Notes on Perfect Competition in Microeconomics

PERFECT COMPETITION

• Definition: Perfect competition occurs when no individual market participant can influence the price of a product. Participants are price takers.

Requirements for Perfect Competition:

• A large number of buyers and sellers in the market.

• No collusion between sellers.

• Goods must be identical (homogeneous).

• Freedom for buyers and sellers to enter or exit the market.

• Perfect knowledge of market conditions by buyers and sellers.

• No government intervention influencing market participants.

• Factors of production must be perfectly mobile.

• Note: While no market completely fulfills these criteria, approximations exist in sectors like agriculture and international commodity markets.

• The term “perfect” signifies the highest degree of competition, not necessarily the most desirable form.

DEMAND FOR THE PRODUCT OF THE FIRM

• Market Price Setting: Under perfect competition, the product price is determined by supply and demand. An individual firm can sell any quantity at the market price.

• Price Behavior:

  • A firm will not charge above the market price, as it would lose all customers.

  • Charging below market price doesn’t benefit firms as they can sell all desired output at the prevailing price.

  • Demand curve for the firm is horizontal (perfectly elastic) at the market price.

Tasks Related to Demand Curve:

• Graph Interpretation:

  • The left graph shows price determination by market demand and supply. The firm can sell its output at that price.

  • The right graph shows the firm's demand curve as horizontal, indicating constant price regardless of output.

• Average Revenue (AR) and Marginal Revenue (MR): In perfect competition, both AR and MR equal the product price ($P$).

FIRMS' REVENUE UNDER PERFECT COMPETITION

• Total Revenue (TR) Situation:

  • Total Revenue increases in a linear fashion as more units are sold, represented graphically as a straight line starting from the origin with a slope equal to the price ($P$).

  • Formula: TR = P × Q

Tasks Related to TR Graph:

• Slope Explanation: The slope of the TR curve equals the price.

EQUILIBRIUM OF THE FIRM UNDER PERFECT COMPETITION

Equilibrium Conditions:

1. Production Decision: Firms decide whether to produce or shut down based on TR compared to total variable cost (TVC) covering normal profit.

2. Optimal Quantity: Determine the output level that maximizes profits where MR = MC.

Shut Down Rule:

• Produce if TR ≥ TVC, or AR (price) ≥ AVC.

• In the short run, it's recommended to continue production if TR covers some fixed costs even if there are economic losses.

Profit-Maximizing Rule:

• Profit Maximization: Achieved when MR = MC, or equationally, when price equals marginal cost (P = MC). This can be visualized using TR and TC curves.

TOTAL REVENUE AND COST ANALYSIS

Total Cost (TC) Structure:

• TC curve appears typically as a reversed “S” shape due to fixed costs.

Economic Profit Analysis:

• Economic profit is total revenue minus total costs (TR - TC). Economic losses occur when TC exceeds TR.

• Profit maximization is illustrated when the positive vertical distance between TR and TC is maximized (between points of intersection).

SUPPLY CURVE OF THE FIRM

• MC Curve as Supply Curve: The upward-sloping portion of the MC curve above the minimum AVC represents the firm's supply curve. The market supply curve is the horizontal summation of individual firms’ supply curves.

LONG-RUN EQUILIBRIUM

• Long-term equilibrium occurs when firms earn normal profit, leading to no incentive for new firms to enter or for existing firms to exit.

• Changes in market supply due to economic profits (new firms enter) or economic losses (firms exit) influence overall market equilibrium.

ECONOMIC EFFICIENCIES IN PERFECT COMPETITION

Allocative Efficiency:

• Occurs when resources are distributed in a way that maximizes consumer satisfaction (P = MC).

Productive Efficiency:

• Achieved when firms produce at the lowest possible cost (minimum point of the AC curve).

Summary: Perfect competition serves as a theoretical benchmark showing how markets operate efficiently under certain extreme conditions where firms can freely enter and exit and all products are identical. Understanding the dynamics of demand, revenue, costs, and market adjustments is critical to grasping how perfect competition differs from other market structures.