THEORY OF MARKET STRUCTURES

PERFECT COMPETITION

Objectives of the lecture

By the end of this lecture, you should be able to:
i) Define perfect competition
ii) Outline the assumptions upon which the model of perfect
competition is based
iii) Show that a firm's profit will be maximized at the point where
marginal cost curve cuts the marginal revenue from below
iv) Derive firm and industry short run supply curve
v) Illustrate and explain the short run and long run equilibrium
positions of a perfectly competitive firm and industry
vi) Describe how the long run supply curves are derived.

1.1 Definition of Perfect Competition

Perfect competition in economic theory is used to describe a hypothetical market in which no

producer or consumer has the market power to influence prices in the market. This type of
market is based on the following assumptions:

a) The market is characterized by a large number of buyers and sellers, so that each
individual seller, however large, supplies only a small part of the total quantity
offered at the market.
b) The next assumption is that firms produce homogeneous products. If the products
were not homogeneous, the firm would have some discretion in setting price. The
assumptions of large numbers of sellers and of homogeneous products imply that the
individual firm in perfect competition is a price taker. The typical demand curve of
the firm is infinitely elastic, indicating that the firm can sell any amount of output at
the prevailing market price (P) as shown in figure 1.1.

Price

P D

1 Q (output)
FIGURE 1.1: DEMAND CURVE OF A COMPETITIVE FIRM
 (a) There is a free entry and exit of the firms in the market. This assumption is
supplementary to the assumption of large numbers of buyers and sellers. If
barriers exist the number of firms in the industry may be reduced so that each one
of them may acquire power to affect the price in the market.

(b) There is free mobility of factors of production from one firm to another
throughout the economy.

(c) There is a perfect knowledge in the sense that the market participants have a
complete knowledge of the conditions prevailing on the markets. Buyers of the
product are well informed about the characteristics of the product being sold and
the prices charged by each firm.

Are these conditions realistic in the real world? If not why are we studying this
model?

It is obvious that there is no any industry in the real world that is perfectly competitive!
Nevertheless, this does not mean that studying perfect competitive model is useless.
 An economic model may be quite useful no matter how pragmatic some or all of its
assumptions are. The real world cannot possibly be complemented in one single step.
 Perfect competition assumes most of the dynamic forces as being constant and thus
allows the problem of product pricing to be easily understood.
 Perfect competition has become a standard yardstick against which other types of market
structures can be compared, evaluated and understood better

1.2 The Supply Curve of a Firm and Industry

“Firm” and “industry”
 The term “firm” in economics is generally defined as a “unit” that employs factors of
production to produce commodities that it sells/supplies to other firms, to households, or
to the government.
 An industry is a group of firms that produce and sell/supplies a well-defined product or
closely related set of products.

How do we derive the supply curve of a firm under perfect competitive model?

 The supply curve of the firm may be derived by joining the points of intersections of
Marginal Cost (MC) curve with successive demand curves.
 Remember that a firm’s demand curve in a perfectly competitive market is horizontal
(see figure 1.1). In other words, it is the same as the prevailing market price.
 Now, if we assume that the market price increases from P 1 to P2 as shown in figure 1.2(a),
then such an upward shift of the demand curve of the firm will give the positive slope of
the MC curve.
  This implies that the quantity supplied by the firm increases as the price of a given
product rises. Thus, the firm will close down if price falls below P w, because at a lower
price the firm does not cover its variable cost as shown in figure 1.2(a).

Price, Cost
SMC Supply Curve

P2 P2
SATC
P1 P1
Pw SAVC Pw
w

O Xw X1 X2 Quantity of X O Xw X1 X2 Quantity of X
Figure 1.2 (a) Figure 1.2(b)
FIGURE 1.2: SUPPLY CURVE OF THE FIRM AND THE INDUSTRY

Note that if you plot the successive points of intersection of MC and the demand curves on a
separate figure such as 1.2 (b), you will find that the supply curve of the individual firm is
identical to its MC curve to the right of the shut down point w. Note that below Pw, the quantity
supplied by the firm is zero. As soon as the price level rises above the P w the quantity supplied
increases.

How do we derive the industry supply?

The industry supply curve is the horizontal summation of the supply curves of the individual
firms such as the one shown in figure 1.2(b). If we assume that prices of factors of production
and the level of technology are given and the number of firms is very large, then, the total
quantity supplied in the market at each price is the sum of the quantity supplied by all firms at
that price.

1.3 Short Run Equilibrium of the Firm

The equilibrium of the firm may be explained in two approaches. The first approach involves
using the total revenue (TR) and total cost (TC) curves. The second approach involves utilizing
the marginal revenue (MR) and marginal cost (MC) curves. We are going to study both
approaches in the following subsections.

