Perfect Competition: Managerial Economics: Lecture 11

Perfect Competition
Managerial Economics: Lecture 11
Ritwik Banerjee
IIM Bangalore
Recap
• Firm’s Problem
• Optimal Input Choice
• Expansion Path
• Cost Functions
Banerjee (IIM Bangalore) ME Lecture 11: Profit Maximization and Perfect Competition PGP Term I, 2019 Slide 2
Lecture Overview
• Section 1: Perfectly Competitive Market
• Section 2: Profit Maximization
• Section 3: Industry Long Run Supply Curve
• Section 4: Perspective
• Section 5: Takeaway
Ideal World
• Question: If you were to create a perfect world, what would the
market structure be?
• Answer: Perfectly competitive markets
• Analogy?
• Perfect competition is similar to Newtonian Laws of Physics
• No friction ala transaction cost
Assumptions of a Perfectly Competitive
Market
The model of Perfect Competition is based on three assumptions:
1. Price taking
2. Product homogeneity
3. Free entry and exit
Price Taking
• Definition: Firm has no influence over market price and thus, takes
the market price as given
• Examples?
• Implicit Assumptions:
• If a competitive price (one that is determined in marketplace) is not offered,
customer can buy their product elsewhere
• The volume of transaction is low and so customer cannot influence the price
Business Inside: Peugeot-Citroën of France - A
Price-Taker in China’s Auto Market
• Citroën division has a minuscule share of China’s auto market—compared to its
market share in France and Europe.
• Entered Chinese market in 1992
• It has very little control over price, thus, operates as a “price taker”
• Citroën would lose customers if it attempted to charge a price premium in the
developing Chinese market
• Citroën’s main decision is how many cars to produce at the market price. It
must ensure that the capacity at factories is sufficient for producing the optimal
volume of cars
Sources: “Citroën Forecasts Slowdown in Sales Growth in China this Year,” Channel News Asia, June 9, 2004; “General
Motors’ China Success,” BusinessWeek, January 8, 2006
Product Homogeneity
• Definition: When the products of all the firms in a market are
perfectly substitutable with one another. Firms produce identical or
nearly identical products.
• Examples
• Most agricultural products are homogeneous.
• Oil, petrol, and raw material such as copper, iron, lumber, cotton and sheet
steel are also fairly homogeneous.
• Economists refer to such homogeneous product as commodities
Free Entry and Exit
• Definition: Condition under which there are
no special costs that make it difficult for a
firm to enter (or exit) an industry. Buyers can
easily switch from one supplier to another,
and supplier can easily enter or exit a market
• Examples
• Violation of Free Entry and Exit:
• The pharmaceutical industry is not perfectly
competitive because Ranbaxy, Pfizer and other
firms hold patent that gives them unique rights to
produce drugs
Are markets ever perfectly competitive?
• Few products are perfectly competitive
• However, many markets are highly competitive
• Low levels of entry and exit cost, implying high degrees of entry
and exit
• Highly elastic demand curve
The Competitive Firm
Price Firm Industry
Price
P* d P*
P*
100 200 Output 100 Q* Output
The Competitive Firm
• Demand curve faced by an individual firm is a horizontal line
• A competitive firm supplies only a small portion of the total output of all the
firms in an industry.
• Firm’s sales have no effect on market price
• Demand curve faced by whole market is downward sloping

• Shows the amount of goods all consumers are willing to purchase at different
prices
Lecture Overview
Profit Function
Pro$it = Total Revenue − Total Cost
=𝑅 𝑞 −𝑐 𝑞
= 𝑝×𝑞 − 𝑐(𝑞)
Note: A perfectly competitive firm is a price taker
Maximizing Profit Function 𝑅(𝑞)
Cost, revenue, profit C(𝑞)
Profits
0 𝑞∗ Quantity
𝑞: 𝑞<
The Mathematics of it
Profit Function: 𝜋 = 𝑝×𝑞 − 𝑐 𝑞
>? >A@ >B(@)

