This session focuses on how managers determine the optimal price, quantity

and advertising decisions under perfect competition. In earlier sessions we

have looked at the nature of competitive markets. We are now going to

analyze the competitive market again along with the cost curves.

The prescribed reading for this session is chapter 10 of the text. The text talks

about varying degree of competition and focuses on highly competitive

markets. These notes label highly competitive markets as perfect competition.

This is consistent with the labels used by economists. Perfectly or highly

competitive market are used to mean the same thing.

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Some of the assumptions of perfect competition include:

Many buyers and sellers- They are many individual buyers and sellers who

buy/sell a small proportion of the good. This implies that both suppliers and

consumers take the market price as given and are unable to influence the

price by their buying or selling decisions. For example, whether I or this whole

class buys milk or not makes absolutely no difference to the price of milk at

Woolies.

Homogenous (identical) products- This condition means that the goods are

exactly the same and consumers view goods by different suppliers as perfect

substitutes. For example, the home brand milk in Woolies and Coles or other

agricultural products. This assumption is difficult to satisfy in most other

markets and most real situations only approximately meet this assumption.

This assumption, however, is very important to buyers switching between

retailers to take advantage of price differences.

Perfect information on both sides of the market- Again this assumption is only

roughly met in reality. If buyers and sellers are badly informed then they are

unable to exploit profitable opportunities in the prevailing markets.

Free entry and exit- The most important implication of this assumption is that if

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a seller wants to enter a profitable market, then they are able to obtain the

necessary resources such as labor and capital.

The implications of these conditions are

a single market price is determined by the interaction of demand and

supply and each buyer and seller is a price taker.

firms earn zero economic profits in the long run.

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Firms in a competitive market try to maximise profit, where Profit=Total

Revenue – Total Cost; where total revenue is simply price times quantity. Think

of a commodity like milk which is homogenous and produced by many different

producers. Essentially the market Demand and Supply diagram determines

the market price and quantity of milk. The market supply is made up of many

individual suppliers and the market demand is made up of many individual

consumers. Lets say the equilibrium price is Pe. Under perfect competition an

individual firm can sell as much as they want at price Pe. Since the individual

is a small supplier in the market, the amount sold by an individual does not

have any influence on the market price and the individual can sell as much as

they want at price Pe. But if an individual firm charges a price higher that Pe,

the individual firm will sell nothing. Therefore, we say that under perfect

competition the individual supplier is a price taker.

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Once we have the price and quantity we can calculate marginal revenue and

average revenue.

Average revenue is the total revenue divided by the amount sold.

Marginal revenue is the change in total revenue from the sale of each

additional unit of output.

Since price is constant

AR = P

MR = P

We are assuming that under perfect competition the firm is so small that

it cannot influence the price and is hence a price taker.

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Recall that in the short run some inputs are fixed. Profit maximizing in the short

run requires that the firm must take the fixed inputs as given and determine

how much variable inputs to employ.

To maximize profit producers must produce at quantity where total revenue

minus total cost is greatest. In previous session we also identified that profit

maximization point can be found by comparing marginal revenue with marginal

cost

If MR > MC: increase production

If MR < MC: decrease production

Maximize profit where MR = MC

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This figure shows the marginal-cost curve (MC), the average-total-cost curve

(ATC), and the average-variable-cost curve (AVC). It also shows the market

price (P), which for a competitive firm equals both marginal revenue (MR) and

average revenue (AR). At the quantity Q1, marginal revenue MR1 exceeds

marginal cost MC1, so raising production increases profit. At the quantity Q2,

marginal cost MC2 is above marginal revenue MR2, so reducing production

increases profit. The profit-maximizing quantity QMAX is found where the

horizontal line representing the price intersects the marginal-cost curve.

Think about outputs below QMAX. At all such points P>MC. This means that the

firm gets more for each additional unit than the cost of producing it. Thus,

profits go up as firm increases output below QMAX. Similarly, at output levels

above QMAX, MC>P. In this instance, each additional unit is costing more than

the gain in revenue from production. A profit maximising firm would reduce

output. Thus, QMAX is the profit-maximizing level of output.

