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ECONOMICS BASIC MICROECONOMICS

Paper No and Title Paper No. 3 : Fundamentals Of Microeconomic Theory

Module No and Title Module 21: Perfect Competition: Introduction, Assumptions

and Pricing Decisions
Module Tag ECO_P3_M21

ECONOMICS Paper No. 3 : Fundamentals Of Microeconomic Theory

Module 21: Perfect Competition: Introduction, Assumptions and Pricing
Decisions
____________________________________________________________________________________________________

TABLE OF CONTENTS

1. Learning Outcomes
2. Introduction
3.Assumptions of Perfectly Competitive Market
3.1 Large Number of Buyers and Sellers
3.2 Homogeneous Product
3.3 Free entry and exit
3.4 Other Assumptions
3.5 Examples: Perfect Competition
4. Pricing and Output Decisions
4.1 Objective of a firm: Profit Maximization
4.2 Profit maximization: Total approach
4.3 Profit maximization: Marginal approach
5. Summary

ECONOMICS Paper No. 3 : Fundamentals Of Microeconomic Theory

Module 21: Perfect Competition: Introduction, Assumptions and Pricing
Decisions
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1. Learning Outcomes
After studying this module, you shall be able to

 Understand the structure of a perfectly competitive market structure.

 Know the working assumptions of perfect competition.
 Evaluate the profit maximizing output level for a firm using total and marginal curves.

2. Introduction

Perfect Competition

A market form refers to the mode in which the firms respond and interact with each other. It is the
environment in which the firms make their pricing and output decisions. The market forms are
usually studied with respect to the degree of competition prevailing in the market. There are
perfectly and imperfectly competitive markets operating in the economic world.

A perfectly competitive market is the extreme case where the market structure is absolutely
impersonal and the ‘invisible hand’ leads to the allocation of resources unhindered. There is large
number of firms behaving in a completely competitive manner. However, it is more of a
theoretical model with only close approximations in reality. Nevertheless, it forms the benchmark
for studying the market forms and provides some useful insights in the economic world. In order
to study the pricing and output decisions of a perfectly competitive market, it is important to look
at the basic assumptions of this market and understand the environment in which it functions.

3. Perfect Competition: Assumptions

3.1 Large Number of Buyers and Sellers

In a perfectly competitive market, there are large number of buyers and sellers. Every consumer
demands only a small fraction of the market output and similarly, every individual firm produces
a negligible fraction of market supply. Therefore, no single producer/consumer can make an
impact on the market price prevailing in the market. The market price in a perfectly competitive
market is determined by the interaction of market demand and market supply curves and each
firm takes that market price as given.

This assumption implies that the firms and the consumers in a perfectly competitive market are
price takers. The firms and the consumers in such a market are independent and correctly believe
that their decisions will not affect the market price.

ECONOMICS Paper No. 3 : Fundamentals Of Microeconomic Theory

Module 21: Perfect Competition: Introduction, Assumptions and Pricing
Decisions
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3.2 Product Homogeneity

In a perfectly competitive set up, each firm produces and sells a homogeneous product. The
homogeneity aspect relates not only to the physical or technical characteristics of the product or
commodity but also to the services associated with the product and the ‘environment’ in which
the purchase is made. When the products of all the firms in a market are perfectly substitutable
with one another, then no firm can raise the price above the market price without losing its market
share to other firms. This reinforces the point that the firms in a competitive market are price
takers. The agricultural products, copper, cotton etc could be apt examples for such goods.

On the other hand if the products are heterogeneous, then the consumers make their buying
decisions depending on the quality of the products. As the goods are not perfectly substitutable,
each firm has the opportunity to raise its price above that of its competitors without losing any of
its sales.

3.3 Free Entry and Exit

In a perfectly competitive market, the firms are free to enter or leave the industry in response to
the monetary incentives. It means that there are no special costs attached if a firm enters the
industry, or exits if it is not making any profit. Moreover, there are no hidden hurdles in terms of
copyrights and patents obstructing new firms to enter the market. For example, the aircraft
industry is not perfectly competitive as the entry requires immense investment in plant and
equipment which has little or no resale value.

