LEARNING OUTCOMES
By the end of this topic, you should be able to:
- Explain the characteristics of a perfectly competitive market;
- Explain how the firm decides on the optimal outputs;
- Analyse the conditions of profit and loss experienced by the firm;
- Review the situations where a firm has to shut down operation;
- Assess how the short-run supply curve of firms and industries are derived; and
- Explain how the firm and industry achieve equilibrium in the long-run.
INTRODUCTION
As what you have already understood, the pricing and output decision does not only depend on demand of consumers and costs faced by firms. The pricing and output decision of the firm also depends on the structure of the market in which the firm is operating.In connection with that, in this topic, we will study the way firms operating in the perfectly competitive market (PCM) determine price and output that maximises their profit. We will begin this lesson by first understanding the characteristics of the perfectly competitive market. Then we will look at the shapes of the demand curve, average revenue curve and marginal revenue curve faced by firms in the perfectly competitive market.
After that, we will study how the perfectly competitive firms achieve equilibrium in the short-run and look at the shape of the supply curve of the firm. Finally, we will study on how perfectly competitive firms and industries achieve equilibrium in the long-run.
Generally, it is undeniable that the main motive of producers is to maximise profit. In other words, profit is the incentive for producers to produce goods and services.
Profit is the difference between total revenue (TR) with total costs (TC).
However, the calculation of profit from the perspective of an economist differs from the calculation of profit by an accountant. This is because accountants will only consider the explicit costs. Hence, the profit calculated by accountants is referred to as accounting profit.Meanwhile, for an economist, the explicit costs and implicit costs are both taken into account. Therefore, profit obtained from the calculation by an economist is known as the economic profit. Here, implicit cost refers to opportunity costs.
For example, Mr. Azman has a degree in mechanical engineering. He was offered to work as an executive with a private company with the salary of RM1,250 per month. However, he decided to open a shop selling motorcycle spare parts by withdrawing his savings of RM50,000 to be used as the capital. Rate of returns on the savings is 10% per annum.
He also rented a shop house with the rental of RM600 per month, and hired two workers with the wage of RM700 per month. Besides that, Mr. Azman spent RM40,000 in that particular year to purchase all the necessary equipment needed for his business.
If the total revenue he obtained for that year is RM120,000 minus the explicit cost amounting to RM64,000, hence Mr. Azman gained an accounting profit of RM56,000 per annum.
For an economist, Mr. Azman has to also take into account the implicit costs in calculating his profit. In this example, implicit costs refer to the opportunity costs since Mr. Azman had turned down the job as an executive, that is, at the amount of RM15,000 per annum. Mr. Azman also had to foregone the returns of RM5,000 per year for using his savings for the business.
This means that the implicit cost involved is RM20,000 per year. By subtracting the implicit cost from the accounting profit, Mr. Azman is actually gaining an economic profit of only RM36,000 per year.
The difference in calculating accounting profit and economic profit is depicted in the following table:
| RM | RM | |
|---|---|---|
| Total revenue | 120,000 | |
| minus Explicit cost: | ||
| Shop rental (RM600 x 12 months) | 7,200 | |
| Wage (RM700 x 2 workers x 12 months) | 16,800 | |
| Necessary equipments | 40,000 | |
| Total explicit cost | 64,000 | |
| Accounting profit (Total revenue minus explicit cost) | 56,000 | |
| minus Implicit cost: | ||
| Salary received as an executive | 15,000 | |
| Returns to savings, 10% from RM50,000 | 5,000 | |
| Total implicit cost | 20,000 | |
| Economic profit (Total revenue – Total costs) | 36,000 |
SELF-CHECK 7.1
Assume that there are companies A, B, C and D. All of these companies produce detergent powder with different brands. How is the detergent price of company A, B, C and D determined?
ACTIVITY 7.1
In your own words, define the meaning of economic profit. Explain further by using diagrams and refer to reference books to have a better understanding.
