9 – Market Structure: Perfect Competition

The primary goal of any business is to maximize profit. Profit is calculated by subtracting the total cost from the total revenue earned. In this context, let’s define some key terms:

• Total Revenue (TR): The income a firm generates from selling its products, calculated as the price per unit (P) multiplied by the quantity sold (Q).

$TR=P\times Q$

• Total Cost (TC): The overall expenditure incurred by a firm in producing its products, obtained by multiplying the quantity produced (Q) by the average cost (AC).

$TC=Q\times AC$

• Average Revenue (AR): The revenue generated per unit of output, calculated as total revenue divided by quantity.

$<span\; style="text-transform:\; math-auto;">AR<span\; style="font-family:\; \text{'}Libre\; Franklin\text{'},\; \text{'}Helvetica\; Neue\text{'},\; helvetica,\; arial,\; sans-serif;\; font-size:\; 1rem;">=</span></span>\frac{\mathrm{TR}}{Q}$

• Marginal Revenue (MR): The change in total revenue resulting from selling an additional unit of output, equivalent to the change in total revenue (ΔTR) divided by the change in quantity (ΔQ).

$\mathrm{MR}=\frac{\mathrm{\Delta }\mathrm{TR}}{\mathrm{\Delta }Q}$

• Marginal Cost (MC): The additional cost incurred in producing one more unit of output, calculated as the change in total cost (ΔTC) divided by the change in quantity (ΔQ).

$\mathrm{MC}=\frac{\mathrm{\Delta }\mathrm{TC}}{\mathrm{\Delta }Q}$In a perfectly competitive market, a firm aims to maximize profits by setting a price where marginal revenue equals marginal cost (MR = MC). This condition is crucial for profit optimization. In the short run, a firm can experience positive, negative, or zero economic profits. If the price exceeds the average variable cost, the firm should continue operations; otherwise, shutting down is recommended. Notably, in the long run, economic profits tend to converge to zero. If the price surpasses the average total cost, the firm operates at a profit; if it falls below, the firm incurs a loss. Understanding and aligning MR with MC is key to profit maximization in a competitive market.

9.3 Perfect Competition in the Short Run

In the short run, a single business can make money. In above diagram , the price, or average income, shown by P, is higher than the average cost, shown by AR.

In the long run, if businesses try to make money, more businesses will join the market where it is perfectly competitive. This will move the supply curve to the right from where it started. The firm’s average price will go down as the supply curve moves to the right. The economic gains will go down until they reach zero as the price goes down.

Firms lose money when the price is less than the average total cost of production. If businesses in a highly competitive market are losing money over time, more businesses will leave the market. This will move the supply curve to the left of the diagram. The price will go up as the supply curve moves to the left. The economic gains will go up as the price goes up until they reach zero.

When there is great competition in the market, companies will make no money in the long run. In a market with perfect competition, the long-term equilibrium point is where the demand curve (P) meets the marginal cost (MC) curve at the point where the average cost (AC) curve is at its lowest point.

9.4 Perfect Competition in the Long Run

In the long run, businesses can’t always make money. The demand curve of each new company will move lower when they enter the market. This will cause the price, the average revenue (AR), and the marginal revenue (MR) to descend. The company will not make any money in the long run. At the point where it is flattest (E), its demand curve will touch its average total cost curve.

The company is in balance when the line between its marginal revenue (MR) and marginal cost (MC) meets at point (E).

9.5 Short-run Equilibrium of a Firm  Under Perfect Competition

In the short run, firms can only change their level of output by increasing or lowering the amounts of variable factors like labour and raw materials. Fixed factors, on the other hand, stay the same, such as capital equipment, machinery, and so on.
That is, the short run is the idea of a period when at least one factor of production stays the same but other factors change.
This is the point where a firm is in short-term equilibrium:

MR = MC, which means that MC is either going up at the point where MR is equal to MC or cutting MR from below.

A firm with perfect competition has a cost curve that looks like a U. In a market with perfect competition, marginal revenue is the same as price or average revenue. This means that the business will match marginal cost with price to reach the equilibrium level of output.

In the short run, a firm with perfect competition that is in equilibrium does not always make money. To make money, the firm figures out the “equilibrium level” of output and price and then tries to make extra money, normal money, or even lose money. The following Diagram shows the firm’s short-term balance state.

 

 

 

 

 

 

 

 

 

 

 

In the provided graph, the level of output is represented on the X-axis, and the price is on the Y-axis. The firm’s financial status, whether it faces excess profit, normal profit, or loss, can be interpreted from the graph.

1. Excess Profit: Excess profit occurs when the firm sells its OQ level of output at the price OP, where E is the equilibrium point satisfying the condition MR=MC. The firm’s profit is calculated as TR – TC, where TR (Total Revenue) is P × Q. In the graph, TR = OP × OQ = OQEP, and TC = OQ × OQRS. Therefore, Profit = OQEP – OQRS = SREP. Hence, when the price is OP, the firm is at equilibrium in the short run, earning SREP, which is the excess or supernormal profit.

