Managerial Economics

1. ME_SESSION 7
MARKET STRUCTURES & PRICING PRACTICES:
Perfect competition
Prof Prema Basargekar

2. Introduction
Objectives of the session:
1. To understand meaning of market
2. To understand various types of markets
3. To examine how equilibrium price & qty is
determined in different types of market
4. To determine the level of profit maximising
price

3. What is common among them?

4. What is common among
them?

5. What is common among
them?

6. What is common among
them?

7. Competitive Environment
What is Market Structure?
Market structure describes the competitive
environment in terms of:
• Number of buyers and sellers.
• Potential entrants.
• Barriers to entry and exit, etc.
• Actual & and potential competitors are
important.

8. Market Structure & Degree of
Competition
Market consists of all the actual & potential
buyers & sellers of a particular product.
Market structure refers to the competitive
environment in which buyers & sellers
operate.
Four types of market structures usually
identified are based on the competition
level
a. Perfect competition
b. Monopolistic competition
c. Oligopoly
d. Monopoly

9. Four Basic Market Types

10. Market Structure
Perfect Competition
Monopolistic
Competition
Oligopoly
Monopoly
MoreCompetitive
LessCompetitive

11. Characteristics of Perfect
Competition
a. Many buyers & many sellers of a product
b. Product is homogenous
c. Perfect mobility of factors of production
d. Perfect knowledge of market
e. Free entry & free exit
f. No government interference
Examples of Competitive Markets
Agricultural commodities, e.g., cotton.
Stock market, discount retailing, Unskilled labor market

12. Fish auction: an example of PC
Auctions of a perishable commodity like fish in a
market period (very short period) can be an example
of Perfect competition.
In a bad weather when few boats go out in a sea and
the catch is small, the price will be high. In a good
weather, the prices will come down.
The buyers (mostly wholesalers) and the sellers
(mostly fishermen) both have enough information to
take the decisions.
There is competition among buyers as well as among
sellers.

13. Pricing and Output Decisions in PC
The Basic Business Decision: entering a
market on the basis of the following
questions:
How much should we produce?
If we produce such an amount, how much profit
will we earn?
If a loss rather than a profit is incurred, will it be
worthwhile to continue in this market in the long
run (in hopes that we will eventually earn a profit)
or should we exit?

14. Pricing and Output Decisions in
PC
Key assumptions of the perfectly competitive
market
The firm operates in a perfectly competitive
market and therefore is a price taker.
The firm makes the distinction between the short
run and the long run.
The firm’s objective is to maximize its profit in the
short run. If it cannot earn a profit, then it seeks
to minimize its loss.
The firm includes its opportunity cost of operating
in a particular market as part of its total cost of
production.

15. Example of a Normal Profit
Suppose a manager of a convenience
store wants to operate a store of her
own. She knows that she will have to
leave her job of Rs. 45,000 per year
and use Rs. 50,000 of her savings
currently earning 10% of interest.

16. Normal Profit, Economic Profit &
Economic Loss
Normal profit Economic
Profit
Economic loss
Revenue 5,00,000 5,50,000 4,80,000
Accounting Cost 4,50,000 4,50,000 4,50,000
Opportunity cost 50,000 50,000 50,000
Profit 0 50,000 -20,000

17. Competitive Market Equilibrium
Balance of Supply and Demand
Equilibrium is a balance of supply and
demand.
Normal Profit Equilibrium
There are no economic profits in
competitive equilibrium; firms earn a
normal rate of return.
With a horizontal market demand curve,
MR=P, so P=MR=MC=ATC.

18. Pricing and Output Decisions in PC
Perfectly Elastic demand
curve: consumers are willing
to buy as much as the firm is
willing to sell at the going
market price.
Firm receives the same
marginal revenue from the
sale of each additional unit
of product; equal to the
price of the product.
No limit to the total revenue
that the firm can gain in a
perfectly competitive market.

