Economics For Managers - Session 11

8/3/2019 Economics For Managers - Session 11

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PSG INSTITUTE OF MANAGEMENT

MBA 2011-13 BATCH

I TrimesterSession XI- For Batch C and D

Markets and Competition- PERFECT COMPETITION


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Perfect Competition- FeaturesFeatures of a Perfect Competition:

1. There are a large number of buyers and sellers in themarket.2. Firms are price takers unable to influence the

market price individually.3. Producers and consumers act rationally and have

the same information.4. The product is homogeneous: one unit of theproduct is the same as the other unit.

5. There is a free entry of firms into the market andfree exit out of the market.

6. All firms (industry participants and new entrants)are assumed to have equal access to resources(technology, other factor inputs) and improvementsin production technologies achieved by one firm canspill-over to all the other suppliers in the market.

15/09/11 2EFM Faculty P.Uday Shankar


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Total Revenue, Average Revenue and Marginal Revenue

Total Revenue is the total incomeobtained from selling a given quantity ofoutput. ( In other words, the soldquantityx price per unit).

Average Revenue is the price per unitsold.

Marginal Revenue is the addition tototal revenue earned from the sale ofone extra unit of the output.

15/09/11 EFM Faculty P.Uday Shankar 3


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Perfect Competition- Profits in Short Run



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Perfect Competition- Profits in Short Run

In the short run the equilibrium market price isdetermined by the interaction between marketdemand and market supply. In the diagram shownabove, price P1 is the market-clearing price and this

price is then taken by each of the firms. Because themarket price is constant for each unit sold, the ARcurve also becomes the Marginal Revenue curve (MR).A firm maximises profits when marginal revenue =marginal cost. In the diagram above, the profit-

maximising output is Q1. The firm sells Q1 at price P1.The area shaded is the economic (supernormal profit)made in the short run because the ruling market priceP1 is greater than average total cost.



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Perfect Competition- Loss in Short Run



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Perfect Competition- Loss in Short Run

Not all firms make supernormal profits in theshort run. Their profits depend on the position oftheir short run cost curves. Some firms may beexperiencing sub-normal profits because their

average total costs exceed the current marketprice. Other firms may be making normal profitswhere total revenue equals total cost (i.e. they areat the break-even output). In the diagram above,

the firm shown has high short run costs such thatthe ruling market price is below the average totalcost curve. At the profit maximising level ofoutput, the firm is making a loss.



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Perfect Competition- Effects of a Change in a Market Demand



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Perfect Competition- Effects of a Change in a Market Demand

In the diagram above there has been an increasein market demand (ceteris paribus). This causesan increase in market price and quantity traded.The firm's average revenue curve shifts up to AR2(=MR2) and the profit maximising output expands

to Q2. Notice that the MC curve is the firm'ssupply curve. Higher prices cause an expansionalong the supply curve. Following the increase indemand, total profits have increased. (An inwardshift in market demand would have the oppositeeffect. Think also about the effect of a change inmarket supply - perhaps arising from a cost-reducing technological innovation available to allfirms in a competitive market.)



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Perfect Competition- Long Run Adjustment Process



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If most firms are making abnormal profits inthe short run there will be an expansion of theoutput of existing firms and we expect to seethe entry of new firms into the industry. Firms

are responding to the profit motive andsupernormal profits act as a signal for areallocation of resources within the market.The addition of new suppliers causes anoutward shift in the market supply curve. Thisis shown in the diagram above.



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Making the assumption that the market demandcurve remains unchanged, higher market supply willreduce the equilibrium market price until the price =long run average cost. At this point each firm ismaking normal profits only. There is no further

incentive for movement of firms in and out of theindustry and a long-run equilibrium has beenestablished.

The entry of new firms shifts the market supply curveto MS2 and drives down the market price to P2. At the

profit-maximising output level Q3 only normal profitsare being made. There is no incentive for firms toenter or leave the industry. Thus a long-runequilibrium is established. (Fig. in next slide)



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Perfect Competition and Economic Efficiency

Does perfect competition lead to economic

efficiency?Perfect competition is used as a yardstick tocompare with other market structures (such amonopoly and oligopoly) because it displayshigh levels of economic efficiency. In both theshort and long run, price is equal to marginalcost (P=MC) and therefore allocative efficiency

is achieved the price that consumers arepaying in the market reflects the factor cost ofresources used up in producing / providingthe good or service.



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Perfect Competition and Economic Efficiency

Productive efficiency occurs when price is equalto average cost at its minimum point. Productiveefficiency is not achieved in the short run firmscan be operating at any point on their short runaverage total cost curve, but productive efficiencyis attained in the long run because the profitmaximising output is achieved at a level whereaverage (and marginal) revenue is tangential tothe average total cost curve. The long run of

perfect competition, therefore, exhibits optimallevels of static economic efficiency.



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Economics For Managers - Session 11