CHAPTER FIVE

PRICE AND OUTPUT DETERMNATION UNDER

PERFECT COMPETTION
Introduction
We shall try to see how a given firm operating in a perfectly competitive market
determines the profit maximizing level of output and price, and how equilibrium
market price and level of output are determined in a perfectly competitive
market. Our discussion starts with giving a brief description about perfect
competition.

5.1 Perfect Competition

Definition and assumptions
Perfect competition is a market structure characterized by a complete absence of
rivalry among the individual firms. Thus, perfect competition in economic
theory has a meaning diametrically opposite to the everyday use of this term.

Most of the time, we see business men using the word “Competition” as
synonymous to “rivalry”. However, in theory, perfect competition implies no
rivalry among firms.

Assumptions
The model of perfect competition was constructed based on the following
assumptions or imaginations.

1. Large number of sellers and buyers.

The perfect competitive market includes a large number of buyers and sellers.
How large should the number of buyers and sellers is large to the extent that the
market share of each firm (and buyer) is too small to have a perceptible effect on
the price of the commodity. That is the action of a single seller or buyer cannot

41
influence the market price of the commodity, since the firm or (the buyer) is too
small in relation to the market.

2. Products of the firms are homogeneous.

This means the products supplied by all firms in the market have uniform
physical characteristics (are uniform in terms of size, quality etc) and the
services associated with sales and delivery are identical. Thus buyers can not
differentiate the product of one firm from the product of the other firm.

The assumptions of large number of sellers and of product homogeneity imply

that the individual firm in pure competition is a price taker: its demand curve is
infinitely elastic, indicating that the firm can sell any amount of output at the
prevailing market price. Since the share of the firm from the market supply is
too small to affect the market price, the only thing that the firm can do is to sell
any quantity demand at the ongoing market price. Thus, the demand curve that
an individual firm faces is a horizontal line.

Fig 5.1 The demand curve indicates a single market price at which the firm can sell any amount
of the commodity demanded. It also indicates the average revenue and marginal revenue of the
firm.

3. Free entry and exit of firms

There is no barrier to entry and exit from the industry. Entry or exit may take
time, but firms have freedom of movement in and out of the industry. If barriers
exist the number of firms in the industry may be reduced so that one of them
may acquire power to affect the market price.
4. The goal of all firms is profit maximization.
Of course, firms can have different objectives. Some firms may have the aim of
making their product wise, others may want to maximize their sales even by
cutting price, etc. But, in this model, it is assumed that the goal of all firms is to
maximize their profit and no other goal is pursued.
5. No government regulation
By assumption, there is no government intervention in the market. That is there
is no tax, subsidy etc. A market structure in which all the above assumptions are

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fulfilled is called pure competition. It is different from perfect competition
which requires the fulfillment of the following additional assumptions.
6. Perfect mobility of factors of production
Factors of production (including workers) are free to move from one firm to
another throughout the economy. Alternatively, there is also perfect competition
in the market of factors of production.
7. Perfect knowledge
It is assumed that all sellers and buyers have a complete knowledge of the
conditions of the prevailing and future market. That is all buyers and sellers
have complete information about the price of the product, quality of the product,
etc. Thus, a perfectly competitive market is a market which satisfies all the
above conditions (assumptions). In reality, perfectly competitive markets are
scarce if not none. But since the theory of perfectly competitive market helps as
a bench mark to analyze the more realistic markets, it is very important to study
it.

Given the above assumptions (based which the model of perfect competition
was built), we will now examine how the firm operating in such a market
determines the profit maximizing output both in the short run and in the long
run. But to determine the profit maximizing output, first we have to see what the
revenue and cost functions of the firms operating in perfectly competitive
market looks like.

Costs under perfect competition

Previously, we have said that the per unit cost (AVC &AC) have U –shape due
to the law of variable proportions (in the short run) and the law of returns to
scale (in the long run). There is no exception for firms operating under perfect
competition i.e., their cost functions have the behavior mentioned in the last
chapter.

Demand and revenue functions under perfect competition

Due to the existence of large number of sellers selling homogenous products,
each seller is a price taker in perfectly competitive market. That is, a single
seller cannot influence the market by supplying more or less of a commodity.

If, for example, the seller charges higher price than the market price to get larger
revenue, no buyers will buy the product of this (the price raising) firm since the
same product is being sold in the market at lower price by other sellers.
Obviously, the firm will not also attempt to reduce the price. Thus firms
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 operating in a perfectly competitive market are price takers and sell any quantity
demanded at the ongoing market price. Hence, the demand function that an
individual seller faces is perfectly elastic (or horizontal line).