2. Normal Profit: If the firm fails to earn excess profit, it may still earn normal profit. In the graph, if the firm is in equilibrium at point E1 with a price of OP1 and output OQ1, it earns normal profit. Profit = OQ1E1P1 – OQ1E1P1 = Normal Profit. Normal profit is what a firm needs to survive, producing the same level of output in the future with the revenue earned. It represents a situation of no profit, no loss.

3. Loss or Sub-normal Profit: When a firm fails to even earn normal profit and continues operating at a loss, it’s in a situation of sub-normal profit. In the graph, if the firm is at equilibrium at point E2 with a market price of OP2 and output of OQ2: Loss = OQ2E2P2 – OQ2US.

4. Shutdown Point: When a firm is unable to cover even its variable costs, the firm should consider shutting down or temporarily ceasing operations. In the given Diagram, if the price is OP, the firm produces the equilibrium level of output, OQ, at that price. At this output volume, the firm’s total revenue (TR) is OQRP, while its Total Variable Cost (TVC) is OQSN. The loss incurred by the firm in terms of variable cost is PRSN, and the total loss is PRUT, where PRSN represents the variable cost, and NSUT is the fixed cost.

 

 

 

 

 

 

 

 

 

 

 

 

In such a scenario, it is prudent for the firm to either shut down its business or wait until the price for its commodity increases. Waiting for a better market price is crucial, as it would allow the firm to at least cover its Total Variable Cost. Variable costs are essential for the firm to sustain its operations, and if the market conditions are not favourable, temporarily closing the business might be a strategic decision.

9.6 Long-Run Equilibrium of A Firm

There’s sufficient time for firms to make changes to all of the factors of production in the long run.

This is why it is said that in the long run, there are no fixed factors of production, but every factor is variable. So, in the long run, the firms can increase or decrease their output by changing their capital equipment. They can either add new plants to the business, replace old plants with new ones with higher capacities, or allow a part of the existing capital equipment to wear out without being replaced.
In the long run, however, new firms can enter the industry and compete with the ones that are already there. Moreover, in the long run, the firms may leave the industry.

The long-run equilibrium then happens when the capital equipment and the number of firms can change freely and fully. Because of this, the long-run average and marginal cost lines are what matter for figuring out the long-run equilibrium output.

Additionally, since all costs are variable and none are set in the long run, the average total cost is what matters.

When marginal cost is equal to price, or MC = P, as explained above, a firm is in equilibrium under perfect competition. However, for the firm to be in long-run equilibrium, the price must also be equal to the average cost (P = MC).

For, there will be a tendency for firms to enter or leave the industry if the price is greater or lower than the average cost. Firms will try to make more money than usual if the price is greater than the average cost. With the entry of new firms in the industry, the price of the

Product will decrease as a result of an increase in output, and cost will increase as a result of increased competition for production factors. The firms will keep joining the industry until the price is equal to the cost to enter, at which point all firms will be making normal profits.

This can be explained with the help of the Diagram displayed below:

 

 

 

 

 

 

 

 

 

 

 

 

 

When there is no competition. In the long run, the firm is in equilibrium when its price is OP and its output is OQ. At this point, E, the firm is in equilibrium (MR = MC). In the long run, the firm makes a normal profit.

So Profit = TR – TC = OQEP – OQEP.

So, in the long run, the firm makes an average profit,

where P=AR= MR= AC= MC.

9.7 Equilibrium of a Firm and Industry Under Perfect Competition

There is no tendency for a firm to change its level of output when it is in equilibrium. You don’t need to expand or contract it. By equating its marginal cost with its marginal income, MC = MR, it hopes to make the most profits possible. Only in the long run is an industry at equilibrium. The condition of equilibrium between a firm and an industry is shown in the next diagram.

MC=MR means that the MC curve and the MR curve are equal. This is the first condition that must be met. But this isn’t a necessary condition for the firm to not be in equilibrium. It may still be met. After the point of equilibrium, the MC curve must be above the MR curve. This is what the second-order condition says must happen in a market with perfect competition. The firm’s MR curve and AR curve are the same. The MR curve is straight across from the X-axis. When MC=MR=AR (Price), the firm is in equilibrium.

 

 

 

 

 

 

 

 

 

In (A), point A is where the MC curve first meets the MR curve. The condition MC = MR is met, but it is not a point of greatest profits since the MC curve drops below the MR curve after point A. When it can make more profits by producing beyond OM, it does not pay the firm to produce the minimum output (OM).
For the best profits, go to point B when both conditions are met. Because MR > MC between points A and B, the firm should increase its output. When it hits the OM1 level of output, where the firm meets both the conditions of equilibrium, production will, however, cease further.

Because its marginal cost exceeds its marginal revenue beyond the equilibrium point B, it will lose money if it tries to produce more than OM1. Figure (B) shows an MC curve that is a straight line. The same findings can be drawn from this.