To summarise under perfect competitive or highly competitive market price is

determined by demand and supply conditions. Each individual firm takes this

price as given. The market price is essentially equal to marginal revenue. To

maximise profit, firm needs to find the point where MR=MC.

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Rules for profit maximization:

If MR > MC, firm should increase output

If MC > MR, firm should decrease output

If MR = MC, profit-maximizing level of output

Marginal-cost curve essentially determines the quantity of the good the firm is

willing to supply at any price. A perfectly competitive firm produces the output

at which price equals marginal cost. Marginal cost curve is essentially the

supply curve of the firm.

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Lets assume there is an increase in the price from P1 to P2. This leads to an

increase in the firm’s profit-maximizing quantity from Q1 to Q2. Because the

marginal-cost curve shows the quantity supplied by the firm at any given price,

it is the firm’s supply curve. However, we need to clarify one caveat before

making this statement.

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To fully appreciate the role of MC curve in firm’s supply, we need to understand

the shutdown decision which is:

Short-run decision not to produce anything

Is made during a specific period of time because of current market

conditions

The shut down decision does not free the firm from paying fixed costs

Shutdown decision is free from the exit decision. Exit is a long run decision

that firms make to leave the market. If the firms leave in the long term then

they don’t have to carry the burden of short run or long run costs.

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To maximize short-run profits, a perfectly competitive firm should produce in

the range of increasing marginal cost where 𝑃 = 𝑀𝐶, provided that 𝑃 ≥ 𝐴𝑉𝐶. If

𝑃 < 𝐴𝑉𝐶, the firm should shut down its plant to minimize it losses. Thus,

competitive firm’s short-run supply curve is the portion of its marginal-cost

curve that lies above average variable cost. The reason is simple. If the firm

cannot even get a price in the market that can recoup its average variable

costs, then it is better to shut down. But why should firm continue operation if

price is any lower than ATC. This is because in the short run firm is stuck with

fixed costs. Completely shutting down at P>AVC will mean firm will make

bigger losses than if it continued operation

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So what exactly is the firms short run supply curve. Each firms short run

supply in perfectly competitive market will be the firms MC curve starting from

minimum point of AVC curve or the red line on the above diagram. Firms

should produce at P=MC=MR as long as 𝑃 ≥ 𝐴𝑉𝐶, which is essentially the red

line in the graph.

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However, in the long run the situation is slightly changed:

Firm exit the market if in the long run if:

Total revenue < total costs; TR < TC

Same as: P < ATC

Firm enter the market if in the long run if:

Total revenue > total costs; TR > TC

Same as: P > ATC

In the long run firms will not stay in the industry if they cannot recoup all their

costs.

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In the long run, the competitive firm’s supply curve is its marginal-cost

curve (MC) above average total cost (ATC). If the price falls below average

total cost, the firm is better off exiting the market.

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Profit is traditionally expressed as:

Profit=TR-TC.

We can unpack this further:

Profit=((TR/q) – (TC/q)) x q

Profit= (P – ATC) ˣ Q

If there is a loss.

Loss=TC-TR

Which is the same thing as expressing it as:

Loss = TC - TR = (ATC – P) ˣ Q

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The diagram above shows perfectly competitive firms. Both firms maximize

profits by setting MC=MR. Whether the firms make profit or loss depends on

the position of ATC. The area of the shaded box between price and average

total cost represents the firm’s profit. The height of this box is price minus

average total cost (P – ATC), and the width of the box is the quantity of output

(Q). In panel (a), price is above average total cost, so the firm has positive

profit. In panel (b), price is less than average total cost, so the firm incurs a

loss, shown by the pink box. The height of the pink box is (ATC – P) and the

width of the box is the quantity of output (Q).