From the buyers’ side too, since there is large number of buyers in the market, a
single buyer cannot influence the market price. Thus, in perfectly competitive
market, both buyers and sellers are price takers. They take the price determined by
the forces of market demand and market supply.

Graphically,

Fig 5.2 the demand curve that a perfectly competitive firm faces is horizontal line with
intercept at the market price. This indicates that sellers sell any quantity demanded at the
ongoing market price and buyers buy any amount they want at the ongoing market price.

Given the horizontal demand function at the ongoing market price, the total revenue
of a firm operating under perfect competition is given by the product of the market
price and the quantity of sales, i.e.,
TR = P*Q
Since the market price is constant at P*, the total revenue function is linear and the
amount of total revenue depends on the quantity of sales. To increase his total
revenue, the firm should sell large quantity.
Graphically, the TR curve is as shown below.

TR=PQ

TR

Q
Fig 5.3 the total revenue of firm operating is linear (and increasing function) of the quantity of sales.

The marginal revenue (MR) and average revenue (AR) of a firm operating under
perfect competition are equal to the market price. To see this, let’s find the MR and
AR functions from TR functions: TR = PQ
By definition, MR is the change in total revenue that occurs when one more unit of
the output is sold, i.e. MR  dTR  P .Hence MR=P
dQ

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Average revenue is the TR divided by the quantity of sales. i.e. AR  TR  P.Q  P
Q Q
Hence, AR = P.

Graphically, the demand curve represents the MR and AR of the firm

Fig: 5.4 the AR curve, MR curve and the demand curve of an individual firm operating under
perfectly competitive market overlap.

5.3 Short run equilibrium of the firm

A firm is said to be in equilibrium when it maximizes its profit (). Profit is
defined as the difference between total cost and total revenue of the firm:
= TR-TC
Under perfect competition, the firm is said to be in equilibrium when it produces
that level of output which maximizes its profit, given the market price. Thus,
determination of equilibrium of the firm operating in a perfectly competitive
market means determination of the profit maximizing output since the firm is a
price taker.
The output which maximizes the profit of the firm can be obtained in two ways:
 Total approach
 Marginal approach
Total approach
In this approach, the -maximizing output is that level of output at which the vertical
distance between the TR and TC curves is maximum. (Provided that the TR curve
lies above the TC curve at this point). -maximizing output is Qe because it is at this
output level that the vertical distance between the TR and TC curves (or profit) is
maximum. For all output below Q0 & above Q1 profit is negative because TC is
above TR.

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Fig 5.5 Total approach of profit maximization

Marginal Approach
In this approach the profit maximizing level of output is that level of output at which:
MR=MC and MC is increasing
This approach is directly derived from the total approach. In figure 4.4, the vertical
distance between the TR and TC curve is maximum where a straight line parallel to
the TR curve is tangent to the TC curve. Or simply, the vertical distance between the
TC and TR curves is maximum at output level where the slope of the two curves is
equal. The slope of the TR curve constant and is equal to the MR or market price.

Similarly, the slope of the TC curve at a given level of output is equal to the slope of
the tangent line to the TC curve at that level of output, which is equal to MC. Thus
the distance between the TR and TC curves () is maximum when MR equals MC.
Graphically, the marginal approach can be shown as follows.

