at that price.

Graphing Profit

A little trick for graphing a firm’s profit Recall for a rectangle: Area = length. width Area length width

We also know TR = P. Q. So, if we can find a rectangle whose length is P and whose width is Q, then its area must be total revenue. P Q TR

To determine Total Cost, first remember ATC = TC / Q So, ATC. Q = TC

Now, if we can find a rectangle whose length is ATC and whose width is Q, then its area is TC. ATC Q TC

Then to determine profit, we just subtract the TC area from the TR area.

Graphing Profit: The six steps

Step 1 a. Draw your axes and label them Q and TL. ( Label the origin 0.) TL Quantity 0

Step 1b. Draw the firm’s ATC curve. (If the price is below the minimum of ATC, you will also need to draw the AVC curve.) TL Quantity ATC MC P 0

Step 1 c. Draw the MC curve and D=MR curve. (For a positive profit, D must be at least partly above ATC.) TL Quantity ATC MC D = MR P 0

Step 2: Determine the profit-maximizing output (Q*) by finding where MR = MC. TL Quantity ATC MC D = MR Q* P 0

Step 3: Find your TR = PQ rectangle. TL Quantity ATC MC D = MR Q* P 0

Step 4: Determine ATC at the profit-maximizing output level. TL Quantity ATC MC D = MR Q* P ATC 0

Step 5: Find your TC = ATC. Q rectangle. TL Quantity ATC MC D = MR Q* P

Step 6: Find profit  = TR - TC. TL Quantity ATC MC D = MR Q* P p r o f i t

You follow the same steps to draw a firm that is making a loss or breaking even (zero profits). Let’s do a firm with a loss.

Step 1: Draw & label the curves & axes. For a loss, put D above the minimum of AVC & below the minimum of ATC. TL Quantity ATC MC D = MR P 0 AVC

Step 2: Determine the profit-maximizing output (Q*) by finding where MR = MC. TL Quantity ATC MC D = MR P 0 Q* AVC

Step 3: Find your TR = PQ rectangle. TL Quantity ATC MC D = MR P 0 Q* AVC

Step 4: Determine ATC at the profit-maximizing (or loss-minimizing) output level. TL Quantity ATC MC D = MR P 0 Q* ATC AVC

Step 5: Find your TC = ATC. Q rectangle. TL Quantity ATC MC D = MR P 0 Q* ATC AVC

Step 6: Find profit (or loss)  = TR - TC. TL Quantity ATC MC D = MR P 0 Q* l o s s AVC

A firm that is breaking even (zero profits)

Step 1: Draw & label the curves & axes. To break even, make D tangent to the minimum of ATC. TL Quantity ATC MC D = MR P 0

Step 2: Determine the profit-maximizing output (Q*) by finding where MR = MC. TL Quantity ATC MC D = MR P 0 Q*

Step 3: Find your TR = PQ rectangle. TL Quantity ATC MC D = MR P 0 Q*

Step 4: Determine ATC at the profit-maximizing output level. TL Quantity ATC MC D = MR ATC = P 0 Q*

Step 5: Find your TC = ATC. Q rectangle. TL Quantity ATC MC D = MR ATC = P 0 Q*

Step 6: Find profit  = TR - TC. TL Quantity ATC MC D = MR ATC = P 0 Q*