Page 148 - DECO405_MANAGERIAL_ECONOMICS

Unit 9: Market Structure – Perfect Competition

Equilibrium of the Industry Notes
The industry is in long run equilibrium when a price is reached at which all firms are in
equilibrium (producing at the minimum point of their LAC curve and making just normal
profits). Under these conditions there is no further entry or exit of firms in the industry,
given the technology and factor prices. At the market price P, the firms produce at their
minimum cost, earning just normal profits. The firm is in equilibrium because at the level
of output Q
LMC = SMC= P = MR

This equality ensures that the firm maximises its profit.
At the price P, the industry is in equilibrium because profits are normal and all costs are
covered so that there are no incentives for entry or exit.

Task Analyze stock market on the basis of the features of perfect market. Do you
find it close to the perfect market?

9.2 Price and Output Determination under Perfect Competitive Firm

9.2.1 Short Run Analysis of a Perfectly Competitive Firm

The aim of a firm is to maximise profits. In the short run some inputs are fixed and these give rise to
fixed costs which have to be incurred whether the firm produces or not. Thus, it pays for the firm to
stay in business in the short run even if it incurs losses. Thus, the best level of output of the firm in
the short run is the one at which the firm maximises profits or minimises losses.
This is possible when the marginal revenue (MR) of the firm equals its short run marginal cost
(MC). As long as MR exceeds MC, it pays for the firm to expand output because by doing so the
firm would add more to its total revenue than to its total costs. On the other hand, as long as MC
exceeds MR, it pays for the firm to reduce output because by doing so the firm will reduce its
total cost more than its total revenue. Thus, the best level of output of any firm is the one at
which MR=MC.

!
Caution Since, a perfectly competitive firm faces a horizontal or infinitely, elastic demand
curve, P=MR, so that the condition for the best level of output can be restated as one of
which P=MR =MC. This can be seen in figure diagrammatically and with calculus as
follows.

A firm usually wants to produce the output that maximises its total profits. Total profits (T) are
equal to total revenue (TR) minus total costs (TC). That is,

= TR–TC .... (1)
where TR and TC are all functions of output (Q).
Taking the first derivative of p with respect to Q and setting it equal to zero gives

d d TR d TC
= 0 .... (2)
dQ dQ dQ

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