CHAPTER FIVE

PERFECT COMPETETION

Market Structure:
The structure of the market is a description of the behavior of buyers and sellers in that
market. Market structure is broadly grouped into two: perfectly competitive market and
an imperfectly competitive market. A competitive market is one in which buyers and
sellers assume that their own buying and selling decisions have no effect on market price.
An imperfectly competitive market is a market where either buyers or sellers take into
account the effects of their own actions on market price. This market includes monopoly,
monopolistic competition, and oligopoly (in the case of output market); or monopsony,
monopsonistic competition and ologopsony (the case of factor market). In this chapter we
consider the first one (i.e. perfectly competitive market).

Perfectly Competition is a market structure in which there is a complete absence of direct

competition among economic agents; i.e. absence of rivalry among individual firms. A
market is said to be perfectly competitive when all firms regard themselves as price
takers; i.e. they can sell all they wish at the going market price. A set of conditions that is
sufficient to guarantee this perfect competition (sometimes known as (assumptions of
perfect competition) are:
i) Very large number of buyers and sellers in the market; and thus the share of
each firm in the market is very small. That is, it is characterized by large
number of small sized firms.
ii) Product homogeneity. There is no way in which buyers could differentiate
among the product of the different firms.
iii) Because of the above two assumptions, individual firms in pure competition is
P a price-taker; i.e. firm’s demand curve is
perfectly elastic, implying that the firm can sell
any amount of output at the prevailing market
P* d price, P*.
Q
0

iv) Free entry and exit from the industry (or market).
v) Government intervention into the market is little or nil.
vi) All buyers and sellers have complete knowledge of conditions of the market.
vii) The goal of the firm is profit maximization.

Review of Some Basic Concepts:

1. The Firm’s Demand Curve:

Under perfect competition a firm is a price taker and faces a perfectly elastic demand
curve (see assumption (iii) above). Thus, the graphical presentation of the firm’s demand
curve is horizontal straight line drawn at the going market price. This implies that the
firm can sell any quantity it wishes at the market price P*. If the firm raises its price
above P* its sales will fall to zero since all the customers realize that they can buy the

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same/identical product elsewhere at the price P*. In other words, the demand curve is
perfectly elastic at the going market price P*.
2. The firm’s Average and Marginal Revenue Curve:
A perfectly elastic demand curve has an important characteristic: the average revenue
(AR) from the sale of every unit will be equal to the marginal revenue (MR) from the sale
of an extra unit. AR is another term for the price at which the firm sells its product. It is
given by total revenue divided by the total quantity sold; i.e. AR = R/Q. MR is the
change in total revenue resulting from the sale of an additional unit of the product. That
is, MR = dR/dQ. Since the firm can sell as much or as little as it wants at the going price,
MR must be equal to AR. This can be shown as below:
P AR (or Demand): P = f(Q); & and hence total revenue (R) is the
product of price & quantity sold; that is,
R = P*Q. Therefore:
P* AR=MR  AR = R/Q = P*Q/Q = P; and
 MR = dR/dQ = d(P*Q)/dQ = P[dQ/dQ] = P. Thus, AR,
Q P and MR are all the same in perfect competition since
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demand is perfectly elastic (or price is fixed).

3. Firm’s Cost Curve:

The cost structure of a firm any market situation is the same; that is, we will consider a
traditional theory of costs, where all unit costs are U-shaped except the average fixed cost
(which is rectangular hyperbola).

5.1 Short-run Equilibrium of the Firm:

The firm is said to be in equilibrium when it maximizes its profit. There are two
approaches in profit maximization:

(i) Total revenue – Total cost Approach: The firm is in equilibrium (maximizes
profit when the difference between revenue (R) and cost (C) is greatest. The
total revenue curve is a straight line through the origin, showing that price is
constant at all level of outputs (see figure below). The slope of revenue curve
is also called marginal revenue (dR/dQ). It is constant and equal to the
prevailing market price. Note that the firm maximizes its profit at the output
level where the distance between revenue and cost curve is the greatest. To the
left of point ‘a’ and to the right of point ‘b’ there is a loss because total cost
exceeds total revenue.

