PERFECT COMPETITION

As discussed in the pre-program module, Perfect Competition is a market structure in

which a firm faces a horizontal demand curve .

This implies that price is taken by the firm from the market and the firm has no power to
change the price. If it raises the price a little, demand will fall to zero. If it lowers the
price a little demand will rise infinitely. This is because the large numbers of sellers sell
the same identical products. Demand faced by the firm under perfect competition is
therefore perfectly elastic.
This is depicted in the following figure:

PRICE PRICE
PANEL A PANEL B

P
P P = AR =MR

QUANTITY DEMANDED

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We see that in panel A, the intersection of the demand and supply curves determine the
market price P. In panel B, we see that at this price the firm has a horizontal demand
curve at which the price is constant and the demand is perfectly elastic.

Since firms have no control and power over price, they can only determine the output
they should sell so as to maximize profits. At the given price a firm can sell any quantity.

It will sell a quantity such that Marginal Revenue (MR) = Marginal Cost (MC).

For a perfectly competitive firm, MR is equal to price since price is constant. This means
that MR which is the addition made to Total Revenue is always same and equal to price
because every additional unit is sold at the same price.
AR is always equal to price because TR = P*Q and AR = TR/Q.

Therefore under Perfect Competition, AR =P=MR.

Since the price is given to the firm, the only decision it can take is to find out what is the
level of output it should produce and sell. For this it uses the condition of profit
maximization, that is MR = MC and MC is rising as depicted in the figure.

PRICE

MC
A B
MR

QUANTITY

As seen in the figure, MR = MC at two points A and B.

At A, MC has just become equal to MR and falls below MR after that. This is when the
firm starts making profits. It goes on making profits on every additional unit produced till
point B is reached.

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It is therefore at point B that profits are maximum, because beyond that point MC rises
above MR and the firm starts incurring losses on every additional unit after that which
eats away some of the earlier profits earned.

Therefore there are two conditions of profit maximization:

1) MR = MC
2) MC is rising.

Given that a perfectly competitive firm is given a price by the market, it cannot compete
in terms of price. What is the option for such a firm then?

The obvious answer is that, such a firm should determine the quantity at which it can
maximize profits at the given price. In the short run, there are four possibilities the firm
could be facing under the constraints of a fixed given price.
They are:

1) When price is greater than Average Cost (AC) then the firm earns profits.
2) When price is equal to Average Cost the firm earns only normal profit.

3) When the price is less than Average Cost the firm incurs a loss .
And lastly,
4) If Price is less than AC and also less than AVC

Let us now analyze each of these situations separately:

1) It can so happen that either due to higher demand or lower supply, price or
average revenue is greater than the firm’s average cost. In such a case, its but
obvious that the firm will make positive profits.
Let us use a diagram to discuss this:

Price
MC
profits AC

E
P MR =AR=P
T L

0
Q
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 Output

As we see in the graph, the firm’s average cost curve is below the price or average
revenue curve. The point of equilibrium or the point at which the firm makes
maximum profits is point E where the following two conditions are fulfilled:

MR = MC
MC is rising

At the point E, the firm sells an output equal to OQ, and don’t forget that at this
level of output production, it maximizes profits.

We can find out its profits or area of profits in this graph.

At OQ output, price or average revenue the firm earns is OP or QE. Therefore the
total revenue it earns is Price * quantity sold, that is OP *OQ which is = the area
of the rectangle OPEQ.

At OQ output, the firm’s average cost is QL or OT. Therefore, its total cost is the
area of the rectangle OTLQ.

The profits earned by the firm is equal to Total Revenue minus total cost, that is
equal to A(OPEQ) – A(OTLQ) that is equal to A(TPEL).

2) Another situation that a firm is likely to experience at a given market price is that
price or average revenue is equal to average cost. In such a case, the firm just
earns that amount of revenue which covers the entire cost.It is important her to
note that, this cost also includes a certain minimum profit that the owner or
entrepreneur should get as an income for the services he renders. Such a minimum
profit which is a part of cost is called normal profit. We can therefore say that in
such a situation, the firm earns normal profits.
We can represent this situation in the following graph:

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Price
MC
AC

E
P MR =AR=P

0
Q
Output

As we see in the graph, the average cost curve lies on the average revenue curve.
The point of equilibrium or the point where marginal revenue is equal to marginal
cost on the rising portion of the marginal cost curve is E. At this point, the firm
produces OQ output. The average revenue or price is OP and therefore the total
revenue = OP*OQ = A (OPEQ).

The average cost at this output is EQ and therefore the total cost = EQ*OQ, which
is again equal to A(OPEQ). Since total revenue is equal to total cost, the firm does
not earn any excess profits and so the firm is said to earn only the normal profit
included in the cost in this case.