Fig 5.6: The Marginal Approach of Profit Maximization

The profit maximizing output is Qe, where MC=MR and MC curve is increasing. At
Q*, MC=MR, but since MC is falling at this output level, it is not equilibrium output.
For all output levels ranging from Q* to Qe the marginal cost of producing additional
unit of output is less than the MR obtained from selling this output. Hence the firm
should produce additional output until it reaches Qe.
Mathematical derivation of the equilibrium condition
Profit () = TR-TC TC is a function of output, TC=f (Q)
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 TR is also a function of output, TR=f (Q)
Thus, profit is a function of output, =f (Q) = TR-TC
To determine the profit maximizing output we find the first derivative of the 
function and equate the result to zero.
d dTR dTC
  0 this leads to MR – MC = 0
dQ dQ dQ
= MR=MC ------------------------------ (First order condition necessary condition)
The equality of MC and MR is a necessary, but not sufficient condition. The
sufficient condition for maximization of II is that the second derivative of the II
function should be less than zero (or negative) i.e.
d 2 d 2TR d 2TC
 0  0
2
dQ 2 2 dQ 2 dQ 2
d TR dMR d TR
 , thus
dQ 2
dQ dQ 2 is the slope MR.
Since MR
2
is horizontal (or constant), the2 slope of MR is equal to zero.
d TC d TC
dMC
Likewise, dQ 2 is equal and thus, dQ 2 is the slope of MC, which is not
dQ
constant
2
TR d 2TC
Thus, d  means
dQ 2 dQ 2
- Slope of MR < Slope of MC
- 0 < Slope of MC or
- Slope of MC > 0 or
- Mc is increasing………………. Sufficient condition
Thus, the condition for profit maximization under perfect competition is
MR= MC………………….necessary condition and
MC is increasing…………. sufficient condition
Conceptually, maximizing the difference between TR & TC means maximizing the
area between the MR and MC curve, i.e., maximizing  (MR-MC)dQ. And the area
between the MC and MR would be maximal only when the firm produces Qe level of
output.

The fact that a firm is in the short run equilibrium does not necessarily mean that the
firm gets positive profit. Whether the firm gets positive or zero or negative profit
depends on the level of ATC at equilibrium thus;
a. If the ATC is below the market price at equilibrium, the firm earns a positive
profit equal to the area between the ATC curve and the price line up to the profit
maximizing output (see fig below)

47
 Fig 5.7 the firm earns a positive profit because price exceeds AC of production at equilibrium
b. If the ATC is equal to the market price at equilibrium, the firm gets zero.

c. If the ATC is above the market price at equilibrium, the firm earns a negative
profit (incurs a loss) equal to the area between the ATC curve and the price line.(
see fig 5.8 below).

Fig 5.8 a firm incurs a loss because price is less than AC of production at equilibrium.

In this case, you may ask that “why do the firm continue to produce if it had to incur
a loss?” In fact, the firm will continue to produce irrespective of the existing loss as
far as the price is sufficient to cover the average variable costs. In other words, the firm
should continue producing as far as the TR sufficiently covers the total variable costs.
This is so because if the firm stops production, it will incur a loss which equals the
total fixed cost. But, if it continues to produce the loss is less than the total fixed costs
because the TR will cover some portion of the fixed costs in addition to the whole
variable costs as far as it is greater than TVC.

However, if the market price falls below the AVC or alternatively, if the TR of the
firm is not sufficient to cover at least the total variable cost, the firm should close (shut
down) its factory (business). It will only lose the fixed costs; but if it continues
operation while the TR is unable to cover even the variable costs, the loss is greater
than the fixed costs since part of the variable cost is also not covered by the existing
revenue.
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To summarize, a firm may continue production even while incurring a loss (when TC
> TR). This occurs as far as the TR is able to cover at least the TVC (TR > TVC). If
the TR is less than the TVC, the firm is well advised to discontinue its operation so
that the loss will be minimized. Hence, to continue its operation (or just to stay in the
business) the firm should obtain the TR which can at least cover its variable costs. The
following example will make the discussion clear.

Example: Suppose a firm has a TFC of $2,000, a TVC of $ 5,000 and a TR of $6,000
at equilibrium. Should the firm stop its operation? Why?

In fact the firm is incurring a loss of $ 1,000 because TC (2,000 + 5,000=7,000) is

greater than the total revenue. But the firm should continue production because the TR
is greater than TVC. If the firm stops operation, it will lose the fixed cost ($ 2.000).
But if it continues production the loss is only $ 1,000 (TR-TC). Thus, the firm requires
a minimum TR of $ 5,000 to continue operation. If the TR is equal to $ 5,000, the firm
is indifferent in between choosing to continue or to discontinue its operations because
in both cases the loss is equal to fixed costs. Thus the level output at which TR and
TVCs are equal is called shut down output level. In other words, shut down point is the
point at which AVC equals the market price.

Equally important point is the point of break-even. Break-even point is the output level
at which market price is equal to the average cost of production so that the firm obtains
only normal profit (zero profit).

Numerical example: Suppose that the firm operates in a perfectly competitive market.
The market price of its product is$10. The firm estimates its cost of production with
the following cost function:
TC=10q-4q2+q3
A) What level of output should the firm produce to maximize its profit?
B) Determine the level of profit at equilibrium.
C) What minimum price is required by the firm to stay in the market?

