PERFECT COMPETITION
Demand and Marginal Revenue for a Competitive
Firm
• Each firm in a competitive industry sells only a small fraction of the
entire industry output, how much output the firm decides to sell will
have no effect on the market price of the product. The market price
is determined by the industry demand and supply curves. Therefore,
the competitive firm is a price taker.
We know that the necessary and sufficient
conditions for the equilibrium of a firm
are:
1. MC = MR
2. MC curve cuts the MR curve from below.
• The firm must keep adding to its output as long as MR>MC . This is
because additional output adds more revenue than costs and increases
its profits. Further, if MC=MR, but the firm finds that by adding to its
output, MC becomes smaller than MR, then it must keep increasing its
output.
• Output Rule: If a firm is producing any output, it should produce at
the level at which marginal revenue equals marginal cost.
Short run equilibrium of a competitive firm
The price under perfect competition is determined by the industry.
The price so determined by the industry is passed on to firms .
Since an individual firm is unable to influence the ruling price and
since it can sell an infinite amount at the prevailing price, the demand
or the AR curve facing an individual firm under perfect competition is
perfectly elastic at the ruling price.
In other words, AR curve is a straight line parallel to X axis. Since
AR is constant at the prevailing price, MR is also constant and it
coincides with AR at the ruling market price so that AR = MR.
If AR = P then naturally MR =P . How much a firm produces depends
on its MC. A firm under perfect competition will be in equilibrium at
the level of output at which MC= MR and MC cuts MR from below.
The firm is in equilibrium when it maximises its profits, defined as
the difference between total cost and total revenue.
profit = TR- TC
The equilibrium of the firm and industry can be shown graphically
by using cost and revenue curve.
• Since it is a perfectly competitive market, the demand for the product
of the firm is perfectly elastic. Further, it can sell all its output at the
market price. Therefore, its demand curve runs parallel to the X-axis
throughout its length and its MR curve coincides with the AR curve.
• The demand curve d facing an individual firm in a competitive market
is both its average revenue curve and its marginal revenue curve.
Along this demand curve, marginal revenue, average revenue, and
price are all equal.
The Competitive Firm’s Short-Run Supply
Curve
We have seen that competitive firms will increase output to the point at which price
is equal to marginal cost, but will shut down if price is below average variable
cost. Therefore, the firm’s supply curve is the portion of the marginal cost
curve for which marginal cost is greater than average variable cost.
The entire short-run supply curve consists of the crosshatched portion of the
vertical axis plus the marginal cost curve above the point of minimum average
variable cost.
Closing Down Point : The point at which the firms covers its variable cost is
called the “ closing down point “.( P< AVC).
Long-Run Profit Maximization
In the long run the firm will be earning just normal profits which
are induced in LAC.
► If they are making excess profits = new firms will be attracted in the industry = will
lead to a fall in price & an upward shift of the cost curves due to the increase of the prices of
factors as the industry expands.
These changes will continue until the LAC is tangent to the demand curve defined by the market
price.
► If the firm makes losses in the long run they will leave the industry = price will rise
& cost may fall as the industry contract until the remaining firms in the industry cover their total
cost inclusive of the normal rate of profit
✔ The firms in long-run competitive equilibrium in perfect
competition only make normal profits, then they are operating at
the intersection of the marginal revenue (MR) and average total
cost (ATC ) curves.
✔ Each additional unit sold yields the same amount of revenue, and
therefore marginal revenue (MR) is equal to average revenue (AR) at
this price level. Thus, the equation for the long-run competitive
equilibrium in a perfectly competitive market is as follows:
The condition for the long run equilibrium of the firm is that the
marginal cost be equal to the price and to the long run average cost,
i.e., LMC=LAC=P.
Perfect competition conditions
1. Economic Efficiency : ( P = MC ).
2. Profit Maximization : ( MR = MC ) .
3. Perfect Competition : (MR = AR = P) .
4. Ideal Output : ( MC= AC & P = MC)/Breakeven Point:(P
=AR =ATC).
5. Minimum Production cost : MC = ATC .
6. Minimum efficient scale : MC = ATC = LRAC =LRMC .
