5.
PERFECT
COMPETITION
OVERVIEW
(A)Market Structures
(B) Demand and Revenue in Perfect Competition
(C) Short-Run Equilibrium in Perfect Competition
(D)Long-Run Equilibrium in Perfect Competition
(E) Shutdown and Exit Decisions
(A) MARKET STRUCTURES
• In the real world, firms operate differently depending on
their market structures.
• Industries are divided into four market structures
according to the degree of competition:
1- Perfect competition
2- Monopoly
3- Monopolistic competition
4- Oligopoly
(A) MARKET STRUCTURES
Characteristics of market structures
Perfect Monopolistic
Criteria Oligopoly Monopoly
competition competition
Number of
Very large Large Few One
sellers
Barriers to
Very low Low High Very high
entry
Differentiated by Unique with
Nature of Identical or
Identical quality, features, no close
product differentiated
and marketing substitutes
More inelastic
Elasticity of Relatively
Perfectly elastic Relatively elastic relative to
demand inelastic
oligopoly
Pricing None (price Some to Significant
Some
power takers) significant (price makers)
Cement Public
Agricultural Restaurants,
Examples (identical), cars utilities, life-
products clothing stores
(differentiated) saving drugs
(B) DEMAND AND REVENUE IN PERFECT
COMPETITION
• In case of perfect competition, the competitive firms will
face a horizontal perfectly elastic demand curve, since
there are many sellers of an identical product (firms are
price takers).
(B) DEMAND AND REVENUE IN PERFECT
COMPETITION
Marginal Revenue (MR) = Change in TR / Change in Q
Since all firms are selling with the same price, then MR = P in
perfect competition
(C) SHORT-RUN EQUILIBRIUM IN PERFECT
COMPETITION
• The producer makes the decision of producing an
additional unit by comparing the marginal revenue (MR)
gained from such additional unit with its marginal cost
(MC).
• Based on the marginal analysis of production, a perfectly
competitive firm will achieve equilibrium by producing the
level of output at which the marginal equivalency
condition is achieved:
MR = MC
(C) SHORT-RUN EQUILIBRIUM IN PERFECT
COMPETITION
(C) SHORT-RUN EQUILIBRIUM IN PERFECT
COMPETITION
(C) SHORT-RUN EQUILIBRIUM IN PERFECT
COMPETITION
(C) SHORT-RUN EQUILIBRIUM IN PERFECT
COMPETITION
(C) SHORT-RUN EQUILIBRIUM IN PERFECT
COMPETITION
MC
$ ATC
Profit = (10 - 8)1000 = $2000
MR = MC
AVC
ATC = $8
Qf
(D) LONG-RUN EQUILIBRIUM IN PERFECT
COMPETITION
• If the industry is perfectly competitive, firms are not only
price takers but there is free entry.
• Therefore, long-term adjustments will take place in the
long run resulting in normal profit. These adjustments
include:
1- If there is economic profit: new firms will enter the
market, resulting in an increase in market supply, and thus a
fall in market price until price is equal to ATC and
economic profits disappear.
(D) LONG-RUN EQUILIBRIUM IN PERFECT
COMPETITION
2- If there is economic loss: existing firms will exit the
market, resulting in an decrease in market supply, and thus
a rise in market price until price is equal to ATC and
economic loss disappears.
Df*
(D) LONG-RUN EQUILIBRIUM IN PERFECT
COMPETITION
MC
$
ATC
P = MC = ATC
Pe Df
Pe* Df*
QL Qf* Q
(E) SHUTDOWN AND EXIT DECISIONS
• Sometimes, the firm continues to operate in the short run
with losses, in order to minimize its losses.
• A profit-maximizing firm should continue to operate
(sustain short-run losses) if its operating loss is less than its
fixed costs.
Example:
A firm will continue to operate if its price is $4, ATC is $5,
and AVC is $3 as shown in the next figure:
AFC = ATC – AVC = 5 – 3 = $2
(E) SHUTDOWN AND EXIT DECISIONS
Loss = (4 – 5) 100 = $100
$ MC ATC
AVC
ATC = $5
Loss
Pe = Df = MR
AVC = $3
Min AVC
Qf
Loss (if continues) = $100
Loss (if shuts down) = TFC = Q x AFC = 100(5 – 3) = $200
The firm will continue to operate so that to minimize loss.
(E) SHUTDOWN AND EXIT DECISIONS
• Shutdown Decision Rule in the short Run:
1- A firm should shutdown when P < min AVC.
2- A firm will continue to operate if P ≥ min AVC.
• In the long run, the firm should exit the market if the
price is not covering ATC; that is, if total revenue is not
covering total cost indicating that the firm is incurring loss
in the long run.
Thus, the firm exits the market if: P < ATC
Look at Problem 1 page 303