A particular market is said to be operating under perfect competition if it has the following characteristics:
a. A Large Number of Sellers and Buyers
The market consists of a large number of sellers and buyers. Therefore, any action by a single seller or buyer will not influence price. This is because the quantity produced (purchased) by a seller (buyer) relatively is very small compared to the quantity produced (purchased) in the market. Therefore, sellers and buyers will only accept the price fixed by the market.b. Goods Produced are Homogeneous
Every firm in the perfectly competitive market produces homogenous goods. This means that buyers are not able to differentiate the goods sold in the market. The most important implication of this characteristic is firms are not given any power in determining the price. Therefore, firms act only as the “price taker”.c. Freedom to Leave or Enter Market
This means that there are no restrictions for a firm to enter or leave the market. If the existing firm experiences positive economic profit, it cannot prevent new firms from entering the market. On the other hand, if the existing firm faces loss, it is free to leave the market. Since firms are free to leave and enter the market, there is always a large number of sellers and buyers in the perfectly competitive market. This freedom is only meant for the long-run. In the short-run however, firms cannot leave or enter market freely.d. Perfect Information
Every firm and buyer is assumed to have perfect information regarding the goods available in the market and the price fixed. With perfect information available, sellers will not sell goods at a price lower than the market price. Meanwhile, buyers will not purchase goods at a price higher than the market price.After knowing the characteristics of a perfectly competitive market, now we can look at the shape of the demand curve, average revenue curve and marginal revenue curve of a firm in this market.
ACTIVITY 7.2
Can the market for petrol be considered as a perfectly competitive market? Explain your opinion.
SELF-CHECK 7.2
Explain the meaning of a perfectly competitive market, and its characteristics.
Hence, at a certain level of market price, it is found that the demand curve of every firm is in the form of a horizontal line or is perfectly elastic. A perfectly elastic demand curve means that the firm can sell as many outputs as desired without changing the price level of the goods. Figure 7.1 helps us to identify why a demand curve bears a perfectly elastic shape.
Any changes in market price will alter the demand curve of the firm. Let us say that there is a decline in supply, and this is shown by the shift of curve from S0 to S1. In effect, the price will increase to P1. This means that the demand curve of firm will shift upwards, to D1. On the other hand, if supply in the market increases, curve S0 will shift to S2 and this will cause the market price to fall to P2. At the market price of P2, it is found that the individual demand curve shifts downwards to D2.
7.3.1 Marginal Revenue (MR) Curve and Average Revenue (AR) Curve
Based on Figure 7.1, assume that the market price is RM4. At the price of RM4, the demand curve of the firm is at D0. Let us say that at the price level of RM4, the firm will produce 100 units of output initially. Assume that the firm increases its production as shown in Table 7.1:
| Output (Unit) | Price (RM) | Total Revenue (TR) | Marginal Revenue (∆TR/∆Q = MR) | Average Revenue (TR/Q = AR) |
|---|---|---|---|---|
| 100 | 4 | 400 | - | 4 |
| 101 | 4 | 404 | 4 | 4 |
| 102 | 4 | 408 | 4 | 4 |
| 103 | 4 | 412 | 4 | 4 |
In conclusion, we conclude that at the price level of RM4, the demand curve of the firm, D, is also the marginal revenue curve and average revenue curve for the firm in a perfectly competitive market.
D = P = MR = AR
There are two approaches that can be used to determine the level of output:
- Total revenue (TR) and total costs (TC) approach; and
- Marginal revenue (MR) and marginal costs (MC) approach.
7.4.1 Total Revenue and Total Costs Approach
| Quantity | Total Revenue | Total Costs | Profit/ Loss | Marginal Revenue | Marginal Costs |
|---|---|---|---|---|---|
| Q (Units) | TR (RM) | TC (RM) | TR − TC (RM) | MR = ΔTR/ΔQ | MC= ΔTC/ΔQ |
| 0 | 0 | 3 | −3 | - | - |
| 1 | 6 | 5 | 1 | RM 6 | RM 2 |
| 2 | 12 | 8 | 4 | 6 | 3 |
| 3 | 18 | 12 | 6 | 6 | 4 |
| 4 | 24 | 17 | 7 | 6 | 5 |
| 5 | 30 | 23 | 7 | 6 | 6 |
| 6 | 36 | 30 | 6 | 6 | 7 |
| 7 | 42 | 38 | 4 | 6 | 8 |
| 8 | 48 | 47 | 1 | 6 | 9 |
In order to maximise profit, the firm must produce at the level of output where the gap (range) between total revenue and total cost is the largest. This means, the firm must produce 4 or 5 units of output because the profit size is the largest, that is, RM7.