1.3.1 Total Revenue and Total Cost Approach

As far as the total approach is concerned, the firm is in equilibrium when it maximizes its profit
(), defined as the difference between total cost and total revenue:
 = TR - TC (1.1)
Where;  = Profit
TR = Total Revenue
TC = Total Cost

In figure 1.3 we show the total revenue and total cost curves of a firm in a perfectly competitive
market.

The total revenue curve is a straight line through the origin showing that the price is constant at
all levels of output.
 Since, the firm is a price taker and can sell any amount of output at the going market
price, with its TR increasing proportionately with sales.
 The slope of the TR curve is the marginal revenue, which is constant and equal to the
prevailing market price, since all units are sold at the same price.
 Thus in perfect competition the condition MR=AR=P holds.1

The shape of the total cost curve in figure 1.3 reflects the U shape of the average cost curve,
which originates from the law of diminishing returns.
 The firm maximizes its profit at the output Qe, where the distance between the TR and TC
curves is very large compared to other points.
 Note that at lower and higher levels of output total profit is not maximized. For instance,
at output levels smaller than Qa and larger than Qb the firm incurs losses because the total
cost is greater than the total revenue as shown by the shaded areas.

Cost/Revenue
TC
TR

O Qa Qe QbQuantity/Unit of time

1
Note that the average revenue is equal to price; AR=TR/Q=PQ/Q=P
FIGURE 1.3: PROFIT MAXIMIZATION - TOTAL APPROACH

The total revenue approach is a bit problematic to use especially when firms are combined
together in the study of the industry. The alternative approach, which is based on the marginal
cost and marginal revenue, uses price as an explicit variable, and shows clearly the behavioral
conditions that lead to profit maximization.

1.3.2 Marginal Approach

The attainment of equilibrium condition under marginal approach requires the fulfillment of two
conditions.
i) The first condition for the equilibrium of the firm is that the marginal cost be equal to the
marginal revenue. However this condition is not sufficient, since it may be fulfilled and
yet the firm may not be in equilibrium. In figure 1.4 we show that the condition MR=MC
is satisfied at point E*, yet the firm is not in equilibrium since profit is maximized at
Qe>Qe*.

ii) The second condition for equilibrium requires that the MC be rising at the point of its
intersection with the MR curve. This means that the MC must cut the MR curve from
below. Put it differently, the slope of the MC must be steeper than the slope of MR.

Price, Cost

SMC
E* E
P =MR

0 Qe* Qe Quantity/unit of time

FIGURE 1.4: PROFIT MAXIMIZATION WHERE MC CUTS MR TWICE

The sufficient conditions for profit maximization are:

(i) MC=MR
(ii) Slope of MC must be greater than the slope of MR.

The MR and MC curves in the figure 1.5 intersect at the point “E” where MC cuts MR from
below. The profit maximizing output is therefore Qe.
Price, Cost

SMC
SATC
P* E P =MR

A B

0 Qe Quantity/unit of time
FIGURE 1.5: PROFIT MAXIMIZATION - MARGINAL APPROACH

The equilibrium price 0P* is equal to Short run Marginal Cost (SMC) at the equilibrium level of
output Qe. The short run average total cost (SATC) at output 0Q e is Qe B. On the other hand, the
total cost which is given by the average cost multiplied by quantity is thus represented by the
rectangle 0ABQe.

At the equilibrium level of output, total revenue is represented by the area of the rectangle 0P*E
Qe. Thus the firm is earning revenue in excess of total costs; which represents the supernormal
profit equal to the area AP*EB. This is to be contrasted from normal profit which is the rate of
return necessary to keep the factors of productions in their present use.

(i) Normal profit is defined as the level of profit necessary to keep factors
of production in their present use.
(ii) Super normal profit is defined the level of profit in excess of normal
profit.

1.4 Short Run Profit Versus Short run Loss

Can the firm make loss in the short run?

  The fact that the firm is in the short run equilibrium does not necessarily mean that it
makes excess profits.
 Whether the firm makes excess profits or losses depends on the position of ATC at the
short run equilibrium.
o If the ATC is below the price at equilibrium as shown in figure 1.5, the firm earns
excess profits equal to the area (P*ABE).
o If, however, the ATC is above the price as shown in figure 1.6, the firm makes
loss equal to the area FP*EC.
o In the later case, the firm will continue to produce only if it covers its variable
costs. Otherwise, it will shut down, since by discontinuing its operations the firm
is better off.
o

What is the difference between breakeven and shutdown points?

Price, Cost SMC

SATC
AVC

F C
P* E P=MR=AR=D
Pw w

O Xe Quantity of X
FIGURE 1.6: BREAK EVEN AND SHUT-DOWN POINT

The point at which the firm covers its variable costs is called the “shutdown point.” In figure 1.6
the shut down point is denoted by the point w. if price falls below Pw, the firm does not cover its
variable costs and is better off if it shuts down.

