ENTERPRISE AND MARKET THEORY

Perfect competition

prof. dr. Žiga Čepar

Contact: forum in e-classroom
Office hours: before lectures and upon agreement
Perfect Competition
Model
Types of competitive environment -
market structures
Typical questions that a firm faces:
- what is the level of production it should choose (Q*)?
- at which price it should sell its products (P*)?
 such, that profit is maximized (loss is minimized)

Specific answers depend on the type of a market structure the firm is in:
- perfect competition
- monopoly
- monopolistic competition
- oligopoly
 Factors that shape the competitive
environment (market structure)

Number of Buyers and Sellers

 Economies of scale can preclude firms with increasing average cost.

Product Differentiation
 R&D, innovation, and advertising are important in many markets.

Entry and Exit Conditions

 Barriers to entry and exit can shelter incumbents from potential entrants.

Information Transparency
 Might be high or low.
 PERFECT COMPETITION
Basic features – assumptions:
1) Many buyers and many sellers:
 The individual firm sells a very small share of the total industry output and, therefore can not influence
market price.
 The individual consumer buys too small share of industry output to have any impact on market price.

2) Product homogeneity:
 The products of all firms are perfect substitutes (zero differentiation).
 Examples: Agricultural products, oil, copper, iron, lumber, unskilled labour market.

3) Free entry into and exit from an industry over the long run:
 Buyers can easily switch from one supplier to another.
 Suppliers can easily enter or exit a market (industry).

4) Perfect information and no artificial interferences:

 Knowledge on any changes on market conditions.
 No government price controls etc…

 IMPLICATIONS: firm is a “price taker” and only has a normal profit

in a long run
Profit maximization - calculus

-
 In perfect competition MR=P
 Marginal revenue (MR) is the additional revenue from producing one
more unit of output.
- MR = ΔTR/ΔQ = ∂TR/∂Q = slope of TR curve
- in perfect comp.: MR = ∂TR/∂Q = ∂(P∙Q)/∂Q = P∙(∂Q/∂Q) = P∙1 = P
= slope of TR curve;
 in perfect competition: P = MR
 so in perfect competition condition MR = MC could be
rewritten as P = MC

 Marginal cost (MC) is the additional cost from producing one more unit
of output.
- MC = ΔTC/ΔQ = ∂TC/∂Q = slope of TC curve
How else do we know that P=MR?
Total Total revenue Marginal revenue
product at P=10 (MR =∆TR/∆Q)
(Q) (TR=10∙Q)

0 0 -
12 120 10
26 260 10
42 420 10 Price P=10 equals MR
56 560 10 at each quantity of production q.
65 650 10 This is why the profit maximizing
69 690 10 condition MR=MC
72 720 10 could be transformed in P=MC.
74 740 10
75 750 10
 Profit maximization - graphically

In general: MR = MC Perfect competition: P = MC

slopeTR=MR
MR = P0
slopeTC=MC

QBEP,1 Q* QBEP,2 Q*

max π
 Perfect competition:
aggregate (industry) and individual
demand and supply curve

qPC* q
 Perfect competition:
firm supply
Firm’s marginal-cost curve shows the amount of output the firm
would be willing to supply at a given market price.

- Marginal cost curve is the short-run supply curve as long as

P > AVCmin.

- Marginal cost curve is the long-run supply curve as long as

P > ACmin.
A competitive firm making
profit

12
A competitive firm incurring losses:
the shut down decision

13
 Short run shut-down decision
Suppose a firm’s TC = 181, FC = 100, VC = 81 when it produces 3 units
of output (q = 3). If P = 50, will it shut down?
 Profit = TR – TC = 50x3 – 181 = -31
 Will the firm shut down?

- Shuts down: has to pay 100 of FC in a short run.

 Loss = 100
- Stays open: - can use revenue of 150 to cover its VC
- has 69 left over to cover part of its FC
- still owes 100 – 69 = 31 for its FC
 Loss = 31
 A loss of 31 is better than a loss of 100  stays open

 A firm will shut down only if P < AVC (TR<VC)

 Summary:
choosing output in the short run
Profit is maximized (or loss is minimized) at the output at which: P = MC
 if P > ATC
min => firm makes positive economic profits: stays open in a long

run and in a short run

 if P < ATCmin => firm makes negative economic profits and shuts down in a long run,
however in a short run:
 if AVCmin ≤ P < ATCmin :
the firm is producing at a loss but is covering VC and a part of FC:
 should continue to produce in a short run (but not in a long run)

 if P < AVCmin < ATCmin :

the firm is producing at a loss (which is bigger than FC) and is not covering even all VC:
 shuts down also in a short run
 A competitive firm short-run supply curve
Curve

Higher price compensates the firm for higher cost of additional output (MC) and increases
total profit (because the higher price applies to all units but MC only to the last unit).
The market (industry) short run
supply curve
 A long-run equilibrium in a perfect
competition
Long run P*  equals LACmin:
- if P>LACmin: firms have profits 
new firms enter the
industry (S)  P
- if P<LACmin: firms have losses 
existing firms exit the
industry (S)  P

Long run q*  the one that

corresponds to
LACmin
a) A long-run supply curve is a horizontal

line

A perfectly elastic industry supply means, that average cost are not
changing in a long run. A firm doesn‘t need to pay higher price for
additional units of production factors.

