LESSON

9
PERFECT COMPETITION

CONTENTS
9.0 Aims and Objectives
9.1 Introduction
9.2 Meaning of Perfect Competition
9.3 Features of Perfect Competition
9.3.1 Large Numbers of Sellers and Buyers
9.3.2 Product Homogeneity
9.3.3 Free Entry and Exit of Firms
9.3.4 Profit maximization
9.3.5 No Government Regulation
9.3.6 Perfect Mobility of Factors of Production
9.3.7 Perfect Knowledge
9.4 Short-run Analysis of a Perfectly Competitive Firm
9.5 Long-run Analysis of a Perfectly Competitive Firm
9.6 Let us sum up
9.7 Lesson-end Activity
9.8 Keywords
9.9 Questions for Discussion
9.10 Model Answer to “Check Your Progress”
9.11 Suggested Readings

9.0 AIMS AND OBJECTIVES

This lesson is intended to discuss equilibrium condition and price-output determination
under perfect competition. After studying this lesson you will be able to:
(i) describe meaning and features of perfect competition
(ii) differentiate perfect competition from pure competition
(iii) understand equilibrium of a competitive firm in the short-run
(iv) describe price and output determination of a competitive firm in the long-run.

9.1 INTRODUCTION
Perfect competition is said to prevail where there is a large number firms producing a
homogeneous product. Competition is perfect in the sense that every firm considers that
it can sell any amount of output it wishes at the prevailing market price, which cannot be
affected by the individual producer whose share in the market is very small. With many
firms and homogenous product under perfect competition, no individual firm is in a portion
Managerial Economics to influence the price of the product and therefore the demand curve facing it will be a
horizontal straight line at this level of the prevailing price.

9.2 MEANING OF PERFECT COMPETITION

Perfect competition is a market structure characterized by a complete absence of rivalry
among the individual firms. Thus, perfect competition in economic theory has a meaning
diametrically opposite to the everyday use of this term. In practice, businessmen use the
word competition as synonymous to rivalry. In theory, perfect competition implies no
rivalry among firms.
The perfect competition is defined as the form of market organization in which (1)
There are many buyers and sellers of a product, each too small to affect the price of the
product; (2) the product is homogeneous; (3) there is perfect mobility of resources; and
(4) economic agents have perfect knowledge of market conditions.

9.3 FEATURES OF PERFECT COMPETITION

Following are the main features of Perfect Competition:

9.3.1 Large Numbers of Sellers and Buyers

The industry or market includes a large number of firms (and buyers) so that each
individual firm, however large supplies only a small part of the totalXquantity offered in
the market. The buyers are also numerous so that no monopolistic power can affect the
working of the market. Under these conditions each firm alone cannot affect the price in
the market by changing its output.

9.3.2 Product Homogeneity

The technical characteristics of the product as well as the services associated with its
sale and delivery are identical. There is no way in which a buyer could differentiate
among the products of different firms. If the product were differentiated the firm would
have some discretion in setting its price. This is ruled out in perfect competition.
The assumptions of large number of sellers and of product homogeneity imply that the individual
firm in pure competition is a price-taker: its demand curve is infinitely elastic, indicating that
the firm can sell any amount of output at the prevailing market price (Figure 9.1).
Y
Price

P P = AR = MR
Market

O X
Q Output
Figure 9.1

9.3.3 Free Entry and Exit of Firms

There is no barrier to entry or exit from the industry. Entry or exit may take time but
128 firms have freedom of movement in and out of the industry. If barriers exist the number
of firms in the industry may be reduced so that each one of them may acquire power to Perfect Competition
affect the price in the market.

9.3.4 Profit Maximization

The goal of all firms is profit maximization. No other goals are pursued.

9.3.5 No Government Regulation

There is no government intervention in the market (tariffs, subsidies, rationing of production
or demand and so on are ruled out).
The above assumptions are sufficient for the firm to be a price-taker and have an
infinitely elastic demand curve. The market structure in which the above assumptions
are fulfilled is called pure competition. It is different from perfect competition,
which requires the fulfillment of the following additional assumptions.

