Chapter Four

Perfect Competition Market

Definition: Market is defined as the contact between seller

and buyer in which transaction (sale and purchase) is made.

 There are three major basis for classifying market structure

. These are:
 The number of firms in the market

 The nature of the product(homogeneous or heterogeneous).

 The nature of entry (free entry or entry barrier). 1

 Cont.
Perfect competitive market is a market which is
characterized by the following features:
Large number of buyers and sellers: there are large
number of buyers and sellers in the market any single seller
or buyer can not influence the market price.
Homogenous or identical product: in perfectly
competitive market any of the producer produces identical
product.

2
 Cont.
Perfect information (knowledge) : in perfectly
competitive market structure the seller and buyer
have perfect information on price of the product
and quality of the product.
Free entry and exit: perfectly competitive firm
has complete freedom of entry and exit.
Perfect mobility of factors of production.
There is no government intervention.

3
 Cont.
5.2. Short run equilibrium of the firm and
industry under PCM
5.2.1. Short run equilibrium of the
competitive firm
Revenue functions of the firm
• Revenue: is an income earned by the seller after
the sale of a certain unit of the product.
• Total Revenue: refers to the total earning by the
seller from the sale of the whole(total output).
TR=PQ
4
 Cont.
• Average revenue: an earning received by the
seller from the sale of each output.
AR=TR/Q but TR=PQ
AR=PQ/Q=P therefore AR=P
In perfectly competitive market structure
AR=P=MR
• Marginal Revenue: is an extra unit of revenue
that the firm produces one more unit of output.
MR = dTR/dQ = dP.Q/dQ, MR = p

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 Cont.
Two approaches of profit maximization under
perfect competitive market structure:
• Total approach (Π= TR-TC)
According to this approach the profit maximizing
level of out put is that:
• Maximize the excess of TR over TC
• Minimize the excess of TC over TR

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Out put Price TR TC Profit /loss
0 5 0 15 -15
1 5 5 17 -12
2 5 10 18.5 -8.5
3 5 15 19.5 -4.5
4 5 20 20 0 Breakeven
5 5 25 22.5 2.5
6 5 30 24.25 5.75
7 5 35 28.5 6.5
8 5 40 32.5 7.5
9 5 45 45 0 Breakeven
point
10 5 50 52.5 -2.5 Loss
7
 TC
TR
Breakeven
point
Loss

TR,TC ,Π

Loss profit

4 8 9 Out put

Figure Total approaches of profit

maximization
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 cont.
• Marginal approaches (MR = MC)
In marginal approach to select the level of output
that maximizes profit two conditions must be
fulfilled:
• 1st order condition (necessary condition)
dΠ/dQ = 0 d(TR-TC)/dQ =0,MR-MC=0
MR=MC
• 2nd order condition (sufficient condition) 9
• dΠ2 /dQ2 < 0, dTR2 /d2Q – dTC2/d2Q <0 i.e slope
of MR must less than slope of MC
• For perfectly competitive market slope of MR is
zero.
• Generally at a profit maximizing level of output
the MC curve cuts the MR from below:

10
 MC
Cost
K L
P=MR

output

Q1 Q2

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 Cont.
• The demand curve for perfectly competitive firm
is perfectly elastic or horizontal line since price is
constant each firm is price taker.
• The firm cannot maximize his/her profit by
producing Q1 unit of output because 2nd order
condition is not fulfilled. Even if at point “K” 1 st
order condition is fulfilled i.e MR = MC, 2 nd order
condition is not fulfilled MC does not cut MR
curve from below.

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 Numerical example
1.Suppose a firm in a perfectly competitive
market facing the following revenue & cost
functions as follows:
TR = 15Q and TC = 50+4Q+0.02Q2
• Calculate the level of output that a firm will
choose to produce for profit maximization.
• Find the Total profit made by the firm.

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 Solution
• Find MR and MC (FOC)
• MR= dTR/dQ = d15Q/dQ = 15
• MC = dTC/dQ = 4+0.04Q
• For profit maximization MR = MC
MC = 4+0.04Q, MR = 15
= 4+0.04Q = 15
0.04Q = 15-4
0.04Q = 11
Q = 275 14
 Cont.
• SOC slope of MR <MC
i.e. 0<0.04
B. Π = TR – TC
Π = 15Q – (50+4Q+0.02Q2)
= 15(275)- 50- 4(275)-0.02(275) 2
= 4,125 -50 – 1,100 – 1,512.5
Π = 1,462.5
• Interpretation: the firm can generate 1,462.5
units of profit by selling 275 units of output
because FOC and SOC are fulfilled. 15
 Categories of short run Equilibrium of a firm
When a firm is operating in a perfectly
competitive market it will earn profit or loss
depending on the revenue and cost conditions.
• Super normal profit(Economic profit) or abnormal
profit: it occurs when P >AC

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

Super normal of abnormal profit when P>ATC

Normal profit :it occurs when P=ATC
Below normal profit(Loss) when P < ATC
Shut down point: when P < minimum AVC

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 Cont.
Numerical example
A firm producing cloth is operating in a perfectly
competitive market. The firms total cost
function is given as:
TC=400+200Q-10Q2+Q3 if the current market
price is birr 200 per cloth,

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 Cont.
a) Should a firm produce at this price in the short
run?
b)If the market price is birr 150 per cloth what will
total profit/loss be in the firm producing ten units
of output? Should the firm produce at this price?