Solution
Given: p=$10 TC= 10q - 4q2+q3

A) The profit maximizing output is that level of output which satisfies the following
condition
MC=MR & MC is rising
Thus, we have to find MC& MR first
 MR in a perfectly competitive market is equal to the market price. Hence, MR=10
Alternatively, MR  dTR where TR= P.q = 10q
dq

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 d (10q)
Thus, MR   10
dq

MC= dTC  d (10q  dq  q3 )

2
 10  8q  3q 2
dq dq
 To determine equilibrium output just equate MC& MR
And then solve for q.
10 – 8q + 3q2 = 10
- 8q + 3q2 = 0
q (-8 + 3q) = 0
q = 0 or q = 8/3
Now we have obtained two different output levels which satisfy the first
order (necessary) condition of profit maximization
i.e. 0 & 8/3
 To determine which level of output maximizes profit we have to use the second
order test at the two output levels i.e. we have to see which output level satisfies the
second order condition of increasing MC.
 To see this first we determine the slope of MC
Slope of MC = dMC = -8 + 6q
dq
 At q = 0, slope of MC is -8 + 6 (0) = -8 which implies that marginal lost is
decreasing at q = 0. Thus, q = 0 is not equilibrium output because it doesn’t
satisfy the second order condition.
 At q = 8/3, slope of MC is -8 + 6 (8/3) = 8, which is positive, implying that
MC is increasing at q = 8/3
Thus, the equilibrium output level is q = 8/3.

B) Above, we have said that the firm maximizes its profit by reducing 8/3 units. To
determine the firm’s equilibrium profit we have calculate the total revenue that the
firm obtains at this level of output and the total cost of producing the equilibrium
level of output.
TR = Price * Equilibrium output
= $ 10 * 8/3= $ 80/3
TC at q = 8/3 can be obtained by substituting 8/3 for q in the TC function, i.e.,
TC = 10 (8/3) – 4 (8/3)2 + (8/3)3  23.12
Thus the equilibrium (maximum) profit is
 = TR – TC = 26.67 – 23.12 = $ 3.55

C) To stay in operation the firm needs the price which equals at least the minimum
AVC. Thus to find the minimum price required to stay in business, we have to
determine the minimum AVC.
AVC is minimal when derivative of AVC is equal to zero
That is: dAVC = 0
dQ

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Given the TC function: TC = 10q – 4q2 +q3, there is no fixed cost i.e. TC = TVC.
Hence, TVC = 10q – 4q2 + q3
TVC 10q  4q 2  q 3
AVC = = = 10 – 4q2 + q2
q q

dAVC d (10  4q  q 2 )
0  0 then = -4 + 2q = 0
dq dq
 q = 2 i.e. AVC is minimum when output is equal to 2 units.
The minimum AVC is obtained by substituting 2 for q in the AVC function i.e., Min
AVC = 10 – 4 (2) + 22 = 6. Thus, to stay in the market the firm should get a
minimum price of $ 6.
Exercise: Show that the breakeven price is also equal to $ 6. What is the reason
behind?

5.4 The short run supply curve of the firm and the industry
The short run supply curve of the firm
In the previous section, we have seen how a competitive firm determines the level of
output which maximizes its profit for a given market price. The profit maximizing
level of output is defined by the point of equality of MC and market price (because
market price is equal to MR in the perfectly competitive market). By repeating this
analysis at different possible market prices, we observe how the equilibrium quantity
supply of the firm varies with the market price. Now consider the figure 5.9 to
understand how to derive the short run supply curve of a perfectly competitive firm.

Suppose that initially the market price and MR is $6 and the demand curve is shown
by line P1. Given the MC curve, the level of output which maximizes the firm’s
profit is defined by the point of intersection of the MC curve and the demand line
(P1), which is equal to 50 units.

Now assume that the market price increases to $7. This is shown by an upward shift
of the demand curve (MR) to P2. Given the positive slope of MC, this higher demand
(MR) curve cuts the MC curve at higher output level, 140. That is, when the market
price increases from $6 to $7, the equilibrium quantity supplied by the firm increases
from 50 units to 140 units. As the price increases further (say to $8), the equilibrium
output increases to 200 units. This implies that the quantity supplied by the firm
increases as the market price increases.