(i) If, at the best level of output, P (i.e price) exceeds SATC the firm is
maximizing total profits; if P is smaller than SATC but larger than
AVC, the firm is minimizing total losses; if P is smaller than
 AVC, the firm minimizes its total losses by shutting down.

(i) If the total cost of the firm, i.e. the fixed cost and variable costs are
just being covered, then the firm is said to be breaking even and this is
known as break even point

(iii) If the firm is making losses but the losses only extend to the level of
the fixed costs, then the firm is said to be at its shut down point.

1.5 Short Run Equilibrium of the Industry

The industry is in equilibrium when the quantity demanded is equal to the quantity supplied as
shown in figure 1.7, where P* is equilibrium price and Q* is equilibrium quantity.

Price D S Price
SMC
SATC
P* P* E

S D
O Q* Qty/time O Q* Qty/time
Figure 1.7(a) Industry Figure 1.7(b) Firm
FIGURE 1.7: SHORT RUN EQUILIBRIUM OF THE INDUSTRY

1.6 Equilibrium of the firm in the Long run

In the long run, firms are in equilibrium when they produce at the minimum point of their long
run AC curve, which is tangent (at this point) to the demand curve defined by the market price.
To be noted is that firms will be earning just normal profits, which are included in the long run
average cost (LAC). If firms are making excess profits, new firms will be attracted in the
industry.

Price
D S
S1 SMC1
 SAC1
LMC
P0 P0
SMC2 SAC2

LAC
P* P*

0 Q1 Q2 Quantity 0 Q1 Q2 Quantity
Figure 1.8(a) Figure 1.8(b)
FIGURE 1.8: LONG RUN EQUILIBRIUM OF THE FIRM

Figure 1.8 (b) shows how firms adjust to their long run equilibrium position. If the price is P 0, the
firm is making excess profit working with the plant whose cost is denoted by SAC 1. It will
therefore have an incentive to build new capacity and it will move along its LAC. At the same
time new firms will be entering in the industry attracted by the excess profits. As the quantity
supplied in the market increases, the supply curve in the market will shift to the right and price
will fall until it reaches the level of P* (in figure 1.8a) at which the firms and the industry are in
long run equilibrium.

The condition for the long run equilibrium of the firm is that the marginal cost be equal to the
price and to the long run average cost: LMC = LAC = P*. Also note that at th long run
equilibrium, the short run marginal cost is equal to the long run marginal cost and the short run
average cost is equal to the long run average cost. Thus, given the above equilibrium condition,
we have: SMC = LMC = LAC= LMC=P=MR

Example: Number of Firms in the Industry

Suppose that the market demand in a perfectly competitive industry is given by QD=70,000-
5,000P and the market supply function is QS=40,000+2,500P. Assume further that the lowest
point on the Long run Average Cost (LAC) of each of the many identical firms in the perfectly
competitive industry is T.Shs 4.00/= and it occurs at the output of 500 units.

(a) Find the equation of the demand curve of the firm.

(b) How many firms are in this industry when in the long run equilibrium?

Solution
(a) Note that in a perfectly competitive market, price is equal to: average revenue;
marginal revenue; and demand. Thus, the equilibrium price is the firm’s demand
curve since all firms take price as given.
QD = QS
70,000-5,000P = 40,000+2,500P
30,000 = 7,500P
4 = P
 In summary, the equation of demand curve for the perfectly firm in this industry
is given by P=T.Shs4.00/=. That is, the firm can sell any quantity at that price.

(b) In order to find the number of firms in this industry, we must find the market
equilibrium quantity. This is obtained by substituting the equilibrium price of
T.Shs 4.00/= into either the market demand function or the market supply
function:
QD = QS
70,000-5,000(4) = 40,000+2,500(4)
70,000-20,000 = 40,000+10,000
50,000 = 50,000

Since all firms are identical and each firm produces 500 units of output, when the
industry is in the long run equilibrium, there will be 100 such firms in the industry
(i.e.50, 000500=100)
1.7 Equilibrium of the Industry in the Long Run

The industry is in the long run equilibrium when firms are producing at the minimum point of
the LAC as shown in figure 1.9. At the price P the industry is in equilibrium because profits are
normal and all costs are covered so that there is no incentive for entry or exit. That is, the firm
just earns the normal profit (neither excess profit nor losses) shown by the equality,
LAC=SAC=P which is observed at the minimum point of the LAC curve (figure 1.9b). With all
the firms in the industry being in equilibrium and with no entry or exit, the industry supply
remains stable, and given the market demand (DD) in figure 1.9(a), the price P is a long run
equilibrium price.

