Mic 9

Microeconomics All Rights Reserved
© Oxford University Press Malaysia, 2008
9– 1

CHAPTER

9 Perfect
Competition

MICROECONOMICS 2 2
9–

DEFINITION AND
CHARACTERISTICS OF A
PERFECTLY COMPETITIVE MARKET
Definition
A market in which there are many buyers and
sellers, the products are homogeneous and sellers
can easily enter and exit from the market.
Characteristics
• Large number of buyers and sellers – firms
are price takers.
MICROECONOMICS 3 3
9–

DEFINITION AND CHARACTERISTICS
OF A PERFECTLY COMPETITIVE
MARKET (CON’T)
Homogenous or standardized product – the
buyers do not differentiate the products of one
seller to another seller.
Free of entry and exit into the market.
Role of non-price competition is
insignificant.
Perfect knowledge of the market – all the
sellers and buyers in perfect competition market
will have perfect knowledge of that market. Rights Reserved
Microeconomics All
9– 4

PRICE DETERMINATION IN A
PERFECTLY COMPETITIVE FIRM
The price is determined by the Since firms are price takers, they
intersection of the market supply face a horizontal demand curve.
curve and the market demand Demand curve in perfect
Price curve. competition is horizontal or
Price
perfectly elastic. Therefore,
Price = MR = AR.

SS

RM10 RM10 P = MR = AR

DD

Quantity Quantity
Q*
Market Firm
9– 5

PROFIT MAXIMIZATION IN A
1. Using Total approach
TOTAL REVENUE – TOTAL COST APPROACH

(1) (2) (3) (4) 5) Using Table:
Quantity Price Total Total Cost Profit/ Profit maximization is
(per kg per (per kg per Revenue (TC) Lloss
determined by scanning
dAy) dAy) (TR)
through the profit at each
0 10 0 60 -60 level, and the level which
10 10 100 140 -40 gives the highest profit is
20 10 200 210 -10 the profit maximizing
30 10 300
output.
290 10
40 10 400 390 10
50 10 500 500 0
60 10 600 630 -30
70 10 700 800 -100

9– 6

TR, TC

TC Using Graph:
TR
TR curve is a straight line
through the origin.
The maximum profit is
where the vertical
Highest vertical difference is the highest.
difference

Quantity
40

9– 7

2. Using Marginal approach
MARGINAL REVENUE – MARGINAL COST APPROACH

(1) (2) (3) (4) (5) (6) (7)
Quantity Price Total Marginal Total Marginal Profit/
(per kg per (per kg Revenue Revenue Cost Cost Lloss
day) per day) (TR) (MR) (TC) (TC) Using Table:
0 10 0 - 60 - -60 The profit
10 8 -40 maximizing
10 100 10 140
output level is
20 10 200 10 210 7 -10 obtained
30 10 300 10 290 8 10 following the
40 10 400 10 390 10 10 MR = MC rule.
50 10 500 10 500 11 0
60 10 600 10 630 13 -30
70 10 700 10 800 17 -100

9– 8

MR, MC

MC
Using Graph:
TR curve is a straight line
through the origin.
The maximum profit is
RM10 MR where the vertical
difference is the highest.

Quantity
40

9– 9

PROFIT MAXIMIZATION USING
THE EQUATION METHOD
The demand function for a product sold by a
perfect competitor is given as
QD = 20 – P
and the marginal cost is
MC = −10 + 3Q.
Calculate profit maximizing price and quantity.

9– 10

THE EQUATION METHOD (CON’T)
Solution
For profit maximization to take place,
we use the MR = MC rule.
Firstly, we need to derive the demand curve.
Given Q = 20 − P
P = 20 − Q
MR = 20 − Q (since in perfect competitive
firm, P = MR = AR)
9– 11

THE EQUATION METHOD (CON’T)
MR = MC
20 − Q = −10 + 3Q
4Q = 30
Q = 7.5

Substitute Q = 7.5 into P = 20 − Q
P = 20 − 7.5
P = 12.5
9– 12

SHORT-RUN SUPPLY CURVE
Price The figure shows the AC, AVC
(RM) and MC. There are five different
MC
market prices. The horizontal
demand curve at each price is
shown.
e AC
Point a is not considered a supply
20 P1 = MR1 = AR1 curve since at any point below the
AVC minimum of AVC, the firm would
shut down its operation and the
quantity supplied would be zero.
d
10 P = MR = AR
The portion of marginal cost curve
c
P2 = MR2 = AR2 which lies above the average
b variable cost curve is the firm’s
P3 = MR3 = AR3 supply curve.
5
a P4 = MR4 = AR4 Supply curve of a competitive firm
is the upward portion of MC above
minimum of AVC as shown by
40 60 Quantity
points b, c, d and e.