9.3.6 Perfect Mobility of Factors of Production

The factors of production are free to move from one firm to another throughout the
economy. It is also assumed that workers can move between different jobs. Finally, raw
materials and other factors are not monopolized and labour is not unionized.

9.3.7 Perfect Knowledge

It is assumed that all the sellers and buyers have complete knowledge of the conditions
of the market. This knowledge refers not only to the prevailing conditions in the current
period but in all future periods as well. Information is free and costless.

9.4 SHORT-RUN ANALYSIS OF A PERFECTLY

COMPETITIVE FIRM
The aim of a firm is to maximise profits. In the short-run some inputs are fixed and these
give rise to fixed costs, which go on whether the firm produces or not. Thus, it pays for
the firm to stay in business in the short-run even if it incurs losses. Thus, the best level of
output of the firm in the short-run is the one at which the firm maximizes profits or
minimizes losses.
The best level of output of the firm in the short-run is the one at which the marginal
revenue (MR) of the firm equals its short-run marginal cost (MC). As long as MR
exceeds MC, it pays for the firm to expand output because by doing so the firm would
add more to its total revenue than to its total costs. On the other hand, as long as MC
exceeds MR, it pays for the firm to reduce output because by doing so the firm will
reduce its total cost more than its total revenue. Thus, the best level of output of any firm
is the one at which MR=MC. Since a perfectly competitive firm faces a horizontal or
infinitely elastic demand curve, P=MR so that the condition for the best level of output
can be restated as one at which P=MR=MC. This can be seen in Fig. 5.12. This can be
shown with calculus as follows:
A firm usually wants to produce the output that maximizes its total profits. Total profits
(T) are equal to total revenue (TR) minus total costs (TC). That is,
p = TR – TC (A)
where p, TR and TC are all functions of output (Q)
p
Taking the first derivative of with respect to Q and setting it equal to zero
gives L
129
Managerial Economics d 2p = d 2 (TC) – d2 (TC) =0 (B)
dQ 2 dQ 2 dQ 2
so that
= (C)
d 2 ( TR ) d 2 (TC)
dQ 2 dQ 2

Equation (C) indicates that in order to maximise profits, a firm must produce where
marginal revenue (MR) equals marginal cost (MC). Since for a perfectly competitive
firm P is constant and TR = (P) . (Q) so that
d(TR)
dQ
= MR = P
the first order condition for profit maximisation for a perfectly competitive firm becomes
P = MR = MC.
The second order condition for profit maximization requires that the second derivative of
p with respect to Q be negative. That is,
dp d(TR) d(TC)
dQ = dQ – dQ < 0 (D)
so that, d(TR) d(TC)
dQ dQ
< (E)

According to equation (E) the algebraic value of the slope of the MC function must be
greater than the algebraic value of the MR function. Under perfect competition, MR is
constant (MR curve is horizontal). So that equation (E) requires that the MC curve be
rising at the point where MR=MC for the firm to maximise its total profits.

The top panel of Figure 9.2 indicates d is the demand curve for the output of the perfectly
competitive firm. The marginal cost curve cuts the SATC at its minimum point. The firm
is in equilibrium (maximizes its profits) at the level of output defined by the intersection
of the MC and the MR curves (point e in Figure 9.5). To the left of e profit has not
reached its maximum level because each unit of output to the left of Xe brings a revenue,
greater than its marginal cost. To the right of Xe each additional unit of output costs more
than the revenue earned by its sale so that a loss is made and total profit is reduced.
SMC
P SATC

Price & Cost E

P d=P=MR

A
B

Q
O Xe Output

Figure 9.2
The fact that a firm is in short-run equilibrium does not necessarily mean that it makes
excess profits. Whether the firm makes excess profits or losses depends on the level of
the ATC at the short-run equilibrium. If the ATC is below the price at equilibrium (Figure 9.3)
the firm earns excess profits (equal to the area PABe). If, however, the ATC is above the
price (Figure 9.4) the firm makes a loss (equal to the area FPeC). In the latter case the
firm will continue to produce only if it covers its variable costs. Otherwise it will close
130
down, since by discontinuing its operations the firm is better off: it minimizes its losses. Perfect Competition

The point at which the firm covers its variable costs is called “the closing down point.”
In Figure 9.5 the closing down point of the firm is denoted by point w. If price falls below
Pw the firm does not cover its variable costs and is better off if it closes down.

