Fundamentals of Microeconomics

Perfect Competition
 Basic Concepts

Profit ( 𝜋 )

Total Revenue (TR), Average Revenue (AR), Marginal Revenue(MR)

Total Cost (TC), Total Fixed Cost (TFC), Total Variable Cost (TVC), Average
Total Cost (ATC), Marginal Cost (MC)
• In economics, profit is the difference between the revenue that an economic entity has
received from its outputs and the total cost of its inputs.
= TR-TC

• Total revenue (TR)in economics refers to the total receipts from sales of a given quantity of
goods or services.
=P.Q
• Average revenue (AR): This refers to the amount of money earned per individual unit.
= TR / Q
• Marginal revenue (MR)measures the change in the revenue when one additional unit of a
product is sold.
=/ Q

Assume that a company sells widgets for unit sales of $10, sells an average of 10 widgets a
month, and earns $100 over that timeframe.
Widgets become very popular, and the same company can now sell 11 widgets for $10 each
for a monthly revenue of $110. Therefore, the marginal revenue for the 11th widget is $10.
• Production costs (TPC)include every expense associated with making a good or service. They
are broken down into two segments: fixed costs and variable costs.
• Fixed costs (TFC)are the relatively stable, ongoing costs of operating a business that are not
dependent on production levels. They include general overhead expenses such as building rental
payments, insurance costs,loan repayments.
Variable costs (TVC) are those directly related to and those that vary with production levels,
such as salaries and wages, the cost of materials used in production or the cost of operating
machinery in the process of production.

TC= TFC + TVC

• Average total cost (ATC) is referred to as the sum total of all production costs divided by the
total quantity of output.
In other words, the average cost is the combination of total fixed and variable costs, which is
divided by the total number of units that are produced by the firm.

= TC / Q
• The marginal cost (MC) is computed by dividing the change (Δ) in the total cost (C) by the
change in quantity (Q).

=/ Q

• A lower marginal cost of production means that the business is operating with lower fixed
costs at a particular production volume.
If the marginal cost of production is high, then the cost of increasing production volume is
also high and increasing production may not be in the business's best interests.
Economies of scale occur as a company’s
production increases and results in fixed
costs becoming a lower percentage of
each unit.

Internal economies of scale can be

because of
technical improvements,
managerial efficiency,
financial ability,
monopsony power,
or access to large networks.

External economies are ones where

companies can influence economic
priorities, often leading to preferential
treatment by governments.

Diseconomies of scale can occur when a

company becomes too big, lowering its
production.
An economy of
scale is achieved
when increasing the
scale of production
decreases long-term
average costs.

In other words, the

cost of production
per unit decreases
as a company
produces more
units. Reducing
the cost per unit of
production is the
major advantage
companies seek
when scaling.
As an example, Walmart
• Economies of scale are the reasons that larger companies have a competitive advantage of
smaller companies.
• As an example, Walmart has a defensible competitive position because of its scale.

Walmart is able to leverage its scale to:

• Buy products at a lower price than competitors. Walmart can distribute and sell high
volumes of a product compared to its competitors.
• Walmart has a highly efficient supply chain which results in lower distribution costs per unit.
As a simple example, it can always fill the trucks which make the distribution costs per unit
low.
• Walmart embraced and invested in technology to become an innovator in the way stores
track inventory and restock their shelves, thus allowing them to cut costs. In 2015, the
company spent a reported $10.5 billion on information technology. Smaller companies could
never afford that level of investment in technology.
Profit Maximising under Perfect Competition and Monopoly
• A firm’s profits are maximised where its marginal cost equals its marginal revenue.
• MC = MR

• QUESTIONS?
-What determines the amount of profit that a firm will make ?
-Will the firm produce a high level of output or a low level?
-Will it be producing efficiently, making best use of resources?
-Will the price charged to the consumer be high or low?

