In this session, you were introduced to the concept of a perfectly competitive market and learnt how a firm
can make decisions while operating in such a market. Although perfectly competitive markets do not exist in
reality, they do provide microeconomic insights, which can be used as a concept for all real markets.
Conditions for a Perfectly Competitive Market (STEP Approach)
Following are the conditions for a perfectly competitive market as per the STEP approach:
o Sellers – A large number of buyers and sellers
o Type of product – Identical or homogeneous products
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o Entry and exit – free entry and free exit of firms
o Price – All producers are price takers
Key Implications for a Perfectly Competitive Market
Following are the key implications for a perfectly competitive market:
1. Firms are price takers (P=MR).
2. In the short run, firms may earn a profit or incur loss. Free entry and exit of firms forces long-run
profits minimise to zero.
In the short run, firms may earn a profit or incur loss depending on the demand conditions of the
product. No new firms can be added and existing firms cannot leave during this period. At least one
factor of production is fixed in the short run.
3. In the short run, firms will produce at a point where Marginal Revenue equals Marginal Costs
(MR=MC). If MR exceeds MC, then firms can earn more profit by increasing the output. If MC exceeds
MR, then firms must reduce their output to avoid losing money.
4. At point E, if the Average Total Cost (ATC) is lesser than the Average Revenue (AR), then the firm is
earning a profit.
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5. If the ATC increases such that the ATC curve, MC curve and MR curve meet at point E, where the
quantity produced is Q at price P, then the revenue and total cost remain the same; this means the firm
is neither making a profit nor incurring loss. This is called the breakeven point. This represents the
minimum sales that a firm must achieve in order to cover all its costs. If sales are lesser than this
amount, then it leads to loss.
6. If the ATC increases and exceeds the AR, then the firm will incur a loss (as shown below). Here, the
firm is still recovering its variable cost and a part of its fixed cost. It can be expressed mathematically
as follows:
ATC = AVC + AFC
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The firm is recovering a part of the fixed cost between AR and ATC, which otherwise could not be
recovered. This is why the firm continues its production even when the ATC exceeds the AR in this
case.
7. If the price of the product moves down such that the variable cost of the firm, AR and MR remain the
same, then the firm is able to recover only the variable cost component of the ATC, that is, the firm is
not able to recover the (Average Fixed Cost) AFC associated with production at quantity Q. This
means that the firm is incurring a loss. Hence, this point is called the shutdown point, where a firm
decides to stop the production of a product.
As a general rule:
A firm should shut down when P < min AVC and
It should continue operating as long as P ≥ min AVC.
8. A short-run supply curve can be obtained from the cost curves. As shown below, it is the MC curve
that lies above the AVC curve.
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Conditions of a Long Run:
Following are the conditions for a long-run equilibrium:
o Firms must earn normal profits, that is, zero profit
o Firms can enter or exit
● What leads to Zero Profit?
o The short run profits lead to entry.
o Entry increases market supply, drives down market price and increases market quantity.
o The demand for the products of an individual’s firm decreases, resulting in a shift of the AR
curve.
o If firms are price takers, but there are barriers to entry, then profit will persist.
o If the industry is perfectly competitive, then firms are not only price takers, but also facilitate
free entry.
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o Effect of entry on the firm’s output and profit (firms reduce Qty at the new price and function
at breakeven)
● Features of Long-Run
o P = MC
▪ Socially efficient output
o P = Minimum AC
▪ Efficient plant size
▪ Zero profits
▪ Firms earn just enough to offset their opportunity cost.
In a long-run perfect competition, firms produce their products at minimum ATC, which leads to the following
two important conditions: productive efficiency and allocative efficiency. This briefly means that resources
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are allocated in the most effective manner and they also provide the maximum satisfaction that is desired by
society.
● Productive Efficiency versus Allocative Efficiency
● If P > MC, the benefit of producing more goods exceeds the cost. Hence, more goods must be
produced.
● If P < MC, the cost of producing more goods exceeds the benefit. Hence,less goods must be produced.
● Difference between Perfect Competition and Real Markets
For a market to have perfect competition, the following conditions must be met::
▪ Companies must be selling the same types of products.
▪ There should be no barriers to entry or exit.
▪ Firms should have equal market share.
▪ Buyers get complete information on prices and products.
If any of the above conditions for perfect competition is not fulfilled, then the following conditions of a
real market arise:
▪ Different companies sell different types of products. Example: Grocery stores
▪ There are barriers to entry or exit. For example, it is difficult for firms to enter the
iPhone market due to high investment in research, and also due to the brand image of
Apple. Also, it is difficult for mining firms to exit owing to the cost that they have to
repay for the environmental damage caused.
▪ Firms compete for market share. Example:Apparel brands, Shoe brands, etc.
▪ Buyers do not get complete Information on prices and products. Example: Real-estate
markets
These unmet conditions allow the existence of market power and different market shares.
Market Power: With market power, firms can increase the market price of goods or services above the
marginal cost to earn more profit.
Price Takers
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In a perfect competition, firms are price takers. All the firms will have to agree to the price set by the market
and they do not have the liberty to set their own price.
Price Makers
Price makers can change the prices of their goods and services because there is no substitute in the market. In
real markets, price makers exist andfirms have the liberty to set the prices to earn more profit.
Market concentration measures the extent to which market sales are dominated by one or two businesses.
● How is market concentration measured?
o The combined market share of the top firms of an industry is measured by the concentration
ratio.
o The number of top firms can range from 3 to 5 or any other smaller number.
o If the top firms have a higher market share, then the industry is said to be highly concentrated.
● Herfindahl–Hirschman Index (HHI): HHI measures market concentration by squaring the market
share of each top firm and then adding the numbers obtained:
HHI = s12 + s22 + s32 + ... + sn2 where s1 , s2, …, sn are the market shares of the top firms.
As per US Department of Justice, HHI < 1,500 indicates a competitive marketplace. HHI between 1,500 and
2,500 indicates a moderately concentrated workplace and HHI >= 2,500 indicates a highly concentrated
marketplace.
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