7.4.2 Marginal Revenue and Marginal Costs Approach
In perfect competition, every firm is a price taker. Therefore, if one additional unit of output is sold, total revenue will increase at the same amount as the market price of that particular good. As a result, in perfect competition, marginal revenue is equivalent to market price. From Table 7.2, it is found that marginal revenue, that is, addition in revenue, is RM6.
In the previous topics, we have learnt that marginal cost is the change in cost divided by the change in quantity or MC = ΔTC/ΔQ. Column (6) in Table 7.2 shows the marginal cost of the firm. The marginal cost decreases initially, depicting the law of increasing returns in the short-run when variable inputs are added.
However, the marginal cost then increases when the law of diminishing returns occurs. The firm will increase output as long as every additional unit of output sold will produce more total revenue compared to total cost, or in other words, as long as marginal revenue exceeds marginal cost.
Referring to Table 7.2, the firm must produce 6 units of output in order to maximise profit because at this level, the marginal revenue is equivalent to the marginal cost. Therefore, an important rule that must be fulfilled by the firm in order to maximise profit is to produce at a level where marginal revenue is equivalent to marginal cost.
We know that the main goal of the firm is to maximise its profit. This means that the firm will continuously produce output at a level where MR = MC. Hence, the firm will be in an equilibrium state when it fulfils this rule.
The question is, if the firm is in an equilibrium state, will it gain profit or loss instead? This is because in the short-run, the firm might gain normal profit, supernormal profit or subnormal profit.
Now let us look at each of these situations.
7.5.1 Supernormal Profit
In a perfectly competitive market, since marginal revenue is equivalent to market price, hence the marginal revenue curve is a horizontal line at the market price level of RM6. This also indicates that the demand curve of the firm is also the marginal revenue curve.
The firm will gain RM6 for every unit of output sold and this is also the average revenue for the firm. Average revenue (AR) is total revenue divided by quantity, or AR/Q. Thus, the demand curve of the firm (D) is also the marginal revenue (MR) curve and average revenue (AR) curve. In conclusion, D is the demand curve, marginal revenue curve and average revenue curve of the firm, that is, D = MR = AR.
ACTIVITY 7.3
Why is the demand curve of a perfectly competitive firm also the marginal revenue (MR) curve, and the average revenue (AR) curve? Explain your answer.
If the output level is less than 5 units, it is noted that the marginal revenue exceeds marginal cost. Therefore, the firm needs to increase production to increase profit.
On the other hand, if output produced is more than 5 units, the firm needs to reduce production to increase profit since the marginal cost exceeds marginal revenue.
At the equilibrium point, it is found that the average cost (AC) curve is situated below the demand curve. This indicates that the firm gains supernormal profit. Profit gained by the firm is denoted by the shaded area. Total profit is:
7.5.2 Normal Profit
7.5.3 Subnormal Profit/Economic Loss
However, the production cost per unit is higher than the price per unit, that is, RM6.50. This is indicated by the average cost (AC) curve that is above the demand curve. In conclusion, the firm gains a subnormal profit in the short-run. The shaded area in the diagram denotes the loss faced by the firm.
ACTIVITY 7.4
In the short-run, a firm may gain THREE types of profit. What are these three types of profit? Illustrate them in a suitable diagram.
Is it true that a subnormal profit will attract new firms to enter the market? Explain your answer.
Is it true that a subnormal profit will attract new firms to enter the market? Explain your answer.