Supply function is a horizontal line on the level of same price for any
level of output. Moreover, that price equals a long-run minimum of a
firm‘s average cost.
Any level output can be produced with the same average cost.
However the level of output is determined by demand.
a) A horizontal long-run supply curve and
constant LAC
price

price
LMC
LAC
S1 S2
P2
B

A C
P1 SL

D1 D2
0 Q*PC2 0
output output
Q*PC1 QIND1 QIND3
Q*PC3 QIND2
b) A long-run supply curve is increasing

While an industry expands, there may emerge some EXTERNAL

DISECONOMIES.

WHY: Demand for some production factors that an industry needs may
increase that much, so that their price is increased. Consequently
average costs of every firm in that industry is increased.
c) A long-run supply curve is decreasing
While an industry expands, there may emerge some EXTERNAL
ECONOMIES.

WHY: Development of infrastructure and urbanization associated with

the development of an industry can reduce average cost of production.

 The final shape of the long-run industry supply curve depends on

the net effect of the both opposite effects

(ECONOMIES and DISECONOMIES).
Which statements are true?
Features of perfect competition are:
a) The number of sellers and buyers is so big, that individual economic subjects
can not influence market conditions.

b) All production factors are perfectly mobile.

c) Buyers and sellers have perfect information about products and purchase
possibilities.

d) Economic subjects are rational.

e) Products are completely homogeneous and are perfect substitutes.

f) Market decisions of each individual economic subject are independent and do not
influence decisions of the others.

g) Each economic subject in perfect competition can increase his motive for
economizing, that is profit (seller) and utility (buyer).

h) Seller can set the price of their products independently and alone.
Problem – Perfect Competition
In a chosen industry, firms produce and sell a perfectly homogeneous product.
Industry demand function is: QD,IND=900-50P. In the industry there are 125
exactly the same firms operating, total cost function of each firm is the same
and is: TC=10+1/4Q2 . Entry in and exit from the industry is free.
a) How do we name the market structure that these firms are forming? Derive the
industry total supply function.
Individual supply function: MC = 1/2QPC  P=1/2QPC  QPC=2P
Industry’s total supply function: QS,IND = 125*QPC = 125 * 2P = 250P

b) Calculate and graphically represent the equilibrium market price and quantity in
that industry in a short-run.
Industry’s demand: QD, IND = 900 -50P
Industry’s supply: QS,IND = 250P
900-50P = 250P  300P=900  PIND*= 3
QIND*= 250PIND* = 250*3 = 750
Problem – Perfect Competition
In a chosen industry, firms produce and sell a perfectly homogeneous product.
Industry demand function is: QD,IND=900-50P. In the industry there are 125
exactly the same firms operating, total cost function of each firm is the same
and is: TC=10+1/4Q2 . Entry in and exit from the industry is free.
c) Calculate the profit maximizing level of output of each individual firm in that industry
in a short-run. Will the firms run their businesses in a short run? Why?
MC = ½*Q
P = MC
3 = ½*Q
QPC*=6

PROFIT = 3*6 – (10+1/4Q2) = 18-19 = -1

Since LOSS < FC (1<10), they will keep running their businesses in a short
run.
Problem – Perfect Competition
In a chosen industry, firms produce and sell a perfectly homogeneous product.
Industry demand function is: QD,IND=900-50P. In the industry there are 125
exactly the same firms operating, total cost function of each firm is the same
and is: TC=10+1/4Q2 . Entry in and exit from the industry is free.
d) Assume that industry demand increases so that the new industry demand is now: QD,IND=1200-50P ,
however the industry supply does not change. What is a new market equilibrium in that industry, how
much is a new profit maximizing level of output of each individual firm and how much is profit of each
firm in a short run?
New market equilibrium in that industry:
1200-50P = 250P  300P=1200  PIND*= 4
QIND*= 250PIND* = 250*4 = 1000
New profit maximizing level of output:
MC = ½*Q
P = MC
4 = ½*Q
QPC*= 8
New profit:
PROFIT = 4*8 – (10+1/4Q2) = 32-26 = 6
Since they make a (positive) profit, they will keep running their businesses.
THE EFFECT OF A TAX AND A SUBSIDY
ON MARKET EQUILIBRIUM
Combining S and D together gives us
market equilibrium

Px
S

Px*

Qx
Qx*

If D or S is changed, market equilibrium will change too.

