PERFECT

COMPETITION
 Marginal analysis

Use of Marginal Analysis for price and output determination

The following is the TR, P/AR and MR schedule of the perfectly competitive firm.

Q P/AR TR MR
1 10 10 10
2 10 20 10
3 10 30 10
4 10 40 10
5 10 50 10
6 10 60 10
 Marginal analysis
In the below diagram when the market forces of demand and supply are moving in opposite directions, at OPe
price and OQe quantity, equilibrium is established and markets are cleared.
This is how the perfectly competitive industry operates. Now extending the equilibrium price into quadrant b
gives us the d=AR=MR=P curve of the perfectly competitive firm. The demand curve is perfectly elastic and so
is a horizontal straight line parallel to the x-axis.
 Marginal analysis

Area underlying AR gives us TR. Here the demand curve/AR= MR = P

Let us now revisit the cost curves that we learnt in the previous chapter. In the below diagram when AC
falls MC also falls. As AC rises, MC also rises back. At the point of equilibrium, when MC curve cuts AC
from below at its most minimum point equilibrium is attained. For instance at OQ output, OCe is the
equilibrium cost.

At cost OC1 or OC2, the costs are much higher and so will not be preferred by the firm. Further, at OC2
cost, the stage of diminishing returns will be in operation and hence it will not be in the rational zone.
 Short-Run Equilibrium of the Firm and Industry

Combining the revenue and cost curves we now proceed to establish the short-run equilibrium of the firm.

Firm’s Demand Curve = P=AR=MR

For a perfectly competitive firm, equilibrium is determined at margins. For a firm to attain equilibrium two
conditions must be satisfied:

(i) MR = MC
(ii) MC curve must cut AC curve from below from its most minimum point
 Perfect competition - Meaning

Perfect competition describes an ideal type of market structure where all producers and consumers have
complete symmetric information, absence of transaction costs, and a large number of producers and consumers
compete with each other.
1. Large number of buyers: Since there are large number of buyers no single buyer can dictate the price
or output demanded.
2. Large number of sellers: Since there are large number of sellers no single seller can dictate the price
or output supplied
3. Firms are price takers – they cannot influence prices with their combined actions
4. Homogenous product – Since all producers sell identical products with similar quality product
differentiation is not possible. Therefore, costs will be identical and so prices will be identical. There may be
some differences in costs of production among different places based on factor prices.
5. Perfect mobility of resources – Labor and capital are perfectly mobile and can be switched from one
use to another use and from one place to another place. That means say there is lack of demand for scooters,
labour and capital can easily be switched to manufacturing smartphones. This results in another critical
assumption of full employment.
 Perfect competition - Meaning

6. Perfect knowledge of prices and other variables – All sellers and buyers have perfect price
knowledge. This means that the model rules out price asymmetries. For instance, one single seller can cheat a
few buyers by charging a price higher than the market price. But he cannot cheat all the buyers since they have
complete price information,
7. Absence of selling costs - No selling costs will be incurred since firms are selling homogenous
goods.
8. Absence of transport costs – Goods are assumed to be sold in nearby small markets and so transport
costs will not be substantial enough to result in price differences.
9. No barriers to entry or exit – Firms are free to enter and exit the industry at their will. If there are
abnormal profits new firms will enter the industry and if there are losses existing firms will leave the industry.
10. Laissez Faire – Let alone or free markets is the cornerstone of perfect competition where the market
forces of demand and supply alone will determine the price and the govt. cannot regulate prices. The price
sends the signal to the market about which goods should be produced and which should not be produced.
 Perfect competition - Meaning

All these features lead to the golden rule of the perfectly competitive market “One price for one commodity at
any given point of time in a given market” For instance, tomatoes on 10th July 2021, 11am will be sold in
Crawford market (Mumbai) at Rs. 40 per kilo.
Short-run equilibrium

There are two short-run equilibrium positions possible:

(a) abnormal profits

The firm earns abnormal profits when TR>TC. Let us look at the following diagram to understand this better.
In the diagram, we plot quantity demanded and supplied on x-axis and revenues/costs on y-axis. SAC is the
short-run average cost curve and SMC is the short-run marginal cost curve. The average revenue/price is equal
to marginal revenue and demand, so that d = AR = MR = P.
 Perfect competition - Meaning

(a) abnormal profits

In the below diagram, at point E, MR = MC and MC curve cuts AC from below at its most minimum point.
When there is a possibility to maximize profits, a rational producer tries to do so. This is possible when MC
curve cuts AC from below at its most minimum point at E. At E, we drop a perpendicular to the x-axis and get
the equilibrium output as OQe.

To find out at what price this OQe output was sold, we extend it to the AR curve and locate a point S. From S,
we drop a perpendicular to the y-axis and get the price as OPe. To find out at what cost this OQe output was
produced, we extend it to the AC curve and at point E, drop a perpendicular to y-axis and get average cost of
OR. The area underlying AC gives us TC and area underlying AR gives us TR. In the below diagram, since the
firm is earning abnormal profits, AR>AC. The AR curve lies above AC curve.
 Perfect competition - Meaning

(a) abnormal profits

In the below diagram, at point E, MR = MC and MC curve cuts AC from below at its most
TC = C X Q
Therefore TC = OPe X OCe = OREQe

Abnormal profits = TR – TC

In terms of the diagram,

OPeSQe – OREQe = PeSRE.

