Price and Output Determination in Perfect Competition4 min read


Learning Objectives

  • Perfect Competition and Producer’s Equilibrium
    • TR – TC Approach
    • MR – MC Approach
  • Short Run Analysis of Perfectly Competitive Firms 
  • Long Run Analysis of Perfectly Competitive Firms

Producer’s Equilibrium 

A perfectly competitive firm is said to be in equilibrium when it maximizes profit or produces profit maximizing level of output. A perfectly competitive firm’s profit will be maximum either when the difference between the total revenue (TR) and total cost (TC) is maximum or when additional cost incur for production of an additional unit of output that is marginal cost (MC) is equal to the additional revenue received from sell of an additional unit of output that is marginal revenue (MR).

  • Total Revenue (TR) and Total Cost (TC) Approach
  • Marginal Revenue (MR) and Marginal Cost (MC) Approach

TR-TC Approach

The perfectly competitive firm is said to be in equilibrium at that point where the gap between Total Revenue and Total Cost is maximum. It means that the producer produces only that quantity of goods or products that maximizes its profit.

The perfectly competitive firm’s total revenue curve linear upward in nature as the total revenue increases in constant rate (as the firm being price taker), and total cost first increases in the decreasing rate, remains constant, and again increases in the increasing rate.

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MR-MC Approach

In MR-MC approach, the firm is said to be in equilibrium if the MR equals to MC, and the MC curve cuts MR from below.

The MR and AR curve of the perfectly competitive firm is equal and parallel to X-axis, that is, the AR and MR of perfectly competitive firm is constant and is equal to price (Visit Link for Clarity). This is because the perfectly competitive firm is a price taker not the price maker. 

Mathematically,

Profit of the firm is maximum when the gap between TR and TC is maximum.

so,

Profit (Π)=TR-TC

Differentiating with respect to Q,

d(Π)/d(Q) = d(TR)/d(Q) – d(TC)/d(Q)

0 = MR – MC

MR = MC ————— First order condition

For profit maximum Second Derivative must be less than zero (0),

d(MR)/d(Q) – d(MC)/d(Q) < 0

– d(MC)/d(Q) < 0 [MR equals to Price, and is constant; so, the derivative of MR is zero]

0 < d(MC)/d(Q)

Slope of MC must be more than Zero (0) ————— Second order condition.

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Short Run Analysis

  • Super Normal Profit of Perfectly Competitive Firm

The perfectly competitive firm will be in super normal profit if the average revenue is more than average cost.

Mathematically,

Super Normal Profit = Area under Average Revenue – Area under Average Cost

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  • Normal Profit of Perfectly Competitive Firm

The perfectly competitive firm will be in normal profit if the average revenue is equals to average cost of the perfectly competitive firm . 

Mathematically,

Normal Profit = Area under Average Revenue – Area under Average Cost = 0

In general sense, if revenue equals to cost then, there is neither profit nor loss. But Economists have called this situation called Normal Profit. This is because the clever firm owners or entrepreneurs includes implicit cost or opportunity cost in total cost.

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  • Loss of Perfectly Competitive Firm

The perfectly competitive firm will be in normal profit if the average revenue is lower than average cost.

Loss = Area under Average Cost –  Area under Average Revenue

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Long Run Analysis

In long run, the perfectly competitive firm earns normal profit. This is because the perfectly competitive firm lacks market power, there is free entry and exit of firms, and availability of close substitute or homogeneous products. Thus in long run, the perfectly competitive firm always have long run average revenue equal to long run average cost.

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