20. Price Determination in Short Run
In PC the firm is price taker.
D curve for the firm is horizontal or (e = infinity)
Equilibrium price & output is determined where
market D & S are equal to each other.
QD = 625 – 5P; QS = 175 + 5P
625 –5P = 175 + 5P
450 = 10P; P = 45
QD = 625 – 5P = 625 –5(45) = 400
QS = 175 + 5P = 175 + 5(45) = 400

21. P C: Short-Run Equilibrium
The best level of output for any firm is where MR = MC
Demand curve of PC firm = Market price = Marginal
Revenue P= MR
Equilibrium comes where P = MR = MC
 Golden rule
 Expand output: MR > MC
 Stop before MC > MR
Supply curve of PC firm = rising portion of Marginal Cost
or where MC > AVC
It is because the competitive firm always produces
where P = MR = MC, as long as P > AVC

23. Short-Run Cost and Revenue for a
Perfectly Competitive Firm

24. Short-Run Profit
Maximization
(a) Total revenue minus
total cost
(b) Marginal cost equals
marginal revenue
TR: straight line, slope=5=P
TC increases with output
Max Economic profit:
where TR exceeds TC by
the greatest amount
MR: horizontal line at P=$5
Max Economic profit:
at 12 bushels,
where MR=MC
Total cost Total revenue
(=$5 × q)
Totaldollars
$60
48
15
Bushels of wheat per day
0 5 7 10 12 15
Dollarsperbushel
$5
4
Bushels of wheat per day
0 5 7 10 12 15
Average total cost
d = Marginal revenue
= Average revenue
Marginal cost
Maximum economic
profit = $12
a
e
Profit

25. Minimizing Short-Run Losses

26. Short-Run Loss
Minimization
(a) Total revenue minus
total cost
TC>TR; loss
Minimize loss: 10
bushels
(b) Marginal cost equals
marginal revenue
MR=MC=$3; ATC=$4
P=$3; P>AVC
Continue to produce
in short run
Total cost Total revenue
(=$3 × q)
Totaldollars
$40
30
15
Bushels of wheat per day
0 5 10 15
Average total cost
d = Marginal revenue
= Average revenue
Marginal cost
Minimum economic
loss = $10
eLoss
Bushels of wheat per day
0 5 10 15
Dollarsperbushel
$4.00
3.00
2.50
Average variable cost

27. Summary of Short-Run Output Decisions
Average total cost
Average variable cost
Marginal cost
d1
d2
d3
d4
d5
1
2
3
4
5
q2 q3 q4 q5q1 Quantity per period
p2
p1
p3
p4
p5
0
Dollarsperunit
Shutdown
point
Break-even
point
p5>ATC, q5, economic profit
p2=AVC, q2 or 0, loss=FC
ATC>p3>AVC, q3, loss <FC
p1<AVC, shut down,
q1=0,loss=FC
p4=ATC, q4, normal profit
Firm’s short-run S curve

28. Output Decisions in PC
The point where
P=MR=MC is the
optimal output (Q*)
Profit = TR – TC
=(P - AC) · Q*

29. Output Decisions in PC
The firm incurs a loss.
At the optimum output
level price is below
average cost.
However, since price is
greater than average
variable cost, the firm is
better off producing in
the short run, because
it will still incur fixed
costs greater than the
loss.

30. Short-Run Profit Maximization and Market Equilibrium
S = horizontal sum of the supply curves of all firms in
the industry Intersection of S and D: market price $5
Market price $5 determines the perfectly elastic
demand curve (and MR) facing the individual firm.

31. Output Determination in Short Run
In the short run some of the inputs are fixed.
It means the firm should stay in business
even if it is incurring losses as long as losses
are smaller than fixed cost or can cover up at
least variable cost.
Equilibrium arises where MR = MC
Since in PC, MR = price
Equilibrium = P = MR = MC

32. Pricing and Output Decisions in PC
Shutdown Point: the lowest price at which the
firm would still produce.
At the shutdown point, the price is equal to
the minimum point on the AVC. This is where
selling at the price results in zero contribution
margin.
If the price falls below the shutdown point,
revenues fail to cover the fixed costs and the
variable costs. The firm would be better off if
it shut down and just paid its fixed costs.

33. Class activity
A lamp manufacturer faces a horizontal
demand curve. The firm’s total costs
are given as below:
TVC = 150Q – 20Q2 + Q3
Below what price the firm should shut
down?

34. Answer
MC = 150 – 40Q +3Q2
AVC = 150 – 20Q + Q2
At the shutdown point AVC = Price
Thus 150 – 40Q + 3Q2 = 150 – 20Q + Q2
= 2Q2 – 20Q = 0
= 2Q (Q – 10) = 0
= Q = 10
P = MC = 150 – 40(10) +3(100) = 50
If the price fall below 50, the firm should shut down.