7.5.4 Decision on Firm Closure
SELF-CHECK 7.3
What will happen if a firm is unable to gain profit at every level of output? Should the firm close down its operations?
We know that the rule to maximise profit in the short-run is to produce at the level where price (marginal revenue) is equivalent to marginal cost.
This is because, if the price is lower than the minimum point of the AVC curve, it will be much better if the firm shuts down its operations (not producing anymore output) in the short-run. This can be further clarified by referring to Figure 7.5.
However, the firm continues its operations since the total revenue gained can still cover the variable costs and a portion of the fixed costs. If the firm stops its operations, the firm will face a bigger loss because without any revenue, it has to bear all the fixed costs.
When price decreases further to RM2.50, it is found that the total revenue can only cover the variable costs, meaning the firm has to bear the fixed costs. If price decreases lower than RM2.50, the firm needs to close down its production operations in the short-run because its total revenue can no longer cover both costs.
We know that the variable costs exist when production is being carried out. Therefore, if production is stopped, the firm will only have to bear its fixed costs. In conclusion, the firm will close down its operations if it faces a condition of price being lower than the average variable costs, or P < AVC.
Since fixed cost is beyond the control of the firm in the short-run, TR gained must at least be able to cover the variable costs. If not, there is no use for the firm in paying the salary of workers and the costs of raw materials if TR is unable to cover the expenditure for purchasing variable inputs.
ACTIVITY 7.5
Firms in a perfectly competitive market will continue to operate even when facing loss. Discuss this issue with your friends.
At P2, the firm is in a condition of indifference between producing Q2 and closing down operations because in whichever condition, the firm’s loss is equal to the fixed cost as price only accommodates the average variable costs. Point 2 is referred to as point of operation shutdown.
When price is at P3, the firm will produce Q3 to minimise loss. At price P4, the firm will produce Q4 of output and will only gain normal profit. Subsequently, at price P5, the firm will produce Q5 of output and gain supernormal profit since the price is much higher than the average cost.
From the explanation above, we find that as long as the price is high enough to cover the average variable costs, the firm will continue to produce output when marginal cost intersects marginal revenue. In other words, the supply curve of the firm in the short-run is the marginal cost curve that begins at and is on the point of firm shutdown, or P = minimum AVC.
When the price increases to P1, it is found that each firm supplies 20 units of output. Therefore, the total quantity in the market increases to 60 units and this is denoted by point B. When point A and point B are connected, the connecting line is referred to as the supply curve of the industry in the short-run which is the horizontal summation of MC1, MC2, and MC3.
7.7.1 The Relationship between the Firm’s Equilibrium and the Industry’s Equilibrium in the Short-Run
Since firms are price takers, the demand curve of the firm is a horizontal line denoted by curve D = MR = AR at the price level of P. In order to maximise profit, the firm will produce output when the MC curve intersects the demand curve (which is also the MR curve).
Firm equilibrium is achieved at point e by producing q units of output and imposing a price of P. At the level of equilibrium, it is found that the firm gains positive economic profit since the AC curve is situated below the price line. Profit of the firm in the short-run is denoted by the shaded area in the diagram.
ACTIVITY 7.6
If a firm wishes to maximise its profit in the short-run, what is the rule that needs to be fulfilled? Explain how the rule ensures the firm maximises its profit.
The rule used to maximise profit in the short-run, that is, MR = P = MC will also be used in the long-run. The difference is firms will be facing costs curve in the long-run.
However, this short-run equilibrium is only a temporary equilibrium because if price does not move from P, the firm will expand the size of its production plant to increase profit. Referring to Figure 7.9, it is observed that the firm will expand its plant (curve SAC1) until point A because profit is maximised.
In the long-run, the firm can change all the inputs used and expand the size of plant used. Therefore, Figure 7.9 illustrates the long-run average costs (LAC) curve and long-run marginal costs (LMC) curve of a firm in a perfectly competitive market.