First order condition: >@ = − >@ = 0>@
𝑝 − 𝑐D 𝑞 = 0
𝑝 = 𝑐D 𝑞
• p: MR in a perfectly competitive firm
• 𝑐 D 𝑞 : MC of the firm
𝑀𝐶 = 𝑀𝑅 = 𝑝
Demonstration Problem 1
The cost function for a firm is given by:
C Q = 5 + QK
If the firm sells output in a perfectly competitive market and other firms
in the industry sell output at a price of $20, what price should the
manager of this firm put on the product?
What level of output should be produced to maximize profits? How
much profit will be earned?
Demonstration Problem: Solution
• Since the firm competes in a perfectly competitive market, it must
charge the same price other firms charge; thus, the manager should
price the product at $20.
• To find the profit maximizing output, we must equate price with
marginal cost. This firm’s marginal costs are 𝑀𝐶 = 2𝑄. Equating this
with price yields
20 = 2𝑄
so the profit-maximizing level of output is 10 units.
• The maximum profits are thus
𝜋 = 20 10 − 5 + 10K = 200 − 5 − 100 = $95
Short Run Supply Curve
P, Cost MC
• In the short run, firms have a
𝑃< fixed amount of capital but
chooses labor
AC • At price 𝑃< how much does the
𝑃K firm produce? Why?
AVC
• At price 𝑃K how much does the
𝑃R firm produce? Why?
• At price 𝑃R how much does the
𝑃S firm produce? Why?
Q
• At price 𝑃S how much does the
𝑞S 𝑞R 𝑞K 𝑞<
firm produce? Why?
P, Cost MC
• In the short run, firms have a
𝑃< fixed amount of capital but
chooses labor
AC • At price 𝑃< how much does the
𝑃K firm produce? Why?
AVC
• At price 𝑃K how much does the
firm produce? Why?
• At price 𝑃R how much does the
𝑃S firm produce? Why?
Q
• At price 𝑃S how much does the
𝑞S 𝑞K 𝑞<
firm produce? Why?
P, Cost MC
• At price 𝑃R how much does
the firm produce? Why?
AC
• Loss at 𝑞 = 𝑞R is the shaded
region
AVC
𝐴𝐶(𝑞R )
Loss at q = 𝑞R
𝑃R
Q
𝑞R
P MC
• At price 𝑃R how much does
the firm produce? Why?
AC
• Loss at 𝑞 = 0 is the shaded
region.
AVC
𝐴𝐶(𝑞R ) • So in the short run it is better
𝑃R Loss at q=0
to continue to produce at
𝑃 = 𝑃R .
Q
𝑞R
Demonstration Problem 2
• Suppose the cost function for a firm is given by
𝐶 𝑄 = 100 + 𝑄K .
• If the firm sells output in a perfectly competitive market and other
firms in the industry sell output at a price of $10,what level of output
should the firm produce to maximize profits or minimize losses?
• What will be the level of profits or losses if the firm makes the optimal
decision?
Demonstration Problem: Solution
• Fixed cost of 100 and variable costs of 𝑄 K i.e. a short-run scenario.
• If the firm produces a positive level of output, it will produce where price
equals marginal cost. The firm’s marginal costs are 𝑀𝐶 = 2𝑄.
• Equating this with price yields 10 = 2𝑄 ⟹ 𝑄 = 5 𝑢𝑛𝑖𝑡𝑠.
• The average variable cost of producing 5 units of output is
^_ K^
𝐴𝑉𝐶 = = = 5. ^ ^
• Since 𝑃 ≥ 𝐴𝑉𝐶, the firm should produce 5 units in the short run. By
producing 5 units of output, the firm incurs a loss of
𝜋 = 10 5 − 100 + 5K = 50 − 100 − 25 = −$75
which is less than the loss of $100 (fixed costs) that would result if the firm
shut down its plant in the short run
P, Cost
MC • In short run, firm chooses its output so that
MC=Price until the firm can cover its AVC
𝑃K
• The short run supply curve is given by the
crosshatched portion of the MC curve
𝑃<
AC • When should a firm shut down in the short
AVC run?
§AVC < P < ATC: Can cover all of its
P=AVC variable costs and some of its fixed costs
§ATC > AVC > P: Cannot cover its variable
costs or any of its fixed costs
Q • Minimum of AVC: Shutdown point
𝑞< 𝑞K
Shutdown (in the short run)
• Why not leave the industry?