P SMC P SMC
SATC SATC

Price
&
Price &
Cost Cost
P e F C
d=P=MR

A P e d=P=MR
B

Q Q
O Xe Output O Xe Output

Figure 9.3 Figure 9.4

P SMC SATC

AFC SAVC
Price &
Cost

pw AFC
W

Q
O XW Output
Figure 9.5

Check Your Progress 1

Draw a diagram depicting loss to a competitive firm in the short-run

9.5 LONG-RUN ANALYSIS OF A PERFECTLY

COMPETITIVE FIRM
In the long-run all inputs and costs of production are variable and the firm can construct the
optimum or most appropriate scale of plant to produce the best level of output. The best level of
the output is one at which price P=LMC equals the long-run marginal cost (LMC) of the firm.
The optimum scale of the plant is the one with short-run average total cost (SATC) curve
tangent to the long-run average cost of the firm at the best level of output. If existing firms earn
profits, however, more firms enter the market in the long-run. This increases the market supply
of the product and results in a lower product price until all profits are squeezed out. On the other
hand, if firms in the market incur losses, some firms will leave the market in the long-run. This
reduces the market supply of the product until all firms remaining in the market just break-even.
131
Managerial Economics Thus, when a competitive market is in long-run equilibrium all firms produce at the lowest point
on their long-run average cost (LAC) curve and breakeven. This is shown by point E in
Fig. 9.6.
In Fig. 9.6 we show how firms adjust to their long-run equilibrium position. If the price is
P, the firm is making excess profits working with the plant whose cost is denoted by
SACS. It will therefore have an incentive to build new capacity and it will move along its
LAC. At the same time new firms will be entering the industry attracted by the excess
profits. As the quantity supplied in the market increases the supply curve in the market
will shift to the right and price will fall until it reaches the level P1 at which the firms and
industry are in long-run equilibrium. The LAC in the Figure 9.6 is the final cost curve.
P P
C
D SMC1 LMC
S
SAC1
LAC
S1
P
P
P1 SAC
SMC

P1
D E

O Q Q1 Q O Q

Figure 9.6

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.
LMC=LAC=P
At equilibrium the short-run marginal cost is equal to the long-run marginal cost and the
short-run average cost is equal to the long-run average cost. Thus, given the above
equilibrium condition, we have,
SMC=LMC=LAC=SAC=P=MR
This implies that at the minimum point of the LAC the corresponding (short-run) plant is
worked at its optimal capacity so that minima of LAC and SAC coincide. On the other
hand, the LMC cuts the LAC at its minimum point and the SMC cuts the SAC at its
minimum point.

9.6 LET US SUM UP

In this lesson we have studied the price and output determination under perfect
competition. Perfectly competitive market is characterised by large number of sellers
and buyers. In the short run a competitive firm may earn abnormal profit, normal profit
or may incur losses. But in the long run firms earn only normal profit.

9.7 LESSON END ACTIVITY

Imagine your textile firm is operating in a perfectly competitive market, and has been
incurring losses for the past two months. Would you recommend that the firm should
stop production? What would be your recommendation if it continues to make losses for
continuous two years? Give reasons for your answer.

9.8 KEYWORDS
Pure Competition
132
Normal Profit Perfect Competition

Supernormal Profit
Free Entry and exit
Break even point
Shut down point

9.9 QUESTIONS FOR DISCUSSION

1. What are the characteristics of perfect competition?
2. Explain the equilibrium of a competitive firm incurring losses.
3. Discuss price and output determination of a firm under perfect competition in the
short run.
4. Show the long run equilibrium of a competitive firm.

9.10 MODEL ANSWER TO “CHECK YOUR PROGRESS”

MC SAC

D
Price and Cost

P MR = AR
E

O Qe
Quantity

Area PF DE shows the amount of loss.

9.11 SUGGESTED READINGS

Dr. Atmanand, Managerial Economics, Excel Books, Delhi.
Bibek Debroy, Managerial Economics, Global Business Press, Delhi.
Shapiro, Bensen, The Psychology of Pricing, Harvard Business Review.

133