PeSRE is the amount of abnormal profits which is shown as the shaded area in the diagram.
 Perfect competition - Meaning

(a) abnormal profits

The firm earns losses when TC>TR. Let us look at the following diagram to understand this better. In
the diagram, we plot quantity demanded and supplied on x-axis and revenues/costs on y-axis. SAC is
the short-run average cost curve and SMC is the short-run marginal cost curve. The average
revenue/price is equal to marginal revenue and demand, so that d = AR = MR = P.

In the below diagram, at point E, MR = MC and MC curve cuts AC from below at its most minimum
point. When there are losses, a rational producer tries to minimize losses. This is possible when MC
curve cuts AC from below at its most minimum point at E. At E, we drop a perpendicular to the x-axis
and get the equilibrium output as OQe. To find out at what price this OQe output was sold, we extend
it to the AR curve and locate a point S.

From S, we drop a perpendicular to the y-axis and get the price as OPe. To find out at what cost this
OQe output was produced, we extend it to the AC curve and locate a point S. From S, we drop a
perpendicular to y-axis and get average cost of OR. The area underlying AC gives us TC and area
underlying AR gives us TR. In the below diagram, since the firm is earning losses, AR>AC. The AC
curve lies above AR curve.
 Perfect competition - Meaning

TR = P X Q
Therefore TR = OPe X OQe = OPeEQe .

TC = C X Q
Therefore TC = OQe X OR = ORSQe

Losses = TC – TR

In terms of the diagram,

ORSQe – OPeQe = PeRSE.

PeRSE is the amount of losses which is shown as the shaded area in the diagram.
 Perfect competition - Meaning

(b) losses
 Long Run Equilibrium of the Firm and Industry

In the long-run the firm as well as the industry earn only normal profits. This is because of the assumption of
freedom of entry and exit. Long run is a time period which is long enough to make it possible to make
adjustments to prices and output.

When there are abnormal profits, new firms attracted by these abnormal profits enter the industry. Existing
firms also increase the output. As output expands, supply increases and price falls so that abnormal profits
disappear.

On the other hand, when there are losses some firms leave the industry. Existing firms reduce the output. As
output falls, demand increases and the price rises so that the losses disappear. Once again only normal profits
accrue to both the firm as well as the industry.

That is why under perfect competition, there will be only normal profits for the firm as well as the industry. In
the below diagram, at point E, MR = MC and MC curve cuts AC from below at its most minimum point. At E,
we drop a perpendicular to the x-axis and get the equilibrium output as OQe. To find out at what price this OQe
output was sold, we extend it to the AR curve and drop a perpendicular to the y-axis and get OPe.
 Long Run Equilibrium of the Firm and Industry

To find out at what cost this OQe output was produced, we extend from point E on the AC curve and drop a
perpendicular to y-axis and get average cost of OPe. The area underlying AC gives us TC and area underlying
AR gives us TR. In the below diagram, since the firm is earning normal profits, LAR=LAC. The LAC curve is
tangential to the LAR curve.
TR = P X Q
Therefore TR = OPe X OQe = OPeEQe .

TC = C X Q
Therefore TC = OPe X OQe = OPeEQe

Normal profits = TR = TC

In terms of the diagram, Since OPeEQe = OPeEQe, there are only normal profits.
Long Run Equilibrium of the Firm and Industry
 Long Run Equilibrium of the Firm and Industry

Let us evaluate the long-run decision to enter and exit in terms of the following diagram which we studied
earlier in Unit 7.

In the below diagram, in quadrant (a), we are showing the perfectly competitive industry and in quadrant (b)
we are showing the perfectly competitive firm. In quadrant (a) the equilibrium price is denoted at OPe and
equilibrium quantity is OQ. Extending this to quadant (b), this gives a normal profit since AC is tangential to
AR. However, when price increases to OP1, TR also increases and in (b), the AR curve shifts outward as AR1.
Since AR1 is above AC, the firms earn abnormal profits. However, when there are abnormal profits, new firms
enter the industry. Existing firms increase the output. This results in supply exceeding demand in quadrant (a).
As producers are left with unsold stocks, the competition between sellers will result in reduction in prices and
the price falls back to the equilibrium of OP. The AR1 curve shifts back to AR and once again only normal
profits accrue to the industry.

However, when prices fall to OP2 in quadrant (a), TR falls. In quadrant (b), the AR curve shifts downward as
AR2. Since the new AR2 curve lies below AC there will be losses. As a result, some firms leave the industry
and existing firms reduce the output. In terms of quadrant
 Long Run Equilibrium of the Firm and Industry

(a), demand exceeds supply. Buyers want to buy more of the commodity but realize there aren’t enough
supplies to buy. Therefore, the competition between buyers will push the price back to OPe and once again
equilibrium is restored. In quadrant (b) this results in AR2 shifting back to its original position of AR and so
once again only normal profits accrue to the industry.

Thus, in the long-run, irrespective of whether there are abnormal profits or losses in the short-run, only normal
profits will accrue to the firm as well as the industry.
Long Run Equilibrium of the Firm and Industry