The answers to these questions largely depend on the amount of competition that a firm faces
A firm in a highly competitive environment will behave quite differently from a firm facing
little or no competition.
ALTERNATIVE MARKET STRUCTURES

• It is traditional to divide industries into categories according to the degree of competition

that exists between the firms within the industry.
• There are four such categories;

1) perfect competition
2) monopoly
3) monopolistic competition
4) oligopoly,
To distinguish more precisely between these four
categories, the following must be considered;

• How freely firms can enter the industry.

Is entry free or restricted/limited?
If it is restricted, just how great are the barriers to the entry of new firms?

• The nature of the product.

Do all firms produce an identical/same product, or do firms produce their own particular
brand or model or range?

• The firm’s degree of control over price.

Is the firm a price taker or can it choose its price,
and if so, how will changing its price affect its profits?
Structure → Conduct → Performance
• Market structure influences how firms behave
• This behaviour (or ‘conduct’) will affect the firm’s performance: its prices, profits,
efficiency, etc.

• Economists thus see a causal chain running from market structure to the performance of that
industry.
Structure → Conduct → Performance

• Two extreme market structures: perfect competition and monopoly.

• The two intermediate cases (monopolistic comp and oligopoly) are sometimes referred to
collectively as imperfect competition.
• The majority of firms in the real world operate under imperfect competition.
Perfect competition
*A market structure where there are many firms,

*none of which is large;

*where there is freedom of entry into the industry; (Firms are free to enter and depart the
market )

*where all firms produce an identical product;

*and where all firms are price takers. (Production components, such as labor and capital, enjoy
complete market mobility and are unaffected by market conditions or pressures.)

• Price taker A firm that is too small to be able to influence the market price.
Assumptions of perfect competition

• The model of perfect competition is built on four assumptions:

1) Firms are price takers.

There are so many firms in the industry that each one produces an insignificantly small portion
of total industry supply, and therefore has no power to affect the price of the product.

2)There is complete freedom of entry into the industry for new firms.

Existing firms are unable to stop new firms setting up in business.

Assumptions of perfect competition

• The model of perfect competition is built on four assumptions:

3) All firms produce an identical product.

There is therefore no branding or advertising.

4) Producers and consumers have perfect knowledge of the market.

Producers are fully aware of prices, costs and market opportunities.

Consumers are fully aware of the price, quality and availability of the product.
The short run and the long run

• In the short run, the number of firms is fixed. Depending on its costs and revenue, a firm
might be making large profits, small profits, no profits or a loss; and in the short run, it may
continue to do so.

• In the long run, however, the level of profits affects entry and exit from the industry. If
supernormal profits are made new firms will be joined into the industry, whereas if losses
are being made, firms will leave.
Normal Profits

• It is the rate of profit that persuades firms to stay in the industry in the long run. But the rate
is not high enough to attract new firms

Supernormal Profits

• It is the rate of profit exceeds the normal profit.

If there is a supernormal profit, new firms enter the market.
Market Price in Perfect Competition
• The market price is determined by supply and demand
in the entire market and not the individual firms

• If a firm in a perfectly competitive market raises the

price of its product, it will lose all of its sales to
competitors

• A perfectly competitive firm faces a horizontal

demand curve at the market price
Profit Maximization in a Perfectly Competitive Market

• A perfectly competitive firm has only one major decision to make—namely, what quantity to
produce

• A perfectly competitive firm must accept the price for its output as determined by the product’s
market demand and supply, can’t change price

• The perfectly competitive firm can choose to sell any quantity of output at exactly the same
price

• Therefore, the firm faces a perfectly elastic demand curve for its product:
• buyers are willing to buy any number of units of output from the firm at the market price