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 C/R
C
R
Maximum b
Profit

a
C

Qe Q

Numerical illustration: Consider the following cost schedule of a certain competitive

firm where market price is given at birr 20. Determine the level of output that maximizes
profit and the maximum profit.
MC TR MR Unit  Total 
Q TFC TVC TC dTC/dQ P*Q dR/dQ P-AC R-TC
0 30 0 30 -- 0 -- 0.00 -30
1 30 10 40 10 20 20 20.0 -20
2 30 15 45 5 40 20 -2.5 -5
3 30 21 51 6 60 20 3.00 9
4 30 29 59 8 80 20 5.25 21
5 30 40 70 11 100 20 6.00 30
6 30 54 84 14 120 20 6.00 36
7 30 74 104 20 140 20 5.43 36
8 30 95 125 23 160 20 4.38 35
9 30 124 154 27 180 20 2.89 26
10 30 160 190 36 200 20 1.00 10
Profit maximizing level of output would be 7 units (not 6 units) because more output is
preferred. Thus, maximum profit equals 36 birr.

(ii) Marginal Approach:

The total revenue-total cost approach can only indicate the level of profit or loss but it
doesn’t help for analytical interpretation of business behavior. So the marginal approach
is used for further analysis. In this case, the firm’s equilibrium occurs at the level of
output defined by the intersection of marginal cost (MC) and marginal revenue (MR)
curves (see point e in figure below).

If MR exceeds MC, profit has to been maximized and it pays the firm to expand its
output. If MR is less than MC, the level of profit will be reduced and hence it pays the
firm to cut its production. Thus, it follows that short-run equilibrium occurs when MC
equals MR. Thus, the first condition for profit maximization is that MC is equal to MR;
and the second (or sufficient) condition for equilibrium requires that MC curve must cut
MR curve from below (i.e. the slope of MC should be greater than the slope of MR).

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In short, at equilibrium (maximum profit) the following conditions must be satisfied:
1. MR MC; and
2. MC must be rising (i.e. slope of MC must be greater than slope of MR).

The fact that a firm is in short-run equilibrium

SMC
C,R,P

SAC
doesn’t necessarily mean that it makes excess
profits. Whether the firm makes excess profits
D e
P* C MR=AR or loses depends on the level of the average
A D B cost at short-run equilibrium. If the average
cost is below the price (or AR) at equilibrium,
Excess  the firm earns excess profit equal to the
shaded are ABeP* in this figure. If AC>P,
there is a loss equal to the shaded region
0 Qe AP*Be.
Q

The Supply Curve of the Firm and the Industry:

The supply curve of the firm is usually upward sloping, indicating a direct relationship
between price and quantity supplied. This upward sloping supply curve of the firm could
be derived by the points of intersection of its MC curve with successive demand curves.
As it can be seen in figure below, at price P1 the firm reaches its equilibrium at point e1,
producing and supplying Q1 units. If market price increases to P2 (demand shifts to d2),
and the firm will be in equilibrium at point e2 producing and supplying Q2 units, and so
on.
P/C
Price
S
MC
AVC
P3 e3
P1
e2 P2
P2
P1 e1 P3

0 Q1 Q2 Q3 0 Q1 Q2 Q3 Q
Q

If the price falls below P1 the firm will not supply any quantity since it doesn’t cover its
variable costs (i.e. the firm will minimize loss by shutting-down the business in which
case it will only pay TFC). Thus, if we plot the successive points of intersection of MC
and demand (or AR) curves, we will obtain the supply curve of an individual firm. It is
identical to the MC curve to the right of (or above) the shut-down point, e1.

Short-run Equilibrium of the Industry:

Even though the individual or firm’s demand curve is perfectly elastic (horizontal, the
industry demand curve is downward-sloping. Therefore, given the market demand curve

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and supply curve of the industry, the market is in equilibrium at a price which clears the
market (i.e. the price at which quantity demanded is equal to quantity supplied). See
figure below for industry equilibrium.

P/C P Industry Equlb.

Firm’s equlb.
S
MC

P* d P*

D
0 qe q 0 Qe Q

The firm is in equilibrium producing qe level of output at price P*. And the industry
reaches equilibrium at the same price P* but producing Qe of output.

5.2 Long-run Equilibrium:

In he long-run since all inputs are variable the firm has the option of adjusting its plant
size as well as output to achieve maximum profit. Similarly, adjustment f the number of
firms in the industry in response to profit motivation is the key element in establishing
long-run equilibrium.

Firm’s Long-run Equilibrium:

In the long-run firms are in equilibrium when they have adjusted their plant so as to
produce at the minimum point of their LAC curve. Thus, in the long-run firms earn just
normal profit (or zero economic profit).