35. Perfect Competition
in the Long Run
 Long run
 Firms enter/exit the market
 Firms adjust scale of operations
 Until average cost is minimized
 All resources are variable

36. Output Determination in Long Run
In the long run as all inputs are variable, the
firm can construct optimum size of plant
where AC is at lowest.
The best level of output is at which –
Price = LMC = SATC which is tangent to Long
Term Avg Cost
In the long run the firm earns only normal
profits or zero economic profits which just
cover explicit as well as implicit costs.
If the firm could not operate at lowest point
at LAC, it will have to leave the market.

37. Perfect Competition
in the Long Run
 Economic profit in short run
 New firms enter market in long run
 Existing firms expand in long run
 Market S increases
 P decreases
 Economic profit disappears
 Firms break even

38. Perfect Competition
in the Long Run
 Economic loss in short run
 Some firms exit the market in long run
 Some firms reduce scale in long run
 Market S decreases
 P increases
 Economic loss disappears
 Firms break even

39. Zero Economic Profit
in the Long Run
 Firms enter, leave, change scale
 Market:
 S shifts; P changes
 Firm
 d(P=MR=AR) shifts
 Long run equilibrium
 MR=MC =ATC=LRAC
 Normal profit
 Zero economic profit

40. (a) Firm
d
(b) Industry or market
Q
Quantity
per period
0q
Quantity
per period0
MC
ATC
Dollarsperunit
p
Priceperunit
p
S
D
LRAC
Long run equilibrium: P=MC=MR=ATC=LRAC. No reason for new firms to enter the market
or for existing firms to leave. As long as the market demand and supply curves remain
unchanged, the industry will continue to produce a total of Q units of output at price p.
e
Long-Run Equilibrium for a Firm and the Industry

41. Output Determination in Long Run

42. Perfect Competition
and Efficiency
Productive efficiency: Making Stuff Right
Produce output at the least possible cost
Min point on LRAC curve
P = min average cost in long run
Allocative efficiency: Making the Right Stuff
Produce output that consumers value most
Marginal benefit = P = Marginal cost
Allocative efficient market

43. Creation of Consumer Surplus
It is defined as the
difference between the
total amount
that consumers are willing
and able to pay for a good
or service (indicated by
the demand curve) and
the total amount that they
actually do pay (i.e. the
market price).

44. Merits of the Perfect Competition
Higher consumer surplus
Better distribution of wealth & income
as economic profits in the long-run are
zero.
Lowest Long-run AC shows the efficient
use of resources
Ease in shifting resources shows higher
welfare

45. Relevance of understanding PC
Even though PC is rare in the real world, the perfectly
competitive model is very important to understand.
It can be applied to those markets which are close to
being perfectly competitive.
It provides the point of reference or standard against
which to measure economic cost or inefficiencies
associated with departures from perfect competition.
Although ‘perfectly competitive’ markets are very
few, the basic short-run & long-run behaviour studied
in this model can be found in all types of market
structures.

46. Implications of Perfect competition
Most important lesson is that it is extremely
difficult to make money.
Must be as cost efficient as possible.
It might pay for a firm to move into a market
before others start to enter.
Firm’s entry into business and exit from business
are important.
It is always better to enter in the business when
costs are low and demand is rising.
It is always better to exit when costs start rising
and demand becomes saturated due to free entry.

47. Class activity
ABC, Inc., provides recycled toner cartridges for
printers which is perfectly competitive market. Total
and marginal cost relations per week are:
TC = $830,000 + $10Q + $0.005Q2
where Q is the number of recycled toner cartridges.
A. Calculate ABC’s optimal output and profits if
prices are stable at $150 per toner cartridge.
B. Is it possible to earn economic profits in the long
run?.

48. A) Calculate ABC’s optimal output and profits if prices
are stable at $150 per toner cartridge.
At profit maximization - MR= MC
$150 = $10 + $0.01Q
0.01Q = 140
Q= 14,000
Profits = TR – TC
= 150Q – [830,000 + 10Q + 0.005Q2]
= 150(14,000) – [830,000 + 10(14,000) +
0.005(14,0002)]
=150,000

49. B) Is it possible to earn economic profits the long
run?.
No because as the firm ABC is making economic
profit, new firms will enter into market and industry
supply curve would shift outside bringing equilibrium
price downwards where every firm is earning nominal
profits or zero economic profits.

50. Concepts learnt
Market mechanism
Price and non-price competition
Entry and exit barriers
Price taking firm
Equilibrium of the firm
Short-run equilibrium
Shut-down point
Long-run equilibrium
Implications of PC for the economy