3) A third possible situation for the firm is that average cost is higher than
average revenue or price. In such a situation, the firm’s revenue falls short of
its cost and therefore the firm incurs negative profit or loss. This represented
in the following graph:

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Price
MC
AC
L
T

P MR =AR=P
E

0
Q

Output

As we see in the graph, the firm’s average cost curve is above the price or average
revenue curve. The point of equilibrium or the point at which the firm makes
maximum profits is point E where the following two conditions are fulfilled:

MR = MC
MC is rising

At the point E, the firm sells an output equal to OQ.

We can find out its profits or area of profits in this graph.

At OQ output, price or average revenue the firm earns is OP or QE.Therefore the

total revenue it earns is Price * quantity sold, that is OP *OQ which is = the area
of the rectangle OPEQ.

At OQ output, the firm’s average cost is QL or OT. Therefore, its total cost is the
area of the rectangle OTLQ.

The profits earned by the firm is equal to Total Revenue minus total cost, that is
equal to A(OPEQ) – A(OTLQ) . Now here we notice, that total cost or A(OTLQ)

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is greater than total revenue or A(OPEQ). As a result, the firm\s profit = negative
A(TPEL) or a loss equal to that area.

How then can we say that E is the point of profit maximization? What is meant by
this is that at E,if the average cost is below average revenue, the firm makes
profits and such profits are maximum at that point. On the other hand, if at E, the
average cost is higher than average revenue, like in this case, then the firm incurs
a loss but such losses are minimum. At any other point or output in this case,
losses would have been higher.The point of profit maximization should therefore
be considered as the best point to operate at which either profits are maximum or
losses are minimum.

Now what do you recommend for such a firm incurring a loss? Should the firm
continue operations, or should it close down its business?

Now this is a very important decision for the firm. In business, let us understand,
there are bound to be instances of losses now and then. That does not mean that
the firm should take a hasty decision and close down the business. It is foolish to
do such a thing without considering several factors. IN the first place, the firm
may want to wait and see whether the situation improves or not. What do we
mean by an improvement? It means that either the market price will rise or the
cost will fall. In either case, the firm’s losses will reduce and there may come a
stage when it starts making positive profits again. Since an analysis depends on
the abilities and foresight, risk taking ability and business acumen of the
entrepreneur. Sometimes, the firm may just decide that it wants to close down its
business because it cannot bear the losses. Sometimes, it may be ready to wait and
bear losses for some time, maybe because it has a backing in terms of reserves
accumulated when the going was good or because it is confident that it has access
to funds at a low interest cost.

Anyhow, during this waiting period, the firm has to still decide whether it should
continue operations or not. By that we mean whether it should continue producing
and selling the product or shut down its factory temporarily. Here, it is important
to remember the difference between Shut down and close down.
Shut down relates to a temporary shutting down of operations and does not
involve the selling off of assets. Close down refers to the permanent close down
of business which also involves the selling off of assets.

Shut down is therefore more of a short run phenomenon and close down is more
of a long run phenomenon.

Coming back to the decision this firm has to take given that it is incurring a loss
and given that the firm is prepared to wait and not close down business till things
improve, it still needs to decide whether during this waiting period it should
temporarily shut down operations or not.

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 For this, the firm will compare its losses in the two situations of continuing with
operations and shutting down operations. When the firm continues operations, it
incurs a certain loss equal to the difference between the total cost and total
revenue, which is A (PTEL) in this example. When it shuts down, it has to incur
the fixed costs anyway because it has not sold off its assets. Therefore, if the loss
is greater than fixed cost, it makes sense for the firm to shut down during the short
run. On the other hand, if loss is less than fixed cost, it makes sense for the firm to
continue operations.

When the loss is less than the fixed cost, it means that the revenue is covering the
entire variable cost and also a part of the fixed cost. Let us not forget, that the first
priority for the firm is to cover its variable costs. In such a case, it implies that the
firm’s price or average revenue should be greater than average variable cost, only
then can the toral revenue cover the entire variable costs. But of course, its
average revenue will be less than its average cost.
Let us represent this case in the following graph.

AC

Price MC
L
T AVC
E
P MR =AR=P
S
R

0
Q

Output

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 Here we see that the average variable cost (AVC) is less than average revenue or
price . At the equilibrium quantity Q, total revenue is equal to area (OPEQ). Total
cost is equal to area OTLQ. It is clear that the total revenue does not cover the
total cost. Average variable cost is equal to RQ and total variable cost = average
variable cost * output, that is RQ*OQ, that is equal to A (OSRQ). Fixed cost is
equal to total cost minus variable cost.

Here total cost = A(OTLQ) and total variable cost = A(OSRQ), therefore, total
fixed cost = A(OTLQ) minus A(OSRQ) = A(STLR)

It is evident from this that the total revenue, A(OPEQ) not only covers the entire
variable cost A(OSRQ) but also a part of the fixed cost. The part of fixed cost that
is covered by the revenue is A(SPER).