An important implication of this assumption is that new firms enter the market if the existing
firms are making exorbitant profits, diluting the profits of incumbent firms in the process.
Similarly, the firms are free to exit the industry in case of losses thereby increasing the market
share (and profits) of the remaining firms. Free entry and exit of firms, thereby implies that in the
long run all firms in the industry are making exactly zero economic profits. The assumption is
important for the competition to be effective. It means that the consumers can easily switch to a
rival firm if the current supplier raises the price.

3.4 Other Assumptions

Large number of buyers and sellers, product homogeneity and free entry and exit are the basic
three assumption of perfectly competitive market structure. Apart from them, it is assumed that
there is no government regulation in this market. The intervention like taxes, subsidies, rationing,
patents etc are ruled out when there is free play of market forces as in the case of perfect
competition.

Moreover, there is perfect mobility of factors of production implying that the factors are free to
move from one firm to another and from one industry to another. The consumers and producers

ECONOMICS Paper No. 3 : Fundamentals Of Microeconomic Theory

Module 21: Perfect Competition: Introduction, Assumptions and Pricing
Decisions
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are assumed to have perfect knowledge about the present as well as the future conditions of the
market. In other words, they are assumed to possess all relevant information essential for making
economic decisions.

Though the assumptions of perfect competition are rigid and unlikely to be fulfilled in reality,
however, moderate deviations from them do not undermine the usefulness of the model.

3.5 Examples: Perfect Competition

The markets of agricultural commodities are close approximations of a perfectly competitive

market. The agricultural produce is more or less homogeneous among the producers and each
producer’s supply accounts for only a small fraction of total output. A single potato seller cannot
individually influence the market price of potato as his produce is approximately homogeneous to
other producers. If he charges a price higher than the market price, then none of the consumers
will buy from him. Also the barriers of entry and exit in terms of movement of resources are
practically non-existent.

Another example for perfectly competitive structure could be the stock market. The market price
of a particular stock is determined by the free play of its demand and supply in the market.
Individual buyers and sellers are too small to influence the price and are thus, the price takers.
Moreover, all the units of stock are identical or homogeneous. The resources are perfectly mobile
as the stocks can be traded as frequently as desired. The assumption of perfect knowledge is also
met as the information on share market is easily available.

4. Pricing and Output Decisions

4.1 Profit Maximization

The output determination model of a perfectly competitive firm requires a close understanding of
the goals of the firm as well as the information available with it. Any business enterprise has the
knowledge of its cost structure but minimizing the cost is not the predominant objective of the
firm. In the economic analysis, profit maximization is usually taken to be the objective of a firm.

Profit = Revenue – Cost

Therefore, in addition to the cost structure, the firm needs to make an estimation of the revenue
which is realized by selling different quantities of the output. The quantity sold multiplied by the
price charged for each unit by the firm is the revenue earned by the firm.

Revenue = Price × Quantity

ECONOMICS Paper No. 3 : Fundamentals Of Microeconomic Theory

Module 21: Perfect Competition: Introduction, Assumptions and Pricing
Decisions
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Therefore, the cost and demand conditions jointly determine the profits of the firm which upon
maximizing gives the equilibrium output level. The question of whether firms actually seek to
maximize profit has been controversial. Profit maximization as an objective of the firm is
discussed in further subsections with respect to the size of firm, control of firm and its structure.