Let us assume that the market price equilibrium remains unchanged at P. In the long-run, in order to maximise its profit, the firm must be at the level where MR = LMC. The output that maximises profit is q3. To produce q3 units of output, the firm has to expand the size of its plant, that is, the short-run average costs curve (not drawn) until it touches the LAC curve at point A.
The long-run equilibrium of the firm is achieved at point E and the firm has gained a larger total profit when producing output at q3. The area of profit is denoted by CPEA. Hence, the plant at point A illustrates the firm in its short-run and long-run equilibrium as long as there are no changes in the market (that will change level of price).
7.8.1 Coordination in Long-Run
Based on Figure 7.9, a firm is shown to gain supernormal profit in the short-run. When firms existing in the market gain supernormal profit, new firms will be attracted to enter the market in order to enjoy the profit as well. This will increase supply in the industry that will further lead to price decline.
This process continues until price is equivalent to average costs, let us say at P1. At the price level of P1, it is found that the demand curve touches the LAC curve at point B. Output that will maximise profit is at q2. At the level of long-run equilibrium of q2, the firm will only gain normal profit because price is equivalent to cost per unit.
Therefore, we cannot determine which firm’s supply curve to be summed up horizontally. This causes the long-run supply curve of a perfectly competitive industry to take into consideration the change in input price when the industry expands.
When the industry expands, there are three possibilities that might occur towards input price, which are price will increase, price is unchanged (constant), or price will decrease. Therefore, in the long-run, perfectly competitive industries will be classified into constant-cost industry, increasing-cost industry and decreasing-cost industry. The shape of industry supply curve in long-run is based on this classification.
7.10.1 Constant-Cost Industry
Now assume that there is an unexpected increase in demand. This will cause the demand curve to shift to D1 and the industry equilibrium is now at point B where market price increases to P’. In the short-run, the firm will produce q2, that is, when P = SMC at point E’. This condition is only a short-run equilibrium due to coordination effects in the long-run by profit-seeking firms.
The condition of supernormal profit gained by existing firms will encourage new firms to enter the market and this will result in an increase in supply in the market as depicted by the shift of the supply curve to the right.
When the supply of output in the market increases, demand towards input will also increase. However, in the constant-cost industry it is found that an increase in input demand will not result in an increase of input price.
Hence, the entry process of new firms and the increase in supply will reduce the price until finally all firms gain normal profits only. In other words, at the new level of the long-run equilibrium, all firms will only gain normal profits.
Since there is no increase in input price, the supply curve will shift to S1 and the new equilibrium of the industry is achieved at C. The market price drops to the initial price of P. Point C is the second point in the long-run supply curve. At the demand curve D1, the supply of industry expands to Q3 and price at P.
Each firm produces q1 output and only gains a normal profit. Increase in the industry output from Q1 to Q3 is due to the entry of new firms.
Hence, the constant-cost industry in a perfectly competitive market faces a perfectly elastic long-run supply curve, that is, curve SL as in the Figure above.
7.10.2 Increasing-Cost Industry
Figure 7.12 illustrates this condition. Let us say that the initial equilibrium of the industry begins at point A where the equilibrium price and quantity is P and Q1. The firm produces q1 at the price of P, and the long-run equilibrium at E.
In the long-run, supernormal profit gained by the firm in the industry will attract new firms to enter the market. Output in the market will increase and this causes the demand towards input to also increase and subsequently resulting in an increase of input price.
Therefore, we will look at how these two different conditions will influence the coordination process in the long-run. Supernormal profit in the short-run will expand the output in the market due to the entry of new firms, and this will be depicted by the shift of the supply curve. This causes a price decline and eventually will reduce profit.
At the same time, input price increases due to an increase in input demand. This condition will increase cost and reduce profit. These two effects will continuously influence the new long-run equilibrium achieved where all firms will only gain zero economic profit.
Based on Figure 7.12, when price increases to P’, it is found that a new firm starts entering the market. This will cause the supply curve S to shift to S’ and the price will decrease to P”. Therefore, the demand curve of the firm will shift downwards along with the price decrease, that is from P’ to P”, and this will reduce profit. At the same time, the increase in input price will shift the costs curve of the firm upwards, that is, from LAC to LAC’.
