The Performance of Firms in Perfect Competition (Cambridge International A-Level Economics)

Revenue in perfect competition

• The firm does not have any market power so it is unable to influence the price and quantity

  • The firm is a price taker due to the large number of sellers
  • The firm's selling price is the same as the market price, P₁= MR = AR = Demand

The relationship between TR, AR & MR when price = $8

• The situation in the table above is illustrated in the diagram below

An illustration of the relationship between AR, MR & TR in a perfectly competitive market

Observations

• The firm is a price taker at P₁ ($8)

  • Every unit of output is sold at the same price
  • A higher price would decrease sales to zero
  • A lower price would result in all sellers lowering their price

• TR increases at a constant rate

• MR = AR = Demand

The role of the MC curve

• The MC curve shows the cost of producing one additional unit
• As price changes, the firm changes output to the point where P = MC
• This means the MC curve determines the quantity supplied at each price

Deriving the supply curve

• For every possible price, the firm produces the output where P = MC
• Plotting these output decisions across different prices traces the firm’s supply curve

Long run equilibrium in perfect competition (normal profit)

Diagram observations

• The MC curve represents the cost of producing one additional unit of output
• In a perfectly competitive market, the firm maximises profit where MC = MR
• Because the firm is a price taker, MR = AR = P, which is shown by the horizontal demand curve
• The profit-maximising output is therefore Q, where the MC curve intersects the price line
• If MC were below price, producing an additional unit would add more revenue than cost, so the firm would increase output
• If MC were above price, producing an additional unit would increase costs more than revenue, so the firm would reduce output
• Therefore, the MC curve determines the output supplied at each market price
• For this reason, the upward-sloping section of the MC curve represents the firm’s short-run supply curve

Profits

• In order to maximise profit, firms in perfect competition produce up to the level of output where marginal cost = marginal revenue (MC=MR)

• The firm does not have any market power so it is unable to influence the price and quantity

  • The firm is a price taker due to the large number of sellers

Firms in perfect competition making supernormal profits

• Firms in perfect competition are able to make supernormal profit in the short-run

  • A seller may gain a competitive advantage for a short period of time, which allows them to make supernormal profit

• However, they will always return to the long-run equilibrium (see diagrm above) where they make normal profit

This firm is making abnormal profit in the short-run as the AR > AC at the profit maximisation level of output (Q1)

Diagram analysis

• The marginal cost curve (MC) is the **supply curve **of the firm

• The firm is producing at the profit maximisation level of output, where MC=MR (Q₁)

  • At this point, AR (P₁) > AC (C₁)
  • The firm is making supernormal profit $=(P_{1}-C_{1})\times Q_{1}$

Supernormal profit eliminated in the long run

• If firms in perfect competition make supernormal profit in the short-run, new firms are attracted to the industry

  • They are incentivised by the opportunity to make supernormal profit

  • There are no barriers to entry

    • It is easy to join the industry

*New entrants shift the industry supply curve to the right (S1→S2 ) which changes the industry price from P1→P2. The firm can now only sell its products at P2 *

Diagram analysis

• The firm is initially producing at the profit maximisation level of output, where MC=MR (Q₁)

  • At this level of output, AR (P₁) > AC (P₂) and the firm is making supernormal profit

• Incentivised by profit, new firms join the industry and supply increases from S₁→S₂

  • Overall quantity in the industry increases from Q₁→Q₂
  • The industry price falls from P₁→P₂

• The firm has to now sell its products at the industry price of P₂

  • The output of the firm falls from Q₁→Q₂ as it now has a smaller market share of the larger industry

• At the profit maximisation level of output (MC=MR) the firm is now producing at the point where AR= AC

  • The firm is making normal profit

• In the long-run, firms in perfect competition always make normal profit

Short-run losses in perfect competition

• Firms in perfect competition are able to make losses in the short-run

  • Periods of intense competition can cause prices to fall below the average costs
  • New firms may enter the industry. This results in the market share being divided up between more competitors and some individual firms may start making a loss

This firm is making losses in the short-run as the AR < AC at the profit maximisation level of output (Q1)

Diagram analysis

• The firm is producing at the profit maximisation level of output, where MC=MR (Q₁)

  • At this level of output, the AR (P₁) < AC (C₁)
  • The firm's loss is equivalent to $(P_{1}-C_{1})\times Q_{1}$

Losses are eliminated in the long run

• If firms in perfect competition make losses in the short-run, some will shut down

  • The shut down rule will determine which firms shut down
  • There are no barriers to exit, so it is easy to leave the industry

* Firms leaving the industry shift the industry supply curve to the left (S1→S2 ) which changes the industry price from P1→P2. Remaining firms can now sell products at P2 which returns it to a position of normal profit*

Diagram analysis

• The firm is initially producing at the profit maximisation level of output, where MC=MR (Q₁)

  • At this level of output, the AR (P₁) < AC (C₁) and the firm is making a loss

• Some firms leave the industry, and supply decreases from S₁→S₂

  • Overall quantity in the industry falls from Q₁→Q₂
  • The industry price increases from P₁→P₂

• The firm now has to sell its products at the industry price of P₂

  • The output of the firm increases from Q₁→Q₂ as it now has a larger market share of the smaller industry

• At the profit maximisation level of output (MC=MR) the firm is now producing at the point where AR= AC

  • The firm is making normal profit

• In the long-run, firms in perfect competition always make normal profit

  • Firms making a loss leave the industry
  • Firms making supernormal profit see them slowly eradicated as new firms join the industry

Efficiency in perfect competition

• Allocative efficiency occurs at the level of output where average revenue = marginal cost (AR = MC)

  • At this point, resources are allocated in such a way that consumers and producers get the maximum possible benefit
  • No one can be made better off without making someone else worse off
  • There is no excess demand or supply

• Productive efficiency occurs at the level of output where marginal cost = average cost (MC=AC)

  • At this point average costs are minimised
  • There is no wastage of scarce resources & a high level of factor productivity

*A perfectly competitive market benefits from both productive and allocative efficiency in the long-run   *

Diagram analysis

• The firm produces at the profit maximisation level of output where MC=MR (Y)
• The firm is productively efficient as MC=AC at this level of output
• The firm is allocatively efficient as AR (P)=MC

Exam Hint You should look to demonstrate your awareness that perfect competition provides a benchmark for judging the extent to which real-world markets perform efficiently or inefficiently

Wherever relevant, critically assess the proposition that perfectly competitive markets lead to an efficient allocation of resources