4.1.1 Large sized versus small sized firm/ Manager controlled versus Owner controlled
firm

Small firms are usually owner managed and profit maximization appears to be a plausible
objective as the profits of any firm are pocketed by the owner. However, in the case of large
corporation, there is separation of ownership and management. When a manager has the power to
take day-to-day decisions of the corporation, then profit maximization may not be the goal as
these managers are salaried personnel having no direct effect of profits on their salary (except the
case when salaries are in accordance to profits of the firm). It has been suggested by William
Baumol that managers of a large corporation aim at maximizing sales instead of profits. Other
goals which could be pursued by the managers of a large firm could be

 Revenue maximization
 Revenue growth
 Higher payments of dividends to the shareholders
 Maximize short rum profits at the expense of long run profits

The above argument suggests that profit maximization is not the predominant objective of a large
manager controlled firm. But such deviation by managers from the profit maximizing objective
could not continue for long. There are several reasons why such deviation of goal is limited:

 The future job prospects of a manager essentially depend on how profitably the current
firm is run by the manager. Therefore, they eventually resort to profit maximization as
their goal.
 If a large firm deviates from profit maximization, then eventually its share prices will
follow a downward trend. A depressed share price could lead to replacement of
management team.
 Usually, the salaries of managers are tied up with the profits of the firm. In such cases,
the managers have a fair incentive to follow profit maximization principle.

Thus it could be said that in any case, firms that come close to maximizing profits are likely to
survive in the long run. Therefore, the working assumption of profit maximization seems quite
reasonable.

4.1.2 Cooperatives

A Cooperative is an association of people or businesses, owned and managed by its members for
mutual benefit. For example, a food cooperative is set up to provide food to its members at the

ECONOMICS Paper No. 3 : Fundamentals Of Microeconomic Theory

Module 21: Perfect Competition: Introduction, Assumptions and Pricing
Decisions
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lowest possible prices. Such enterprises do not follow profit maximization as their major
objective. Their purpose is to provide the best service to its members at the minimum cost.

4.2 Profit Maximization: Total Approach

Profit maximization is a common objective of firms belonging to different market forms. The
goal of maximizing profits determines the equilibrium quantity supplied by the firm. Profits are
defined as the difference between the revenues and costs of the firm. Suppose the firm’s output is
denoted by Q, then the total revenue (TR) is defined as

TR (Q) = P×Q

Where P is the price of the product and Q is the number of units of output sold. Thus, TR is the
product of the price of the good and the number of units sold.TR increases as the quantity sold
increases. However, the quantity is a function of price and a downward sloping demand curve
suggests that the demand falls as the price of good increases. Thus, the TR of a firm is a
positively sloped curve as shown in the figure 4.1 below.

TC(Q)
Cost
Revenue TR(Q) (Rupees
(rupees per year)
per year)

0 Quantity (units per year) 0 Quantity (units per

Figure 4.2 year)
Figure 4.1

ECONOMICS Paper No. 3 : Fundamentals Of Microeconomic Theory

Module 21: Perfect Competition: Introduction, Assumptions and Pricing
Decisions
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The total cost (TC) is also a function of output. The short run total cost curve is shown in figure
4.2 above. A firm’s profit is the difference between the revenue and cost and therefore, is a
function of output.

Π(Q) = TR(Q) – TC(Q)

The profit is, therefore, maximized where the difference between the total revenue and total cost
is maximum.

ECONOMICS Paper No. 3 : Fundamentals Of Microeconomic Theory

Module 21: Perfect Competition: Introduction, Assumptions and Pricing
Decisions
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Revenue,
Cost, Profits TC(Q)
(rupeesper
year) A
TR (Q)

0
Q0 Q* Q1
Quantity (units per
∏ (Q) year)

Figure 4.3

In the above figure 4.3, TR and TC curves are shown and the corresponding profit curve is
derived. From the output level 0 to Q0, the profits are negative as the total cost curve is above the
total revenue curve. It implies that the revenues are not sufficient to cover the fixed and the
variable costs of production. As the quantity sold increases, the total revenue increases more
rapidly than the total costs and the profits become positive. At the output level Q*, the difference
between TR and TC is maximum and it is where the profits are maximized. However, if the firm
sells more than Q*, the profits start to fall and eventually become negative after the output level
Q1.

ECONOMICS Paper No. 3 : Fundamentals Of Microeconomic Theory

Module 21: Perfect Competition: Introduction, Assumptions and Pricing
Decisions
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The bold red curve in figure 4.3 is the profit function. It is negative at the initial output levels,
then starts to increase and reaches the maximum level at Q* after which it falls off.