Price Cost LMC

D SMC LAC
S SAC

P P
D
S
O Q O Q
Figure 1.9(a) Figure 1.9(b)
FIGURE 1.9: EQUILIBRIUM OF THE INDUSTRY IN THE LONG RUN

Example : Equilibrium of the firm in the long-run

Assume maize is sold under perfectly competitive conditions. All sellers in the industry face the
same long run average cost given by
 100
AC=0.01q-1+ q

And the same long run marginal cost curve given by:

MC=0.02q-1, where q is the kilograms sold per day.

(a) Assuming the market is in the long run equilibrium, how much kilograms will
each firm sell per day?
(b) What are the long run average cost and marginal cost at the level of output in part
(a)?
The market demand for maize is given by Q D=2,500,000-500,000P, where QD is the quantity
demand of rice per day and P is the price of maize.
(c) Given your answer to part (a) what will be the price of maize in the long run
equilibrium?
(d) How many kilograms of maize will be demanded
(e) How many firms (sellers) will be in the industry?

Solution
(a) Each firm supplies in the long run when the LAC is equal to the market price or
(marginal cost). Thus, we equate LAC to LMC as follows;

100
0.01q-1+ q =0.02q-1

100
q -0.01q=0

100
q =0.01q

100=0.01q2

10,000=q2

100=q

(b) Then the long run average and marginal cost are given by substituting q=100 into
the LAC and LMC functions as follow

100
0 . 01q−1+
LAC = q

= 0.01(100)-1+100/100
 = 1-1+1

= 1

LMC = 0.02(100)-1

= 1

(c) Note that the long run supply function is equal to the LMC, which is also equal to
price level, i.e. P=MC;P=1
(d) Substitute the price level (i.e.P=1) into the demand function

QD = 2,500,000-500,000(1) =2,000,000 kilograms

(d) If we divide 2,000,000 by 100 kilograms supplied by each firm we should be able
to get 20,000 kilograms.

Numerical example
Each firm in a competitive market has an identical cost function C(q)=16+q2 , with marginal cost
MC=24. The market demand function is q=24-p.

(a) Find the individual’s firm supply function and the market supply function (assuming that
there are “n” many firms).

(b) What is the condition for this market to be in the long run equilibrium?

(c) Assuming that the market is in the long run equilibrium, how many firms are in this
market? (Hint: first find the equilibrium price and quantity as functions of “n”. Then, solve
for “n”).

(d) Find the equilibrium price and quantity in this market

(e) How much does each firm supply?

Solution

(a) The MC=MR condition gives us an individual firm’s supply: p=2q or

p np
q= Qs =nq=
2 . Market supply is 2
 (b) For market to be in the long run equilibrium (assuming free entry and
exit) the market quantity supplied must equal the market quantity
demanded and each firm must be earning zero profit.

(c) First use the quantity supplied =quantity demanded to get:

Qs = Qd
np
⇒ =24− p
2
48
⇒ p=
n+ 2
p 24
⇒q= =
2 n+2
The zero profit condition says that total revenue=total cost, so:
2
48 24 24
×
n+2 n+2
=16+
n+2 ( )
1152 576
⇒ =16+
n+2 n+2

1152 576
⇒ − =16
n+2 n+2

576
⇒ =16
n+2

⇒n=4

48
p∗ =8
(d) Equilibrium price is 4 +2 and equilibrium quantity is
Q*=24-p*=16

Q∗¿ 16
q∗¿ = =4 ¿
(e) Individual firm’s supply is 4 4
SUMMARY

1. Perfect competition is a market structure in which there are many

firms; each firm sells an identical product; there are many buyers;
there are no restrictions on entry into the industry; firms in the
industry have no advantage over potential new entrants; and firms
and buyers are completely informed about the price of each firm’s
product.

2. In the short run the firm maximises profit or minimises losses by

producing the output at which the marginal cost equals price.
However if market price is less than the firm's average cost at all
levels of output, the firm will minimise loss by discontinuing
production.

3. The short run of the industry is determined by the interaction

between the demand and supply sides of the market. As a rough
approximation, the industry short run supply curve is regarded as
the horizontal summation of the short run supply curve of the
individual firms.

4. The long run equilibrium position of the firm is at the point at

which its long run average costs equal price. Moreover, firms
must be operating at the minimum point on their long run average
cost curves.

5. The constant cost industry occurs when the price of inputs

remains constant as the level of output produced by the firms
expands. In this case, the long run supply curve is usually
horizontal indicating that greater units of output per unit of time
will be forthcoming in the long run at the same market price for
the commodity

6. The increasing cost industry occurs when the price of inputs

 increases as the level of output expands. In this case, the industry
long-run supple curve is positively sloped, indicating that greater
outputs of the commodity per unit of time will be forthcoming in
the long run only at higher prices.

7. The decreasing cost industry occurs when the price of inputs

decreases as the level of output expands. In this case, the industry
long-run supply curve is negatively sloped, indicating that greater
outputs per unit of time will be forthcoming in the long run at
lower prices.