Another way of looking at this is that the loss is less than the fixed cost.
Loss is = A(PTLE) and fixed cost is A(STLR) and therefore the loss is less than
fixed cost.

In such a case therefore, the firm can continue operations in the short run so long
as the revenue covers the entire variable cost and a part of the fixed cost or in
other words its price or Average Revenue is less than AC but greater than
Average Variable Cost or AVC. This is because if the firm decides to shut down
its operations (that is, shut down operations and not produce any output and not
close down the business) then the firm will incur a fixed cost which will be larger
than the loss incurred in production. By operating the business, at least a part of
the fixed cost is covered

The firm continues to operate in the short run in spite of losses ( given that price is
greater than AVC) because it is hopeful that things will improve in the long run. It hopes
that some of its competitors may not survive this loss and so will slowly leave the
industry leading to a fall in industry supply and a rise in industry price . This will help the
firm to better its position in the long run .How long it can survive with a loss and hope for
things to improve will depend on its ability to survive or the amount of reserves it has or
loans it will get to pay for the loss. It is only a strong firm which has existed for a long
period and grown its business and reserves which will be able to survive with a loss.

4) The last situation that a firm can encounter in the short run is that the price is
not only lesser than the average cost but also lesser than the average variable
cost. Such a situation is represented in the following graph which depicts that

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 both the average cost curve, AC as well as the average variable cost curve,
AVC are higher than average revenue or price and so both these curves lie
above the average revenue curve

AC

Price MC
L
T AVC

R
S
P MR =AR=P

0
Q

This means that the revenue will not cover even the variable cost then it means
that the loss is greater than the fixed cost or the firm loses all the fixed cost and
also a part of the variable cost. In such a scenario it is better for the firm to shut
down operations and wait for things to improve. When it shuts down it has to
incur only fixed cost as a loss.

In such a case, we cannot mark a point of equilibrium because a firm will

never operate at such a point..

In analyzing a situation the following steps have to be followed

a) Is MR = MC and is MC rising

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 b) Is Price greater than or less than AC
c) If Price is less than AC then is price at least greater than AVC. If Price is
greater than AVC in case of a loss then the firm can continue operations in the
short run. If Price is less than AVC then the firm should shut down.

What do you think happens in the long run?

In each of the above 4 situations, in the long run there will be changes brought about due
to a variation in price.

Let us take the first situation of profits, where price is greater than AC. This will not last
forever, because, on seeing that the existing firms are earning profits, other firms find this
business lucrative and also enter this industry, as a result of which the supply rises and
the price falls. This happens till all the profits of existing firms are wiped away and all
firms earn normal profit or operate such that price is equal to average cost. This is
represented in the following figure:

PANEL A
PANEL B
PRICE D S PRICE
S1
MC
AC
P E
P
P1 P1 E1 P = AR =MR

Q Q1 Qo Q

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 Panel A in the figure denotes the price determined in the industry or market where total
demand is equal to total supply. Panel B represents the revenue and cost for an individual
firm.
As we see in the figure, the original price is determined at P in the market where demand,
Dis equal to supply S. At this price the firm is at equilibrium at E where MR =MC and
produces and sells output Q. At this output, the Average cost is less than price and so the
firm earns profits in the short run. In the long run however, when more firms enter the
industry, the supply curve shifts to the right and the new supply curve is S1. A new price
P1 is determined. As we can see, at this price P1, the firm’s average cost is equal to price
and the firm earns only normal profit. It is interesting to note, that at the new price P1, the
industry quantity demanded and supplied rises from Q to Q1 but the firm’s supply falls
from Q to Qo.This is obviously because the firm has to share the market with more firms
now.

Now what if the firm makes a loss in the short run? In the long run such a firm will make
normal profit because some firms will start leaving the industry and the supply will fall
and price will rise. We can represent this in the following graph.

PANEL A
PANEL B
PRICE S1 PRICE
D S
MC AC

P1 E1
P1
P E
P
P = AR =MR

Qo Q Q Q1
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As we see in the figure, the original price is determined at P in the market where demand,
D is equal to supply S. At this price the firm is at equilibrium at E where MR =MC and
produces and sells output Q. At this output, the Average cost is more than price and so
the firm incurs a loss in the short run. In the long run however, when some firms exit the
industry, the supply curve shifts to the left and the new supply curve is S1. A new price
P1 is determined. As we can see, at this price P1, the firm’s average cost is equal to price
and the firm earns only normal profit. It is interesting to note, that at the new price P1, the
industry quantity demanded and supplied falls from Q to Qo but the firm’s supply rises
from Q to Q1.This is obviously because the firm has to now share the market with lesser
firms than before.

We can conclude that in whatever situation a perfectly competitive firm is in the short
run, in the long run it earns only normal profit. This relates to the fact that there is free
entry and exit of firms into and from the industry and new firms are attracted when
existing firms earns profits and some firms easily exit when losses are incurred.

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