Prices & Markets Chapter 8

• - Many buyers and many firms
• - Small firms
• - Products sold are identical (homogeneous product)
• - No barriers to new firms entering the market
• - Firms unable to control the prices of goods
• - Firms unable to earn economic profits in the long run

The demand curve facing the firm under perfect competition is horizontal: perfectly elastic.

Determined by the interaction of market demand and market supply.

Since each firm must accept the market price, the firm is called a price taker.

Profit is the difference between total revenue and total cost.

The firm will produce the output for which marginal revenue (MR) is equal to marginal cost (MC). MR = MC

Marginal revenue is the same as price in this instance.

MR = MC = P

In the short run the firm’s price:

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• (a) will exceed its average total cost (ATC) which means it will make an economic profit, or

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• (b) will equal ATC so its total cost will equal total revenue and it earns no economic profit (or normal profit), or

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• (c) will be less than ATC, which means the firm experiences an economic loss. (long-run decision)

In the short run, the firm can either produce the profit maximising level of output or produce zero output.

If shutting down (Q = 0) would lose an amount greater than its fixed cost, the firm will shut down temporarily.

If the firm can reduce its loss below the amount of its fixed cost it will continue to produce. The firm will produce output even though total profits remain negative if total revenue is greater than total variable cost.

This is identical to saying that the price of its output (P) must exceed average variable cost (AVC). The condition P = AVC is called the shutdown condition.

The minimum point on the firm’s average variable cost curve is called the shutdown point.

• 
• Here, total revenue is much lower than total costs (negative economic profit). Any point below this, and the firm will be operating at a loss, and should shut down.

A firm’s supply curve helps determine price, output, revenue and profits.

The higher the price, the greater the quantity supplied. A supply curve is derived from a supply schedule. The upward slope of a supply curve illustrates the direct relationship between supply decisions and price. In this case, the supplier of cola would supply 200 more cans at 80p compared with 60p.

When firms earn short-run profits, other firms will enter the industry. This shifts the industry supply curve to the right and lowers the market price. Entry continues until economic profits are zero.


When firms suffer short-run losses, some firms will exit the industry. The exit of firms shifts the industry supply curve to the left and the market price increases. Exit continues until economic profits are zero.

The Law of diminishing returns:

Economic theory predicts that, when employing extra variable factors, such as labour, the marginal returns (additional output) from each extra unit of input will eventually diminish.

Take, for example, a hypothetical firm that has a factory in which computers are assembled. The machinery is fixed, and extra workers can be hired to increase the output of assembled computers. At first, the addition of extra workers creates a significant benefit because it becomes possible to divide up the labour, and for workers to specialise in undertaking one task.

Initially, there are increasing marginal returns to each additional worker.However, marginal returns will eventually fall because the opportunity to divide labour and to specialise must eventually ‘dry up’.

The supply curve slopes upward, reflecting the higher price needed to cover the higher marginal cost of production. The higher marginal cost arises because of diminishing marginal returns to the variable factors.

In the long run firms are attracted into the industry if the incumbent firms are making supernormal profits. This is because there are no barriers to entry and because there is perfect knowledge.

The effect of this entry into the industry is to shift the industry supply curve to the right, which drives down price until the point where all super-normal profits are exhausted. If firms are making losses, they will leave the market as there are no exit barriers, and this will shift the industry supply to the left, which raises price and enables those left in the market to derive normal profits.

It can be argued that perfect competition will yield the following benefits:

1. No information failure and knowledge is shared evenly between all participants.

2. There are no barriers to entry, so existing firms cannot derive any monopoly power.

3. Only normal profits made, so producers just cover their opportunity cost.

4. There is no need to spend money on advertising, because there is perfect knowledge and firms can sell all they can produce.

5. In addition, selling unbranded goods makes it hard to construct an effective advertising campaign.

• 6. There is maximum possible:
• >> Consumer surplus
• >> Economic welfare

• 7. There is maximum allocative and productive efficiency:
• >>Equilibrium will occur where P = MC, hence allocative efficiency.

>> In the long run equilibrium will occur at output where MC = ATC, which is productive efficiency.

7. There is also maximum choice for consumers.