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The market (or industry) supply curve is derived from individual firms supply

curve. In the competitive market, each firm’s supply curve is the firm’s

marginal cost curve above the minimum AVC. Each firm will supply at P=MC if

it is getting price greater than AVC. The market supply curve for a perfectly

competitive industry is the horizontal sum of each firms individual supply

curve. Remember each firm in a perfectly competitive market is producing

exactly the same stuff and face exactly the same market conditions. Thus, the

MC curves of perfectly competitive are probably identical.

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In the short run, the number of firms in the market is fixed. As a result, the

market supply curve, shown in panel (b), reflects the individual firms’ marginal-

cost curves, shown in panel (a). Here, in a market of 1,000 firms, the quantity

of output supplied to the market is 1,000 times the quantity supplied by each

firm. So at price $1.00, one individual firm supplies 100 units. Because there

are a total of 1000 firms in the market then the total market output is 100,000.

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So far we have discussed the short run behaviour of firms in a competitive

industry. Since we know that firms can freely enter or exit the competitive

market, if firms sustain long term losses then some will leave the market. This

will shift the supply curve to the left and the market price will increase. For

individual firms the demand curve will move up increasing their profits. On the

other hand, if firms are making positive economic profit in the industry then

other firms will enter the market, shifting the supply curve to the right and

causing a drop in price. This will result in a reduction in profits. The process

will continue until all firms earn zero economic profit in the long run.

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Firms can enter and exit the market

If P > ATC, firms make positive profit

New firms enter the market because of the profit potential

If P < ATC, firms make negative profit

Firms exit the market because of long term losses

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In the Long run

Process of entry and exit ends when

Firms still in market make zero economic profit (P = ATC)

Because MC = minimum ATC, it is known as the efficient scale

Long run supply curve is perfectly elastic

Horizontal at minimum ATC

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The market starts in a long-run equilibrium, shown as point A in panel (a). In

this equilibrium, each firm makes zero profit, and the price equals the minimum

average total cost. To clarify the market supply curve in the long run is

horizontal at P1. In the short run we face the familiar looking demand and

supply curve.

The long run point for a individual firm is P=min ATC=MC. Since we know that

firms can freely enter or exit the competitive market, if firms sustain long term

losses then some will leave the market. This will shift the supply curve to the

left and the market price will increase. For individual firms the profit

maximising point will move up along the MC curve, increasing their profits. On

the other hand, if firms are making positive economic profit in the industry then

other firms will enter the market, shifting the supply curve to the right and

causing a drop in price. This will result in a reduction in profits. The process

will continue until all firms earn zero economic profit in the long run.

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We have just stated that in perfect competition firms make zero economic

profit. But why do the firms operate if they make zero economic profit? The key

lies in the way we defined costs. The total cost defined earlier includes the

opportunity cost of time of the firm’s owner. This is different from accounting

profit. So in the long run economic profit is zero. At the equilibrium point the

firm’s revenue must compensate the owners for the time and money that they

devote to the business.

The zero economic profit is also known as normal profit.

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Now that we have covered the long run and short run, we will bring the two

time horizon together in one graph to see what happens when there is a

change in market condition. In this case we will look at the change in market

demand.

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Lets say the market starts in a long-run equilibrium, shown as point A in panel

(a). In this equilibrium, each firm makes zero profit, and the price equals the

minimum average total cost.

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Now lets say that there is an increase in demand and price increases. The

increase in price means that the firms profit maximising point will change

leading to short run profits. Panel (b) shows what happens in the short run

when demand rises from D1 to D2. The equilibrium goes from point A to point

B, price rises from P1 to P2, and the quantity sold in the market rises from Q1

to Q2. Because price now exceeds average total cost, each firm now makes a

profit, which over time encourages new firms to enter the market.

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Because there is potential for profit, other firms enter the market causing the

supply curve to shift to the right- leading to a lower price. As the price falls,

each individual firm reaches the point P1, restoring long run equilibrium point.

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