 THE EFFECT OF A TAX ON MARKET
EQULIBRIUM
„ad rem“  tax as an absolute amount per unit of a product
(e.g.: excise duty)

„ad valorem“  tax as a % of value or P of a product (e.g.: VAT)

Amount and structure of the motor fuel prices in Slovenia (€/liter) in a chosen time
Motor fuel Selling Carbon tax Energy saving Excise Electricity production VAT Final retail
type price supplement duty support provision (22%) price
without supplement
taxes

Euro-super
0,44122 0,03979 0,007 0,50780 0,00911 0,22108 1,226
95-okt

Diesel 0,43265 0,04671 0,006 0,42605 0,00990 0,20269 1,124

 THE EFFECT OF A TAX ON MARKET
EQULIBRIUM
What is the final economic effect of the tax imposed?
Who actually bears the tax burden?

EXAMPLE
 Excise tax of 1 $ is imposed per 1 gallon of gasoline.
 The tax is paid by the supplier of gasoline (the statutory taxpayer is a
producer of the excise products).
 Because of the tax, the producers reduce their supply (the supply curve
is shifted to the left and up).
 The quantity demanded is reduced but not a lot if the price elasticity of
demand is low (steep demand curve).
 The price - at which suppliers are willing to supply any quantity of
production - is increased by the amount of tax 1 $ (the vertical shift of the
supply curve is by 1 $ upwards).
 THE EFFECT OF A TAX ON MARKET EQUILIBRIUM
The tax burden in distributed between consumers and producers

1.9

80

THE FINAL EFFECT OF THE TAX:

only a small portion is born by the producers: 0.1 $ (the new equilibrium price that they receive is
1.9 $ and 0.9 $ after tax instead of 1$ that they received before);
the most of the tax is born by the consumers: 0.9 $ (the new equilibrium price that they pay is 1.9
$ instead of 1 $);
 Q* is decreased, P* is increased.
Distribution of the tax burden at perfectly inelastic demand
(tax T=0.5 $ is paid by the supplier)

The whole tax burden is born by the consumer (P*

is increased exactly by the amount of tax T)
Distribution of the tax burden at perfectly elastic demand
(tax T=0.5 $ is paid by the supplier)

 The whole tax burden is born by the producer (P* is not changed)
If a government imposes a tax on the suppliers, S shifts to the left:
 P*(P which is paid by the consumer)↑  Q*(production and consumption)↓

If a government imposes a tax on the consumers, D shifts to the left:

 P*(P which is received by the supplier)↓  Q*(production and consumption)↓

General rules for incidence of a tax, which is imposed by the

government:
• if D is inelastic relative to S then most of the tax will fall on the consumers;
• if S is inelastic relative to D then most of the tax will fall on the suppliers.
 In short:
- a subject with less elastic curve will bear greater portion of a tax,
- consumers always pay more and suppliers receive less

THE FINAL EFFECT OF A TAX IS THE SAME, REGARDLESS OF WHO IS THE

TAXPAYER (THE CONSUMER OR THE PRODUCER)!
 THE FINAL EFFECT OF A SUBSIDY IS THE SAME,
REGARDLESS WHO IS THE RECIPIENT (THE
CONSUMER OR THE PRODUCER)

Government gives Government gives

subsidy to the producer subsidy to the consumer
(S shifts to the right) (D shifts to the right)

P P

S 2 S
P2*
1 SubsS 1
P1* D´
Subs
S´ SubsD
P2* 2
D D
Q Q
Q1* Q2* Q1* Q2*

P2* - a new price paid by the consumer P2* - a new price received by the producer
If a government gives a subsidy to the suppliers, S shifts to the right:
 P*(P which is paid by the consumer)↓  Q*(production and consumption)↑

If a government gives a subsidy to the consumers, D shifts to the right:

 P*(P which is received by the supplier)↑  Q*(production and consumption)↑

General rules for incidence of a subsidy, which is given by the

government:
•if D is inelastic relative to S then most of the subsidy will be gained by the consumers;
•if S is inelastic relative to D then most of the subsidy will be gained by the suppliers.
 In short:
- a subject with less elastic curve will gain greater portion of a subsidy,
- consumers always pay less and suppliers receive more

THE FINAL EFFECT OF A SUBSIDY IS THE SAME, REGARDLESS OF WHO IS THE

RECIPIENT (THE CONSUMER OR THE PRODUCER)!
Problem – Subsidies to the producers (suppliers)
Using market equilibrium model explain what will be the effect of
subsidies given to the suppliers of milk on the prices and quantities of
milk that are sold? Who benefits most from the subsidies, the suppliers
or the consumers?
Pmilk S

S‘

SubsS
1
SubsD
2

D
Qmilk

P* will decrease and Q* will increase.

