Chapter 7

Market Structure: Perfect Competition

Perfect competition
Characteristics
1. Large no. of firms in the market
‒ Price taker
2. Undifferentiated products
‒ Basis for buying is price
3. No barrier to entry and exit from the market
4. Complete information
Characteristics Perfect Monopolistic Oligopoly Monopoly
Competition Competition
1. No. of Large no. Large no. Small no. One
competing firms
2. Nature of the Undifferentiated Differentiated Undifferentiated Unique,
product Differentiated differentiated
product w/ no
substute

3. Entry into No barrier to Few barriers to Many barriers Many barriers

the market entry entry to entry to entry
4. Availability of Complete Relatively good Protected by Protected by
information information information patents, patents,
available available copyrights, copyrights,
trade secrets trade secrets

5. Control over None Some Some but Substantial

price limited by
interdependent
behavior
Perfect competition model
P S MC
P

ATC
Pe
Pe=MR
D

Q Q
Qe Qe
Market demand and supply Perfectly competitive firm
supply and demand
Profit maximizing level of output
P 1. Profit maximizing rule: MR = MC
MC 2. At Q2, P1=MR1 > MC
п2 = P1Q2 – ATC2Q2
P1 P1=MR1
3. At Q1, P1=MR1 = MC
п2
ATC2 п1 п3 п1 = P1Q1*- ATC1Q1
ATC3 ATC 4. At Q3, P1= MR1 < MC
ATC1 п3 = P1Q3 – ATC3Q3

Where,
MR = ∆TR/∆Q = dTR/dQ
Q MC = ∆TC/∆Q = dTC/dQ
Q2 Q1* Q3
Shutdown point for perfectly
competitive firm п = PQ – ATCQ
P
MC п = PQ – AVCQ – TFC
P3 п = (P – AVC)Q – TFC
S
The firm produces output in the short-
P2 ATC run only if (P – AVC)>0 so as to reduce
P1 AVC TFC.

The firm stops operating in the short-run

AFC if (P – AVC)<0 because it incurs loss more
Q than TFC.
Q1 Q2 Q3
 Long-run adjustment in perfect
competition: Entry and Exit
P MC
P
S1
2 S2 2
Pe2
1 ATC
Pe1 4 1, 4 AVC
Pe3 D2 3
3
D1

Q Q
Qe1Qe3Qe2 Q3 Q1 Q2
1: Initial market demand and supply equilibrium
2: Change in demand from D1 to D2; other firms enter the industry due positive economic profits;
change in supply from S1 to S2
3: Initial market demand and supply equilibrium
4: Some firms exit the industry in the long-run due to economic losses; change in supply from S2 to
S1
 Long-run adjustment in perfect
competition
P
MC1
SATC1 MC2 SATC LRAC
P1 2
P1=MR1
P2
P2=MR2

Q1 Q2 Q

If a perfectly competitive firm knows the LRAC, it can increase its scale of operations from Q1 to
Q2 to earn positive economic profits (п2 = P1Q2 – SATC2Q2 > 0) until other firms enter the industry
and drive prices down from P1 to P2. By then, economic profits will be zero again.
 Competition and the agricultural
industry
S1 P
P S2 MC1
SATC1 MC2 SATC LRAC
2
P2 P2=MR2
P1 P1=MR1
P3 P3=MR3

D2
D1
Q
Q1 Q2 Q
Price elasticity of supply
Es = ∆%Qs/∆%P
= (∆Qs/Qs)/(∆P/P)
= (∆Qs/∆P)(P/Qs)
The price elasticity of supply is a measure of how much a
firm increases its quantity supplied of a good Qs given a
one percentage change in the price of the good P.