• When the firm chooses what quantity to produce, the quantity will determine the firm’s total
revenue, total costs, and level of profits.!!!
 Determining the Highest Profit by Comparing Total Revenue
and Total Cost
Table 1. Total Revenue, Total Cost, and Profit at the Raspberry Farm
Quantity
Total Revenue (TR) Total Cost (TC) Profit
(Q)
• A perfectly competitive firm can sell as 0 $0 $62 −$62
large a quantity as it wishes, as long as 10 $40 $90 −$50
it accepts the valid market price 20 $80 $110 −$30
30 $120 $126 −$6
• Total revenue is going to increase as the 40 $160 $138 $22
firm sells more 50 $200 $150 $50
• Consider the case of a small farmer who 60 $240 $165 $75
produces raspberries and sells them frozen
for $4 per pack 70 $280 $190 $90
80 $320 $230 $90
90 $360 $296 $64
100 $400 $400 $0
110 $440 $550 $−110
120 $480 $715 $−235
Comparing Marginal Revenue and Marginal Costs

• Firms often do not have the necessary data they need to draw a complete total cost curve for
all levels of production

• Firms experiment with costs and profits through production or cutting production

• Every time one more unit is sold, the firm sells one more unit and revenue goes up by equal
amount as the market price

• Every time the firm sells a pack of frozen raspberries, the firm’s revenue increases by $4

MR=P
The Profit-Maximizing Rule

• Notice that marginal revenue does not change as the firm

produces more output

• The price is determined by supply and demand and does

not change as the farmer produces more

• Since a perfectly competitive firm is a price taker, it can

sell whatever quantity it wishes at the market-determined
price
• The Profit-maximizing rule for a perfectly competitive
firm is to produce the level of output where marginal
revenue equals marginal cost

MC = MR
The Profit-Maximizing in Short Run

• A Furniture company– chair- P= 8 TL (fixed price)

• How many chairs should the firm produce and sell so that its profits are maximized?
• A furniture company employs L=3 workers and produces Q=23 chairs and sells them for
P=8 TL, and when the total fixed cost is 50 TL and the total variable cost of one worker is 30
TL;

total revenue TR=8x23=184 TL, (P x Q)

total cost TC=140 TL ((3x30) +50)
profit (𝜋=TR−TC)=44TL
MC = MR
The Shutdown Point
• A firm can not avoid losses by shutting down and not producing because shutting down can
reduce variable costs to zero

• In the short run, however, the firm has already committed to pay its fixed costs

• The firm produces a quantity of zero, it would still make losses because it would still need to pay
for its fixed costs.

• Should a firm continue producing or shut down?

• For example:
• A yoga center has a signed contract to rent space that costs $10,000 per month
• The yoga center’s marginal costs for hiring yoga teachers is $15,000 per month
• If the center were to shut down, it would still pay rent but it wouldn’t pay for hired labor
The Shutdown Point: Yoga Center 1

• Should the Yoga Center Shut Down Now or Later?

• Scenario 1:
• If the center shuts down now, revenues are zero but it will not incur any variable costs and would only need to pay fixed
costs of $10,000
The Shutdown Point: Yoga Center 2

• Should the Yoga Center Shut Down Now or Later?

• Scenario 2
• The center earns revenues of $10,000, and variables costs are $15,000, the center should shut down now
The Shutdown Point: Yoga Center 3

• Should the Yoga Center Shut Down Now or Later

• Scenario 3
• The center earns revenues of $20,000, and variable costs are $15,000, the center should continue business
Entry and Exit Decisions in the Long Run
• The line between the short run and the long run cannot be defined
• In the short run, firms cannot change the usage of fixed inputs
• In the long run, the firm can adjust all factors of production

• When businesses are making profit, in the short run, they have incentive to expand.
• When new firms come into an industry in response to high profits, it is called entry.
• If businesses are making losses, in the short run, they will limp along or shut down

• If businesses are making losses, in the long run, they will downsize, reduce their capital
stock, or shut down completely

• When firms leave an industry due to a pattern of losses, this is called exit
How Entry and Exit Lead to Zero Profits in the Long Run

• A perfectly competitive firm can’t alone affect the market price

• A combination of many firms entering and exiting the market will affect the overall supply
in the market

• A shift in supply for the market as a whole will affect the market price

• Entry and exit to and from the market are the driving forces behind a process that, in the long
run, pushes the price down to minimum average total costs so that all firms are earning a
zero profit

• The long-run equilibrium is where all firms earn zero economic profits producing the
output level where.