9– 13

PROFIT MAXIMIZATION IN THE SHORT RUN
A competitive firm earns economic profit

Price (RM) MC The firm’s demand curve is
ATC horizontal at the price of RM20
where AR = MR.

The marginal cost curve intersects
the demand curve at point B. A
competitive firm maximizes its profit
when MR = MC.
PROFIT B The profit maximizing price and
P* P = MR = AR output is P* and Q*.
20
At output Q* respectively the firm
earns economic profit or
supernormal profit equal to the area
shaded.
Economic profit or supernormal profit
is the profit earned by a competitive
Q* firm when TR>TC.
Quantity

9– 14

PROFIT MAXIMIZATION IN THE
SHORT RUN (CON’T)
A competitive firm at breakeven
Price (RM)
MC Normal profit or breakeven profit is necessary
for a firm to stay in business (TR =TC).

ATC At output Q*, the firm is at breakeven and
earns normal profit.

The profit maximizing price and output is P*
B and Q*, respectively.
P* P = MR = AR
20 The firm’s demand curve is horizontal at the
price of RM20 where AR = MR.

The marginal cost curve intersects the
demand curve at point B. A competitive firm
maximizes its profit when MR = MC.
Q*
Quantity

9– 15

SHORT RUN (CON’T)
A competitive firm suffers economic losses
The firm’s demand curve is
horizontal at the price of RM20
MC where AR = MR.
Price (RM)
The marginal cost curve intersects
the demand curve at point B. A
competitive firm maximizes its profit
when MR = MC.
ATC
The profit maximizing price and
B output is P* and Q* respectively.
P* P = MR = AR
20 At output Q*, the firm suffers
LOSSES economic losses or subnormal profit
equal to the area shaded.
Economic losses or subnormal
Quantity profit is the losses incurred by a
Q* competitive firm when TR<TC.

9– 16

SHORT RUN (CON’T)
SHUT DOWN PRICE A firm will continue its operations
even if it suffers losses.

MC A firm can continue production until
Price (RM) the price is equal to minimum
average variable cost (AVC).

At the price of RM5, the losses
incurred by the firm is equal to the
ATC fixed cost.
B
P = MR = AR If price falls below RM5, the firm
20
TOTAL FIXED AVC
LOSSES
COST
would incur more operating losses
than fixed cost and the firm must
shut down.
5
Shut down point is at the point
where the price equals to minimum
Q*
Quantity AVC.

9– 17

SHORT RUN (CON’T)
EFFECT OF ENTRY

Price is determined by the intersection of the market Firms that earn supernormal profits in
short run will only be able to earn normal
supply curve and the market demand curve.
or zero profits in long run due to entry of
newcomers.
Price (RM)
Price (RM) The economic profit MC
attracts newcomers AC
SS to the industry. As a
SS1 result, many firms
20 will enter the market 20 P = MR = AR
and this will lead to
15 an increase in
PROFIT
15 P1 = MR1 = AR1
supply.
DD

Quantity Quantity
Q* 60
Supply curve will shift to the The competitive firm sells 60 kg of
right and equilibrium market chicken and earns an economic
Market price will fall to RM15. Firm profit shown by the shaded area.

9– 18

PROFIT MAXIMIZATION IN
THE LONG RUN
EFFECT OF EXIT

The losses in short run forces those sellers who Firms that suffer
losses in short run
cannot cover their AVC or TVC to leave the market.
Supply curve will shift to left and equilibrium market can still continue
As many firms exit the market, RM15
price will rise to this will lead to a their operation. As in
The competitive
decrease in the market supply. long run they are
firm sells 60 kg of able to earn normal
chicken and or zero profits due to
Price (RM) Price (RM) suffers losses exit of the firms.
MC
shown by the
SS shaded area. AC

SS1
10 20 P = MR = AR
15
LOSSES
15 P1 = MR1 = AR1
DD

Quantity Quantity
Market Q* Firm 60

9– 19

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