1. Perfect Competition Defined
Perfectly Competitive Markets
2. The Profit Maximization Hypothesis
3. The Profit Maximization Condition
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c. Each buyer’s purchases are so small that he/she
has an imperceptible effect on market price.
A perfectly competitive market consists of
firms that produce identical products that sell at
the same price. Each firm’s volume of output is so
small in comparison to the overall market demand
that no single firm has an impact on the market
price.
d. Each seller’s sales are so small that he/she has an
imperceptible effect on market price. Each seller’s
input purchases are so small that he/she perceives no
effect on input prices
More formally…
a. Firms produce undifferentiated products in the
sense that consumers perceive them to be identical
e. All firms (industry participants and new entrants)
have equal access to resources (technology,
inputs).
b. Consumers have perfect information about the
prices all sellers in the market charge
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•The Law of One Price: Conditions (a)
and (b) imply that there is a single price at
which transactions occur.
Definition: Economic Profit
•Price Takers: Conditions (c ) and (d)
imply that buyers and sellers take the price
of the product as given when making their
purchase and output decisions.
Example:
Sales Revenue-Economic (opportunity) Cost
Revenues: £1M
Costs of supplies and labor: £850,000
Owner’s best outside offer: £200,000
•Free Entry: Condition (e) implies that all
firms have identical long run cost functions.
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“Accounting Profit”: £1M - £850,000
= £150,000
Max π(q) = Pq – TC(q)
q
“Economic Profit”: £1M - £850,000 £200,000 = -£50,000
business “destroys” £50,000 of wealth
of owner
Definition: A firm’s marginal revenue is the rate at
which total revenue changes with respect to output:
MR(q) = {TR(q + Δq)-TR(q)}/Δq =
Δ(Pq)/Δq = P…the firm's "marginal benefit" from
a sale…
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Total Cost, Total Revenue, Total Profit (£/yr)
Total revenue = pq
Total Cost
If P > MC then profit rises if output is
increased
Example: Profit Maximization Condition
Total profit
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q (units per year)
If P < MC then profit falls if output is increased.
Therefore, the profit maximization condition for a
price-taking firm is P = MC
MC
P, MR
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Definition: Producer Surplus is the area above the market supply
curve and below the market price. It is a monetary measure of the
benefit that producers derive from producing a good at a particular
price.
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q (units per year)
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Further, since the market supply curve is simply the sum of
the individual supply curves…which equal the marginal cost
curves…the difference between price and the market supply
curve measures the surplus of all producers in the market.
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Example: Producer Surplus
P
1. Perfectly Competitive markets have 5 characteristics:
homogeneous products, perfect information,
“fragmentation” (small buyers and sellers), equal access to
resources
Market Supply Curve
P*
2. A price taking firm maximizes profit by producing at an
output level at which (rising) marginal cost equals the
market price (which is the marginal revenue for a pricetaking firm)
Producer Surplus
Q
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3. If all fixed costs are sunk, a perfectly
competitive firm will produce positive output in
the short run only if market price exceeds AVC.
4. The short run market supply is the horizontal
sum of the short run supplies of individual firms.
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