• Expects the price of its product to increase or the cost of production to fall
• Stopping production and starting later on may be costly
Short Run Supply : Increase in input cost
P
𝑀𝐶K 𝑀𝐶<
• Increase in input cost
Savings to the firm
from reducing output increases marginal cost
• At same price, less quantity is
𝑃< produced
Q
𝑞K 𝑞<
Short Run Market Supply Curve
P
𝑀𝐶< 𝑀𝐶K 𝑀𝐶R
• Horizontal
𝑀𝑎𝑟𝑘𝑒𝑡 𝑆𝑢𝑝𝑝𝑙𝑦
summation of
individual supply
𝑃R
…
curve gives the
market supply
curve.
𝑃K
𝑃<
Q
𝑞< 𝑞K
Long Run Competitive Equilibrium
Rupees Firm Rupees Industry
LMC per unit 𝑆<
per unit (a) (b)
of of
output LAC output
𝑃< 𝑆K
Rs. 40 𝑃<
𝑆R
𝑃K
Rs. 30 𝑃K
𝑃R
𝑃R
Rs. 20
D
𝑞K Output 𝑞< 𝑞K Output
• Suppose the long run price is Rs.40 per unit, shown in (b) as
interaction of demand and supply curve
• In (a) firms earn positive profit as LRAC reaches a min of Rs.30
• Positive profit encourages entry of new firm , supply curve shifts to 𝑆K
• The long run equilibrium occurs at Rs.30, where each firm earn zero
economic profit and there is no incentive to enter and exit the industry
• Price in the long run is equal to minimum of LAC
• All economies of scale are exhausted
• Market Price is equal to Marginal Cost
• What is the interpretation of Market Price?
• Value to the society of an additional unit of output
• What is the interpretation of Marginal Cost?
• Cost to the society of producing an additional unit of output
• Industry produces socially efficient level of output
Lecture Overview
Adam Smith
“... the annual revenue of every society is always precisely equal to the exchangeable
value of the whole annual produce of its industry.... As every individual ...
endeavours ... to direct (his) industry (so) that its produce may be of the greatest
value, every individual necessarily labours to render the annual revenue of the society
as great as he can. He ... neither intends to promote the public interest, nor knows
how much he is promoting it. ... (rather) he intends only his own security, and by
directing that industry in such a manner as its produce may be of the greatest value,
he intends only his own gain. In this he is led by an invisible hand to promote an
end which was no part of his intention. By pursuing his own interest he frequently
promotes that of the society more effectually than when he really intends to
promote it.”
“It is not from the benevolence of the butcher, the brewer or the baker that we
expect our dinner, but from their regard to their own interest.”
Adam Smith in Book IV, Chapter II of The Wealth of Nations:
Joseph Stiglitz
“…The argument of Adam Smith [1776], the founder of modern economics, that
free markets led to efficient outcomes, “as if by an invisible hand” has played a
central role in these debates: it suggested that we could, by and large, rely on
markets without government intervention. There was, at best, a limited role for
government. The set of ideas that I will present here undermined Smith’s theory
and the view of government that rested on it. They have suggested that the reason
that the hand may be invisible is that it is simply not there – or at least that if is
there, it is palsied.” Nobel Prize Lecture, 2001
“Adam Smith, the father of modern economics, is often cited as arguing for the
“invisible hand” of free markets. But unlike his followers, Adam Smith was aware of
some of the limitations of free markets, and research since then has further clarified
why free markets, by themselves, often do not lead to what is best. The real debate
today is about finding the right balance between the market and government. Both
are needed. They can each complement each other. Their balance will differ from
time to time and place to place.”
Adam Smith
“People of the same trade seldom meet together, even for merriment or
diversion, but the conversation ends in a conspiracy against the public,
or in some contrivance to raise prices.”
Adam Smith, The Wealth of Nations:
Competition or lack of it
• Debate among Economists: Vigorous enforcement action against

Microsoft or Microsoft to be left to itself?
• Adam Smith:
• It is not from the benevolence of the butcher, the brewer or the baker that we
expect our dinner, but from their regard to their own interest.
• People of the same trade seldom meet together, even for merriment or
diversion, but the conversation ends in a conspiracy against the public, or in
some contrivance to raise prices.
Lecture Overview
• Section 4: Perspectives
Takeaway
• A perfectly competitive market is characterized by many buyers and sellers,
undifferentiated products, no transaction costs, no barriers to entry and exit, and perfect
information about the price of a good.
• A firm in a competitive market tries to maximize profits. In the short-run, it is possible

for a firm's economic profits to be positive, negative, or zero. Economic profits will be
zero in the long-run.
• In the short-run, if a firm has a negative economic profit, it should continue to operate if
its price exceeds its average variable cost. It should shut down if its price is below its
average variable cost.

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Perfect Competition

Managerial Economics: Lecture 11

100 200 Output 100 Q* Output

• Demand curve faced by whole market is downward sloping

Note: A perfectly competitive firm is a price taker

>? >A@ >B(@)

• Why not leave the industry?

𝑞K Output 𝑞< 𝑞K Output

Adam Smith, The Wealth of Nations:

• Debate among Economists: Vigorous enforcement action against

• A firm in a competitive market tries to maximize profits. In the short-run, it is possible

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