The firm, given its cost structure, will not supply any quantity (will shut down) if the
price falls below $6, because at a lower price than $6, the firm cannot cover its
variable costs. Thus, supply is zero for all price levels below $6 (minimum AVC). If
we plot the successive equilibrium points on a separate graph we observe that the

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supply curve of the individual firm over laps with (is identical to) to part of its MC
curve to the right of the shutdown point.
P, C P

MC
MC of the
AC firm
E2 AVC
$8 P3= MR3 $8
E2
$7 P2= MR2 $7

E1
$6 P1= MR1 $6

50 140 200 50 140 200

Fig,5.9 The short run supply curve of a perfectly competitive firm is obtained by connecting
different equilibrium points E1, E2, E3 that occurs at successive price levels p1, p2 and p3
respectively. When the market price is $6, the firm supplies 50 units to maximize its profit. As the
price increases to $7, the equilibrium quantity supplied increases to 140 units and so on.

Thus, the short run supply curve of a perfectly competitive firm is that part of MC
curve which lies above the minimum average variable cost (Shut down point)

5.5 Short run supply curve of the industry

The word ’industry’ is defined as group of firms producing homogeneous products.
Thus the industry supply is the total supply or market supply. The industry –supply
curve is the horizontal summation of the supply curves of the individual firms. That
is, the total quantity supplied in the market at each price is the sum of the quantities
supplied by all firms at that price. This is based 0n the assumption that the factor
prices and the technology are given.

For detailed information as to how to derive the short run industry supply curve from
the supply of individual firms, consider the following figure. S 1, S2 and S3 denote the
supply curves of firms existing in a given industry. The industry supply curve is
obtained by adding the quantities supplied by all the firms at each price. For example,
at price which equals $ 6, firm 1 supplies 50 units, firm 2 supplies 80 units & firm 3
supplies 120 units. The market supply at $ 6 price is thus 250 units (50+80+120
units). The short run industry- supply is derived by repeating the above process at
each price levels.

When the market price falls below $ 4, only firm2 exists in the market. Thus, for
prices below$ 4, the industry supply curve is identical with the supply curve is

52
identical with the supply curve of firm 2. Similarly, for price levels ranging from $4
to $5, only firm1 and firm2 are producing and searching in the market. Thus, the
industry- supply curve for this range of price is the sum of the quantities supplied by
firm 1 and firm 2, and so on.
S1 S2 S3

$6
Industry supply
curve
$5

$4

$3

50 80 120
Fig, 5.10 the industry- supply curve is the horizontal summation (at each price) of the supply
curves of all firms in the industry.

5.6 Short run equilibrium of the industry

In our previous discussions, we have seen the short run equilibrium of the individual
firm, which is defined by the point of intersection of the horizontal MR curve (or the
demand curve that the individual firm faces) and MC curve (or the supply curve of
the firm). In other words, the short run equilibrium of an individual firm is defined by
equality of MC of firm and the market price.

Short run equilibrium of the industry is defined by the intersection of the market
demand and market supply. The intersection of market demand and market supply of
a given commodity determines the equilibrium price and quantity of the commodity
in the market.

While discussing the short run equilibrium of an individual firm we have said that the
demand curve that an individual firm faces is horizontal line (perfectly elastic). This
is due to the fact that; since there are large numbers of sellers in the market, an
individual firm is too small to influence the market price. Rather, the firm sells any
amount demanded at the prevailing market price.

Unlike the individual demand curve, the market demand curve (the total demand
curve that the industry faces) is down-ward sloping, indicating that as the market
price of the commodity increases, the total quantity demanded for the product
decreases and vise versa. In fig.5.11 the industry is in equilibrium at price Pe, at
which the quantity demanded and supplied is Q e. At this equilibrium market price,

53
individual firms can earn a positive profit, zero profit (normal profit) or even can
incur a loss depending on their cost structures.

Fig5.11:- short run equilibrium of the industry. Short run equilibrium of the industry is defined by the
intersection of the market demand and the industry supply Curve. At equilibrium price, Pe firm 1 gets a
positive profit because the average cost of the firm at equilibrium is less than the market Price, pe. On the
other hand, firm 2 is incurring a loss as its average cost is higher than the market price.

5.7 The long-run Equilibrium

1. Equilibrium of an individual firm in the long run
In the long run, firms are in equilibrium when they have adjusted their plant size so
as to produce at the minimum point of their long run Ac curve, which is tangent (at
this point) to the demand curve defined by the market price. That is, the firm is in the
long run equilibrium when the market price is equal to the minimum long run AC.
Thus since price is equal to long run AC (LAC now on) at the long run equilibrium,
firms will be earning just normal profits (zero profits), which are included in the
LAC. Firms get only normal profit in the long run due to two reasons.