4.3 Profit Maximization: Marginal Approach

The profit maximization behavior of the firm can also be understood with the help of marginal
curves. Marginal revenue (MR) is the change in revenue resulting from one unit increase in the
output level sold. It is per unit change in the total revenue of the firm and is, therefore, the slope
of the TR curve. In figure 4.4, the MR at point A would be the slope of the dotted line. Marginal
cost (MC) is the per unit change in cost resulting from one unit increase in the output level
produced. It can be read as the slope of the TC curve. In figure 4.5, MC at point B is the slope of
the dotted line.

TR (Q) TC(Q)
Revenue Cost
(rupees per (rupeesper
year) year)
A

0 Quantity (units per 0 Quantity (units per

year) Figure 4.5 year)
Figure 4.4

In figure 4.3, the equilibrium has been obtained at output level Q* where the distance between TR
and TC curves is maximum. At this level, the slope of the TR and the TC curves are same (the
tangents to both the curves are parallel). This implies that the marginal revenue and marginal cost
are same at the equilibrium level of output. The rule for profit maximization for any firm is MR =
MC (whether the firm is competitive or not). Marginal revenue curve is derived from the demand
curve; therefore it is downward sloping whenever the demand curve is downward sloping.
However, the MC curve is U-shaped and it has both a downward and upward curvature. Thus,
equality of marginal revenue and marginal cost is not enough for maximizing profits. It becomes
important to check the consequence of this condition under following two cases:

a. Marginal cost is downward sloping.

b. Marginal cost is upward sloping.

ECONOMICS Paper No. 3 : Fundamentals Of Microeconomic Theory

Module 21: Perfect Competition: Introduction, Assumptions and Pricing
Decisions
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MC, MR
MC (Q)

X Y
MR (Q)

0 Quantity per period

Q1 Q2
Figure 4.6
In the above figure 4.6, the MR curve is taken to be a straight line (the case when price is constant
for every output level). The MC curve is U-shaped and intersects the MR curve at X and Y.
According to the condition, MR = MC, both the points X and Y should qualify to yield the profit
maximizing output level. However, only one of these points is profit maximizing. The firm
should not stop the production at Q1 as increasing the output level will add more to the revenues
than to the costs, thus increasing profits. But as the firm reaches output level Q2, it has no further
incentive to increase the output. If the output increased further, the firm will add more to the cost
than to the revenues, thus reducing the profit level. Hence, the profit maximizing output level is
given by point Y and not by point X.

The profit maximization condition can be summarized as follows:

Total Approach Marginal Approach

 MR = MC
 The difference between TR and TC curves  MC curve should be steeper than MR
is maximum curve in case the MR curve has a zero
slope as under perfect competition. (or
MC curve should cut the MR curve
from below).

ECONOMICS Paper No. 3 : Fundamentals Of Microeconomic Theory

Module 21: Perfect Competition: Introduction, Assumptions and Pricing
Decisions
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Using calculus, the profit maximization condition can be derived as follows

∏(Q) = TR(Q) – TC(Q)

d∏/dQ = (dTR/dQ) – (dTC/dQ) = 0

i.e. according to first order condition, MR = MC, and the second order condition is

𝑑2 𝑇𝑅 𝑑2 𝑇𝐶
− <0
𝑑2 𝑄 𝑑2 𝑄

i.e, slope of MR curve < slope of MC curve.

Thus, both the conditions for profit maximization are derived algebraically.

5. Summary
 The assumptions of perfectly competitive firm are existence of large number of buyers
and sellers, product homogeneity, free entry and exit of firms, perfect mobility of factors
of production, perfect knowledge and absence of government intervention.
 Profit maximization is the predominant goal of every firm.
 The profit is maximized where the difference between the total cost and total revenue
curves is maximum. In other words, marginal revenue equal to marginal cost gives the
equilibrium quantity.

ECONOMICS Paper No. 3 : Fundamentals Of Microeconomic Theory

Module 21: Perfect Competition: Introduction, Assumptions and Pricing
Decisions