Laxmi Narain Dubey College, Motihari
(a constituent unit of B.R.A. Bihar University, Muz.)
NAAC Accredited ‘B+’
Department of Economics
Topic: Perfect Competition
Paper-I: MICROECONOMICS
Part-I
B.A. (Hons.)
Instructor
Durgesh Mani Tewari
Assistant Professor
dmtewari@[Link]
PERFECT COMPETITION
Perfect competition is a market structure where there is large number of buyers and sellers of the goods
for which there is no close substitute (homogenous), with there being free entry and exit.
The characteristics of perfect competition are as follows:
i. Large number of buyers and sellers of the goods. There exist such a large number of buyers and
sellers that no single buyer and no single seller can influence the price of the goods. Each is a price
taker.
ii. Homogenous goods. As far as certain goods are concerned, each and every unit of the good is
similar to the other unit. For the buyer, each unit of the good is identical to the other unit
irrespective of which firm has produced the said goods. Thus, no firm has any control over the price
of the specific goods.
iii. Free entry and exit of firms. Firms are free to enter or exit the industry without there being any
restrictions or barriers. Also, there is no cost involved as far as entry and exit are concerned.
iv. Buyers and sellers have perfect knowledge about the conditions in the market. Buyers and
sellers have a complete knowledge about the prices prevailing in the market. There are no
uncertainties in the market about the future conditions.
v. Factors of production are perfectly mobile. All factors of production including land, labour, and
capital are perfectly mobile from one place to another and from one occupation to another
occupation. There are no legal restrictions or obstacles in the form of trade unions.
vi. There is no government intervention. Laissez-faire policy is followed by the government in the
sense that there are no taxes, subsidies, duties, etc., imposed by the government.
vii. There is no cost of transportation. Since it is necessary for a single fixed price to exist in all
markets, it is assumed that there is no cost related to transport.
viii. The goal of the firm is to maximise the profits. Every firm in the market aims at maximising its
profits.
REVENUE CURVES UNDER PERFECT COMPETITION
A firm's revenue under perfect competition is of three types.
Total revenue curve: Total revenue can be defined as the total proceeds earned by a firm from the sale of a
certain amount of the output. Thus,
TR = P×X
where, TR is the total revenue, P the per unit price of the goods, and X the quantity of the goods or the output
level. Since, under perfect competition, a firm is a price taker, the TR curve will be a straight line through the
origin as shown in the following figure.
Total Revenue Curve
Average revenue curve: Average revenue can be defined as the average proceeds earned by a firm from the
sale of a certain amount of the output. Thus,
where, AR is the average revenue.
Average Revenue Curve
So the average revenue is the price of the goods, which is determined by the market demand and supply of the
goods. The AR curve is also the demand curve for the said good. It is shown as a straight line parallel to the
X-axis, depicting that whatever is the quantity sold, the price of the good will remain the same.
Marginal revenue curve: Marginal revenue is the change in the total revenue when the output increases by one
unit.
MR= ∂TR/∂X
or, MR=TRN −TRN−1
Thus, in the following figure, the MR curve is shown as a straight line parallel to the X-axis. It is important to
note that it coincides with the AR curve. Thus,
P=AR=MR
Marginal Revenue Curve
SHORT-RUN EQUILIBRIUM OF THE FIRM
Two approaches-
1. TR-TC approach and
2. Marginal approach.
TOTAL REVENUE - TOTAL COST APPROACH
A firm is said to achieve the equilibrium when its profits are the maximum.
Profits can be defined as the difference between TR and TC. Thus, π=TR−TC
In the following figure,
The TR curve is a straight line through the origin.
The TC curve is inverse S-shaped due to the law of variable proportions.
The profit curve is the difference between the TR and the TC curves.
Profits are maximum at the output OX* while at the outputs OX1 and OX2, the firm breaks even or
makes zero profits.
Total Cost - Total Revenue Approach
MARGINAL APPROACH
Profits will be a maximum when the first-order derivative is zero while the second-order derivative is
less than zero or negative.
Let, π=TR−TC
∂π/∂X = ∂TR/∂X − ∂TC/∂X =0
or, ∂TR/∂X = ∂TC/∂X
or, MR=MC
But under perfect competition, P = AR = MR
P=MC
∂2π/∂X2 = ∂2TR/∂X2 − ∂2TC/∂X2 < 0
∂2TR/∂X2 < ∂2TC/∂X2
Slope of MR< Slope of MC
This implies that at the equilibrium point the MC curve should intersect the MR curve from below
(Fig1).