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 Solution

• The firm should continue production in the short run

if price 200 is greater than the minimum average
variable cost.
• The minimum average variable cost can be
calculated as first let us determine AVC,
• AVC=TVC/Q, AVC=200-10Q+Q2

• FOC: AVC’=0, dAVC/Dq=-10+2Q=0,Q=5

• AVC=200-10(5)+(5)2=175 , Then P> The minimum
AVC so the firm should continue production.
Because the firm covers its variable cost of
production 20
 Short run supply curve of the competitive firm and industry

• Industry: consists of all firms that supply output

to a particular market
• Portion of the firm’s MC curve that intersects and
above AVC curve is short-run firm supply curve.

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22
Derivation of firms supply curve in short run

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• In the Fig, the short run supply curve of a perfectly competitive

firm is obtained by connecting different equilibrium points E1,

E2, E3 that occurs at successive price levels p1, p2 and p3

respectively. When the market price is $6, the firm supplies 50

units to maximize its profit. As the price increases to $7, the

equilibrium quantity supplied increases to 140 units and so on.

• Thus, the short run supply curve of a perfectly competitive firm

is that part of MC curve which lies above the minimum average

variable cost (Shut down point).

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25
Short Run equilibrium of the industry

• An industry is in equilibrium in the short run when market is

cleared at a given price i.e. when the total supply of the industry
equals the total demand for its product, the prices at which market
is cleared is equilibrium price. When an industry reaches at its
equilibrium, there is no tendency to expand or to contract the
output.
• Unlike the individual demand curve, the market demand curve (the
total demand curve that the industry faces) is down-ward sloping,
indicating that as the market price of the commodity increases, the
total quantity demanded for the product decreases and vise versa.
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• In short – run equilibrium of the industry, some
individual firms may make pure profit, some
normal profits and some may make even losses
depending on their cost and revenue conditions.
• Short run supply curve of the competitive industry
is the horizontal summation of the short run
competitive firm

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5.3.Long run equilibrium of the firm and
industry under PCM
5.3.1. Long run equilibrium of the firm
In the long run;
• Firms have time to enter, exit, or adjust their size.
• No distinction between fixed and variable cost
because all resources are variable.
In the long run the firm will earn only normal profit
in PCM.
• Because the short run abnormal profit is avoid by
new entering firms.
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 Short-run economic profit will:
 encourage new firms to enter the market.
 prompt existing firms to expand the scale of operations.
 Economic profit will attract resources from
industries where firms earn normal profit or suffer
losses.

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• In the long run the firm will not incur a loss.
Because if the firm is incurring a loss he will be
leave out the market.
• The firm in a perfectly competitive market will be
in its long run equilibrium when:
P=AR=LMC=LAC=MR
• Graphically the long run equilibrium of the firm
can be shown as follows:
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 LMC
LAC

P1

P2 P=MR=AR
E
P3

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• In the above figure we can infer that the firms
long run equilibrium is not established at price
op1 because P>AC. The firm is at its long run

equilibrium at op2 because at this level of price

P=AR=LMC=LAC = MR.

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33
 Long run equilibrium of the industry

• In the long run equilibrium of the industry all firms in the

industry should be in the long run equilibrium when P=LMC.
• In short, the long run equilibrium of the competitive industry is
Qd =Qs or
P=LMC=min LAC

In the long run all costs are variable because the firm can change the

quantity of all inputs. Thus, in the long run the firm shuts down

when its revenue falls below the long run total cost.
• Or in the long run shut down decision occurs, if the market price

falls below the minimum LAC of the firm. 34

 Cont….
• An industry is in the long-run equilibrium when the price
is reached at which all firms are in equilibrium. That is,
when all firms are producing at the minimum point of
their LAC curve and making just normal profits, the
industry is said to be in the long-run equilibrium.
• Under these conditions there is no further entry or exit of
firms in the industry (since all the firms are getting only
normal profit), so that the industry supply remains stable.
• The long-run equilibrium of the industry is shown by the
next fig.
• At the market price, P, the firms produce at their
minimum LAC, earning just normal profits. At this price
all firms are in equilibrium because LMC=SMC=P=MR
and they get only normal profit because LAC=SAC=P .35
36
 The long-run supply curves of the firm

• we have noted that in the long run the firm shuts

down if the market price is below the its minimum
long run average cost.
• Thus, the firm will not supply for all price levels
below the minimum LAC.
• As a result, a firm‘s long- run supply curve is its
LMC curve above the minimum of its long-run
average cost curve. 37
 Long run supply curve of the industry

• The long run supply curve of the industry is the horizontal sum of the

supply of individual firms just like the case of short run supply curve

of the industry.
• Thus, the long run supply curve of the industry is up ward sloping,

provided that the firms are of different size. This is because, firms

with relatively lower minimum LAC, are writing to inter the market

than others.
• So that as the market price increased in the long run more firms will

find it profitable to inter the market, resulting in up ward sloping long-

run supply curve of industry. 38

The End

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