Price decrease and increase in costs will finally eliminate the profit gained by the firm. This occurs at the price level of P”, that is when price is equivalent to cost per unit. Output is produced at the point where price is equal to the minimum point of the LAC’ curve and this indicates that the new long-run equilibrium has been achieved.
The new long-run equilibrium of the industry is achieved at point C. Connecting points A and C will form the long-run supply curve in a perfectly competitive industry facing an increasing cost, SL that is positively sloping from left to right.
The concept of increasing cost illustrates that the costs curves of all firms increases when the industry expands because the expansion of output will result in an increase of input price.
7.10.3 Decreasing-Cost Industry
The difference is when demand in the market increases, output will expand and it is found that the expansion of output will decline the costs curve of each firm. The downwards shift of the costs curve is due to the reduction in input price.
The question is, how does an increase in demand for input (due to the increase in quantity of supply) reduce the price of input? We know that in the long-run, a firm can expand its capacity and this will allow the firm to enjoy economies of scale, that is, the increasing returns to scale.
Besides that, the entry of new firms will facilitate the occurrence of economies of scale resulting in the decrease of input price. This is the condition that causes the supply curve of a decreasing-cost industry to slope negatively from left to right. This can be seen in Figure 7.13.
Therefore, new firms will enter the market and this will result in the expansion of output. This is depicted by the shift of the supply curve to the right from S to S’. When output expands, the demand towards input increases and in a decreasing-cost industry, it is found that the costs curve shifts downwards indicating a reduction in input price.
Hence, the supply curve will shift until S’ where at the price level of P”, the long-run equilibrium of the industry and firm is achieved where all firms will only gain normal profit.
The new long-run equilibrium of the industry is at point C. When point A and point C are connected, we will derive the long-run supply curve for the decreasing-cost industry that is curve SL.
- Productive efficiency, that is, producing output at the lowest cost; and
- Distributive efficiency referring to the emphasis on production of output that will benefit the consumers.
a. Productive Efficiency
Productive efficiency occurs when the firm produces at the minimum point of the long-run average costs curve where price is equivalent to average cost. We know that in the long-run, firms in perfect competition can freely enter and leave the market.Long-run coordination will stop when the firm achieves a long-run equilibrium in which it produces at the level where price is equivalent to the minimum point of the long-run average cost curve. Production at point P = minimum LAC indicates that a perfectly competitive firm has achieved productive efficiency.
b. Distributive Efficiency
Distributive efficiency occurs when the firm produces output at a level that is most desired by consumers. We know that a perfectly competitive firm will produce at the level of P = MC in the short-run. Why does a firm not produce at a level where P<MC or P>MC? Look at Figure 7.14 for further explanation.
Meanwhile, from society’s point of view, producing output at the area of P > MC is referred to as less distribution of resources used in the production of the good. On the other hand, producing output at the level where P< MC will cause a loss to the firm since the addition in costs (P) to produce the q2 unit is much higher than price per unit, P.
Society views the area at P < MC as excess distribution of resources used in the production of the good. Therefore, producing at the level of P = MC is the level of distributive efficiency that will be achieved by the firm in perfect competition.
- Perfectly competitive firms only take the price that has been fixed by the market.
- In order to maximise profit, firms will produce output at levels where price is equivalent to marginal costs.
- In the short-run, there are three possibilities of firm profit, namely the subnormal profit, normal profit, and supernormal profit.
- If the price is lower than the average variable costs, the firm will shut down its operations in the short-run.
- You have studied about the shape of supply curves of perfectly competitive firms and industries in the short-run. You have also looked at how equilibrium of the firm and industry is achieved in the long-run. Due to the factor of freedom of entering and leaving market, firms in a perfectly competitive market only gain normal profit in the long-run.
- The shape of the long-run supply curve of an industry is derived based on costs. Getting the picture on how firms operate in a perfectly competitive market will help us to study firm behaviour in the next market structure.
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