Perfect Competition
Learning Objectives:
• What are the features of a perfectly competitive market?
• How do firms make production decisions in the short run and in the
long run?
• How are firm and industry supply curves are obtained?
Perfectly Competitive Market
• Many buyers and sellers, each being very small relative to the total
market size
• All the firms produce an identical product with the same features
• Both the producers and consumers have perfect information
• Transaction costs are absent in the market
• There exist free entry and free exit in the market
• Are these examples of perfectly competitive markets?
• Example: VHS vs Betamax
• Example: Time Warner Boosts My Speed, Cuts My Bill: I Just Happen To Live Near
Google Fiber
Market Demand vs Demand for a Firm’s Product
• An individual firm in a perfectly competitive market faces a perfectly
elastic demand curve.
• Each firm can sell as much as it wants at the equilibrium market price.
• If a firm charges anything higher than the equilibrium market price,
then no one will buy its product.
Profit Maximizing Condition for a Firm in a Perfectly
Competitive Market
Marginal Revenue = Marginal Cost
• Marginal revenue is the extra revenue obtained by the firm by selling
one extra unit of the output.
• Marginal cost is the extra cost the firm incurs for producing one extra
unit of the output.
• In a perfectly competitive market, marginal revenue for each firm is
equal to the equilibrium market price.
Shut Down and Break-Even Points
• A firm in a perfectly competitive market is breaking even when total
revenue equals total cost (normal profit or zero economic profit).
• A firm in a perfectly competitive market will shut down if price falls
below the average variable cost (AVC) as the firm can neither recover
the entire variable cost of production nor recover at least part of the
fixed cost of production.
Production Condition for a Perfectly Competitive Firm
in the Short Run
• The firm will produce in the short run as long as:
• P = MC
• P ≥ AVC
Short Run Firm Supply Curve
• For a perfectly competitive firm in the short run, the supply curve is
represented by the MC curve above the minimum of AVC curve.
Long Run Entry and Exit
• If there exist economic profits in a perfectly competitive market, then
in the long run more firms will enter the market, driving down the
equilibrium market price.
• If there exist economic losses in a perfectly competitive market, then in
the long run some firms will exit the market, driving up the
equilibrium market price.
Production Condition for a Perfectly Competitive Firm
in the Long Run
• A perfectly competitive firm in the long run will operate where:
• P = MC
• P = minimum of Average Cost (AC)