Perfect Competition by Komilla Chadha

8/2/2019 Perfect Competition by Komilla Chadha

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Perfect Competition (P.C) Explained by Komilla Chadha

Note: Please watch these videos to guide you with this post http://a2withkomilla.blogspot.co.uk/2010/11/perfect-competition.html/.

What is P.C?

P.C is a market structure where there are a large number of buyers and sellers, so muchso that individually they cannot affect market price,.

What are the assumptions?

i. The products are homogeneous.ii.There are no barriers to entry or exit, at least in the long-run.iii.There are a large numbers of buyers and sellers.iv.Firm are rational i.e. they aim to operate at MC=MR.

The demand curve

The demand curve for a perfectly competitive firm is one which is perfectly elastic for tworeasons (i) perfect knowledge exists so any changes in price will force consumers to lookelsewhere and (ii) in P.C. demand = price = average revenue = marginal revenue and thisis called the demand formula. Demand here is equal to price because of the elastic natureof the curve, this is equal to average revenue because average revenue is the income foran individual product which is same as price as goods are homogeneous and this is equalto marginal revenue because price does not change, it is constant so the amount ofincome you get for one extra unit is the same. Below you can see on the left the demand

and supply curve for the industry and on the right the demand curve for the industry.
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The Supply Curve

The supply curve in P.C. is the marginal cost curve to the right of the shut-down pointwhich is the point at where AC=AVC. you can see how it is formulated below.

Functioning at the profit maximization output

We can explain the profit maximization output in two ways.

1. The Total Revenue - Total Cost Approach

So to begin it is important to accept a few crucial facts...

The first is the profit = total revenue - total cost which is fairly simple and most people

already know this.

The second is that the slope/gradient (so essentially differential) of the total revenue curveis marginal revenue. The same is for total cost and marginal cost. In order to arrive at a amarginal value we differentiate the total value because differentiating is the process ofgoing to the gradient of a curve.

The last is that graphically profit is maximized where the distance between the two curvesis the greatest and this is also the point at which the gradients of the two curves are equal.

In a normal total revenue curve is an upside down parabola because demand curves areusually negatively sloped. However, as discussed previously the demand curve for aperfectly competitive firm. So the total revenue curve is a straight upward diagonal line asyou can see below. The average revenue and marginal revenue are constant for a


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perfectly competitive firm and thus as they sell more quantity, only total revenue canincrease, especially as demand is constant. So instead of looking at the point at where thegradients match you can just match the gradient of the total cost curve and make it parallelto the total revenue.

2. The second approach to showing the profit maximization output of a perfectlycompetitive firm is the marginal cost - marginal revenue approach.

The derivatives we found in the first approach can be termed first order derivativesbecause they are the results of the first time total cost and revenue is differentiated inrespect to quantity. We can use our first order derivatives to begin by proving the maximMR=MC.

So profit max: R-COnce differentiated in respect to Q gives us:

= R - C = 0

q q q

Essentially then

R = C which is MC=MR

q q

So now that we have proved that at profit maximization output MC=MR, we can derive thesecond condition that must be met for profit maximization to take place.


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Second order derivatives are when TR and TC have been differentiated twice, so basicallythe differentials of marginal cost and marginal revenue. These second order derivativemust be proved to be equal to less than zero because this will demonstrate that they aremaximum points. This is important because MR and AR are a horizontal line, it is likelythat MC cuts the curve at two points, so we have to make sure it cuts them at the max

point.

= R - C < 0

q q q

So basically...

R < C slope of MR (which is zero coz it is flat) < slop of MC (thus is positive)

q q

We can conclude than for profit to be maximized two conditions must be satisfied:1. MC=MR2. Slope of MC> Slope of MR (0). This condition is not only important because it is likely

that the MC cuts the MR twice but because if it is not satisfied a loss will be made. Aloss will be made because if the MR slop is bigger than that means the MC is negativelysloping. So where MC=MR=AR=P=D, AC curve will be above MC as to ensure thanslope of MR > MC and this means that AC> AR and thus result in a loss. Thats why thiscondition is so important.

Short-run equilibrium

So as we were previously talking about how and why perfectly competitive firms can makeloss, there are three scenarios for the short-term equilibrium of these firms: (i) losses (ii)supernormal profits and (iii) normal profits.


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1. So scenario A, depicts a loss making firm, their price i.e. average revenue is belowaverage total cost and thus they are making a loss but they will not shut down nowbecause they are able to meet their average variable costs.

2. Scenario B, show a firm making normal profit as average revenue is equal to averagecost.

3. Scenario C, shows a firm making profit as average revenue is greater than averagecosts.

Earlier in my video as youll have seen I say how a firm cannot manipulate price withoutbeing eliminated from the market. These scenarios are different in the sense the firmmakes profits and losses as a result in the price which has been set by changes in levelsof supply and demand.

Long-run equilibrium

- In the long-run firms can only make a normal profit .- They operate at the minimum point of the LRAC and thus SRAC. The reason for this is

that at any other points they will always have scope to reduce cost and thus be in short-run.

- The diagram below shows the relationship between the short-run curves and long-runcurves.


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Finally....efficiency

- Both allocative and productive efficiencies are achieved in the long-run P.C. where profit

maximization takes place.- We know allocative efficiency s achieved because firms operate where costs are lowestand that is when resources are optimally utilized and that is at the minimum point ofLRAC. Consumers also pay the lowest possible price because profits =0.

- It is important to recognize that just because static efficiency is achieved that doesntmean that dynamic efficiency is.

- The ascertainment of allocative efficiency can also be shown in through consumer/producer surplus as both of these are maximized too.


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Perfect Competition by Komilla Chadha