The marginal approach to equilibrium for a perfectly competitive firm has been depicted
diagrammatically in the figure:
The firm’s demand curve, d, is parallel to the X-axis at a height equal to OP*. It is also the firm’s
AR and MR curve.
The SRAC curve of the firm is represented by the curve SAC. It is U shaped due to the law of
variable proportions.
The SRMC curve of the firm is represented by the curve SMC. It is also U shaped due to the law of
variable proportions. It cuts the SRAR curve, SAC at its minimum point.
The firm is in equilibrium at point E, where MR = MC and also the MC curve intersects the MR
curve from below. The firm is in a position to earn supernormal profits equal to the
rectangle AP*EB.
Fig 1: Perfectly competitive firm making supernormal profits in the short run
It is not necessary that a perfectly competitive firm will make super normal profits in the short run.
The following figure depicts a firm which is making losses in the short run.
The firm’s demand curve, d, is parallel to the X axis at a height equal to OP'.
The firm is in equilibrium at point E'.
The equilibrium price is OP' and the quantity is OX'.
This market price covers only a part of the AFC. It does not cover the AFC.
Thus, the firm will incur losses equal to the rectangle P'ABE'.
The firm will continue to produce as long as it covers the AVC.
Perfectly competitive firm incurring losses in the short run
FIRM’S EQUILIBRIUM IN THE LONG RUN
A firm remains in the LR equilibrium when it is earning normal profits.
This implies that to reach equilibrium in the long-run, a firm will have to make adjustments as depicted
in the following figure.
Long-Run Equilibrium of the Firm
APPLICATIONS OF PERFECT COMPETITION
The equilibrium price of certain goods is determined by the intersection of the market demand and
market supply curves of the said goods.
This can often be applied to analyse the effects of different government policies and is also often of use
to the individual firm when they are involved in making the decisions.
They include the following:
Price controls
Often the government has to intervene in the market through controls on the price using tools like monetary
policy and fiscal policy.
Minimum price policies:
It aims at keeping the market price above the equilibrium price.
In the following figure, the equilibrium is determined by the market demand and supply curves, DD'
and SS', respectively, at point E.
The equilibrium price is OP* while the equilibrium output is OX*.
Often, for example, in the case of some agricultural goods and also under the minimum wage laws, the
government may fix minimum price for the goods at PMin, which is above the equilibrium price OP*.
This will result in an excess supply of the goods, which the government will have to purchase.
Minimum Price Policy
Maximum price policies:
It aims at keeping the market price below the equilibrium price.
In the following figure, the equilibrium is determined by the market demand and supply curves, DD'
and SS', respectively, at point E. The equilibrium price is OP* while the equilibrium output is OX*.
Often, for example, when the government wants to control the production of specific goods, the
government may fix a maximum price for the goods at PMax, which is below the equilibrium price OP*.
This will result in an excess demand for the goods, which, if not satisfied, may result in black
marketing.
Maximum Price Policy
IMPACT OF TAXES AND SUBSIDIES
Taxes, like excise tax adds to the costs leading to a left wards (inwards) shift of the supply curve.
Subsidies or negative tax leads to a rightwards (outwards) shift of the supply curve.
In the following figure, the equilibrium is determined by the market demand and supply curves, DD'
and SS', respectively, at point E.
The equilibrium price is OP* while the equilibrium output is OX*.
An indirect tax on the goods adds to the costs leading to a leftwards (inwards) shift of the supply curve
to S1S1'.
There occurs a change in the equilibrium price and the equilibrium output of the goods.
The price of the goods increases from OP* to OP1 while the equilibrium output decreases from OX*
to OX1.
Impact of Tax
Subsidies or negative taxes also have an impact on the equilibrium price and the equilibrium output of
the good.
There are many other applications of perfect competition like to analyse the stable equilibrium and the
unstable equilibrium and also for understanding the break–even analysis, where the total approach can
be used.
An understanding of perfect competition and determination of price in the short run and the long run is
of immense help if one wishes to apply it to solve some of the problems one faces in reality.
