6. Perfect Competition, Price & Output Determination. This blog post provides a simple and comprehensive explanation of Perfect Competition, one of the most important market structures in microeconomics. It covers how price and output are determined under perfect competition in both the short run and long run, supported by easy-to-understand diagrams. Ideal for students of economics, business, and finance looking for clarity on competitive market behavior.
This topic is equally important for the students of economics across all the major Boards and Universities such as FBISE, BISERWP, BISELHR, MU, DU, PU, NCERT, CBSE & others & across all the business & finance disciplines.
Table of Contents
6. Perfect Competition, Price & Output Determination
Perfectly Competitive Market
Perfectly competitive market is rarely existing due to its tough conditions to exist but we can understand perfect competition or perfectly competitive market through following characteristics:
Characteristics/Assumptions
- Large Number of Buyers and Sellers: There are large number of buyers and sellers in the perfectly competitive market and none of them has significant control over the market. We can say that individual’s decision does not matter.
- Homogeneous Products: All firms produce identical products or we can say the products are perfect substitutes which eliminates the buyer’s preference.
- Free Entry and Exit: Firms can easily enter in the market when the business is profitable and can easily exit when there is loss.
- Price Takers: No single firm can alter or change the price because individual decision does not matter. All the products are homogenous or identical so if one firm increases the price, consumer will turn to other products so the firms have no power to alter the price and they are just price taker, the price which is decided by the market.
- No Government Intervention: In a perfectly competitive market, there’s minimal or no government interference. Prices are set by the equilibrium of supply and demand.
- Profit Motivation: Under perfect competition, the objective of all the firms is only to earn profit and maximize the profit.
- Complete knowledge of the Market: Under perfect competition, producer and consumer both have perfect knowledge about the market. Both buyers and sellers have complete knowledge of prices, products, and production techniques, which ensures that everyone makes well-informed decisions.
- Perfectly Elastic Demand Curve: Under perfect competition, demand line is perfectly elastic.
- Mobility of Factors of Production: Under perfect competition, all the factors of production are completely mobile on the basis of their maximum economic efficiency.
Determination of Price Under Perfect Competition
Under perfect competition, price of goods is determined on the basis of equilibrium of market demand and market supply of that good. Individual firm has no power to change or alter the price so they only follow the price decided by the market forces. We can understand it through following diagram:
Explanation
- A side of the above diagram is representing the market side and B side is representing individual firm.
- Quantity Demand Q.D and Quantity Supply Q.S is presented on x-axis and Price per unit is presented on y-axis.
- In market side, downward sloping curve is DD is intersecting upward moving supply curve SS at the point E. which is an equilibrium point where quantity demand and quantity supply both are intersecting each other.
- At point of equilibrium E, the price is 100 which is an equilibrium price at the quantity demanded and supplied 30.
- Same price is taken by the individual firm, which is presented in the individual firm’s diagram B.
- Individual firm is bound to sell the products at the price of 100, if the individual firm increase the price, consumer tends to buy other products at market rate.
Determination of output under Perfect Competition
For the determination of output under perfect competition, there are two approaches. One is called Total Revenue (TR) & Total Cost (TC) Approach and other one is called Marginal Revenue (MR) & Marginal Cost (MC) Approach.
1. Determination of Output Under Perfect Competition (Total Revenue TR & Total Cost TC Approach)
Output of the firm under perfect competition can be done through total revenue & total cost approach which can be explained through following diagram:
Explanation
- In the above diagram output Q is presented on the x-axis and total cost TC, total revenue TR is presented on the y-axis.
- Right upward moving line originated from the origin is representing total revenue.
- Second multi curved line is representing total cost TC.
- Total Cost line starting from above the Total revenue TR instead of origin because of fixed cost.
- In the first phase total cost TC is above the total revenue TR which means that firm bears loss which is the difference of B-A at Q1 output.
- At Q2 level of output, firm earns minimal profit because at this point firm’s TR and TC both are equal at point C.
- At Q3 level of output, firm earns maximum profit which is the difference between E-D.
- At the level of output Q4, once again firm earns minimal profit because its TC and TR both become equal at point F.
2. Determination of Output Under Perfect Competition (Marginal Revenue MR & Marginal Cost MC Approach)
Under marginal revenue & marginal cost approach firm determines its output where its marginal profit becomes zero or we can say when their difference of marginal revenue and marginal cost becomes zero:
MR – MC = 0
For detail observation follow the below given diagram:
Explanation
- In above diagram, output Q is taken on x-axis and price P is taken on y-axis.
- straight horizontal line from left to right is average revenue and marginal revenue line.
- Line moving below and finally above the marginal revenue line is marginal cost MC line.
- At the level of output Q1 firm’s marginal revenue is greater than marginal cost MR > MC so the firm keeps increasing its output until its marginal revenue MR becomes equal to marginal MC.
- At Q2 level of output, Price P*, firm’s marginal revenue MR becomes equal to marginal cost MC which is presented in above diagram at point E. This is the point where firms marginal profit is zero.
- Beyond point E and output Q2 firm’s marginal revenue MR is less than marginal cost MC such as at Q3 level of out which is not favorable for the firm.
- So we can conclude that at point E, Q2 level of output, firm’s total profit is maximum because here the marginal profit which is the difference of marginal revenue MR and marginal cost MC is zero. Logic behind this point is as we studied in law of diminishing marginal utility that the point where marginal utility is zero, the total utility becomes maximum at that point.
Related Posts
Evolving different thoughts of Economics
2.1 Theory of Consumer Behaviour
2.2 Total Utility, Marginal Utility, Point of Satiety & Types of Utilities
2.3 The Law of Diminishing Marginal Utility DMU
2.4 The Law of Equal Marginal Utility EMU
3.1 Demand, Individual Demand, Aggregate Demand, Law of Demand
3.2 Change and Shift in Demand, Extension and Contraction in Demand, Rise and Fall in Demand
3.4 Point and Arc Elasticity of Demand
3.5 Income Elasticity of Demand, Cross Elasticity of Demand
4.2 Extension and Contraction, Rise and Fall in Supply
4.4 What is Equilibrium of Demand and Supply, Market Equilibrium
5.Focused Questions, Theory of Costs and Revenues
6.1 Perfect Competition, Short Run Equilibrium, Long Run Equilibrium