Who benefits most depends on elasticities of D and S.
Example – tax burden incidence
Market demand is given as QD=50-PD and market supply as
QS=1,5PS.
a)Calculate market equilibrium.

QD = Q S
50-P = 1,5P
2,5P*= 50 P
P*= 20
Q*=50-P = 1,5P = 30

20
D
Q
30
Problem – tax burden incidence
Market demand is given as QD=50-PD and market supply as
Q =1,5P  PS=Q‘S/1,5
S S

b) A government imposes an „ad rem“ tax (T) of 5 money units on

suppliers (the statutory taxpayer is a supplier). Calculate the new
equilibrium price that will be paid by the consumers; the new price (per
unit revenue) that will be received by the suppliers as well as the new
equilibrium quantity.

QD = Q‘S Q‘S: PS = Q‘S/1,5 + 5

50-PD = 1,5PS – 7,5 Q‘S=1,5PS – 7,5
2,5P‘*= 57,5 P
P‘*= 23 (paid by the consumers)
Q‘*= 27
S‘

The new price (per unit revenue)

S
that will be received by the 23
3
suppliers is for the amount of tax 20
5

(T=5) less than what is paid by the 2

D
consumers = 23-5=18.
Q
27 30
Problem – tax burden incidence
Market demand is given as QD=50-PD and market supply as
QS=1,5PS.
c) How much of the 5 money unit tax is born by the supplier and
how much by the consumer?

We identify the absolute value of the slope „IkI“

from D and S function (where P=f(Q)):
Problem – tax burden incidence
Market demand is given as QD=50-PD and market supply as
QS=1,5PS.
d) Who actually bears the tax burden which is imposed on the
supplier in case of perfectly elastic demand?

We identify the absolute value of the slope „IkI“

from D and S function (where P=f(Q)):

The tax is born completely by the supplier (producer).

When calculating, the following rules apply:
- if T is imposed on the consumers, then we substract T from D (in
the form of P=f(Q));
- if Subs. is given to the consumers, then we add Subv. to D (in the
form of P=f(Q)).

- if T is imposed on the suppliers, then we add T to S (in the form

of P=f(Q));
- if Subs. is given to the suppliers, then we substract Subv. from S
(in the form of P=f(Q)).
Exercise – perfect competition
Perfectly competitive firms produce perfectly homogeneous
product. Demand function of each individual consumer in the
industry is P=40-2,5QD,indiv (or QD,indiv=16-0,40P), and there are
200 equal consumers. Products are produced by 140 equal
firms, total cost function of each individual firm is
TC=60+(1/8)Q2. Entry and exit is completely free.
a) Write down the industry total demand function.
QD,IND = n* QD,indiv = 200*(16-0,40P) = 3200-80P

b) How do we name the market structures of that firms?

Write down the industry total supply function.
Perfect competition.
Each firm‘s individual supply is: P=MC:
since MC=1/4QPC:
P=1/4QPC  QPC=4P

The industry supply: QS,IND = 140*QPC = 140 * 4P = 560P

Exercise – perfect competition
Perfectly competitive firms produce perfectly homogeneous product. Demand function
of each individual consumer in the industry is P=40-2,5QD,indiv (or QD,indiv=16-0,40P),
and there are 200 equal consumers. Products are produced by 140 equal firms, total
cost function of each individual firm is TC=60+(1/8)Q2. Entry and exit is completely
free.
c) Calculate and graphically present the equilibrium price and quantity in
the industry.
The industry demand: QD, IND = 3200-80P
The industry supply: QS,IND = 560P
3200-80P=560P  640P=3200  PIND*= 5
QIND*=560PIND*=560*5=2800
d) How much is optimal quantity of production for each firm in the industry
in a short run? Will the firms keep running their businesses in a short
run? What about in a long run? Why?
P = MC since P=5 and MC=(1/4)*Q we get:
5 = (1/4)*Q
QPC*=20
π = P*Q-TC = 5*20 – (60+(1/8)Q2) = 100-110 = -10
Since loss (10) is less than FC (60), they will keep running their businesses in a short run (but not in
a long run, since they are making a loss).
EXAMPLE
Perfect
competition
Calculate the
optimal
quantity of
production for
the perfectly
competitive
firm!
EXAMPLE
Perfect
competition
Calculate the
optimal
quantity of
production for
the perfectly
competitive
firm!