First, if the firms existing in the market are making excess profits (the market price is
greater than their LACs) new firms will be attracted to the industry seeking for this
excess profit. The entry of new firms results in two consequences:
A. Entry of new firms leads to a fall in market price of the commodity (which is
shown by the downward shift of the individual demand curve). This happens because
entry of new firms increases the market supply of the commodity (which is shown by
the rightward shift of the industry supply), resulting in the lower market price.
Moreover, if firms are getting excess profit, they have an incentive to expand their
capacity of production, which increases the market supply and then reduces the
market price.
B. Moreover, the entry of new firms results in an upward shift of the cost curves.
This happens because, when new firms enter into the market the demand for factors
of production increases which exerts an upward pressure on the prices of factors of
production. An increase in the price of factors of production in turn shifts the cost
curves upward. These changes (decrease in the market price and upward shift of the

54 AU
cost curves) will continue until the LAC becomes tangent to the demand curve
defined by the market price. At this time, entry of new firms will stop since there is
no positive profit (since P = LAC) which attracts new firms in to the market.

Second, if the firms are incurring losses in the long run (P < LAC) they will leave the
industry (shut down). This will result in higher market price (since market supply of
the commodity decreases) and lower costs (since market demand for inputs decreases
as the number of firms in the market decreases). These changes will continue until
the remaining firms in the industry cover their TC inclusive of the normal rate of
profit.

Thus, due to the above two reasons, firms can make only a normal profit in the long
run. The following figure shows how firms adjust to their long run equilibrium
position excess profit ( higher price than minimum lack) if the market price is p, the
firm is making excess profit working with plant size whose cost is denoted by SAC, (
short run average cost1). It will therefore have an incentive to build new capacity or
larger plant size and it moves along its LAC. At the same time new firms will be
entering the industry attracted by the excess profits. As quantity supplied in the
market increases(by the increased production of expanding old firms and by the
newly established ones) the supply curve in the market will shift to the right and price
will fall until it reaches the level of P1, at which the firms and the industry are in the
long- run equilibrium.

Fig5.12: Long run equilibrium of the firm. Entry of new firms reduces the market price from p to
p1 (in panel A) and the long run equilibrium is established at E (panel B).
The condition for the long run equilibrium of the firm is that the long run
marginal cost (LMC) should be equal to the price and to the LAC i.e. LMC =
LAC = P. The firm adjusts its plant size to so as to produce that level of output
at which the LAC is the minimum possible, given the technology and prices of
inputs. At equilibrium the short – run marginal cost is equal to the long run
marginal cost and the short –run average cost is equal to the long run average
cost. Thus, given the above condition, we have,

55
 SMC = LMC = SAC = LAC = P = MR
This implies that at the minimum point of the LAC the corresponding short run
plant is worked at its optimal capacity so that the minimum of the LAC and
SAC coincide.

Long run shutdown decision

In the short-run the firm should continue production as far as the market price is
greater than the minimum AVC, If the market price falls below the minimum
AVC, the firm is well advised to shut down because if it shut down it well loose
only the fixed costs but if it continues production the loss is greater than the
fixed cost.
The long-run shut down decision (point) is different from that of the short run.
The firm shuts down if its revenue is less than its avoidable or a variable cost. In
the long run all costs are variable because the firm can change the quantity of all
inputs. Thus, in the long run the firm shuts down when its revenue falls below
the long run total cost. In other words, in the long run shut down decision occurs
if the market price falls below the minimum LAC of the firm.

The long-run supply curves of the firm

Previously, we have noted that in the long run the firm shuts down if the market
price is below the its minimum long run average cost. Thus, the firm will not
supply for all price levels below the minimum LAC. On the other hand, the
firm's long run equilibrium output is defined by the equality of the MR and its
LMC. As a result, a firm’s long- run supply curve is its LMC curve above the
minimum of its long-run average cost curve.

Long run supply curve of the industry

The long run supply curve of the industry is the horizontal sum of the supply of
individual firms just like the case of short run supply curve of the industry.
Thus, the long run supply curve of the industry is up ward sloping, provided that
the firms are of different size. This is because, firms with relatively lower
minimum LAC, are writing to inter the market than others. So that as the market
price increased in the long run more firms will find it profitable to inter the
market, resulting in upward sloping long-run supply curve of industry.
Long-run equilibrium of the industry
An industry is in the long-run equilibrium when the price is reached at which all
firms are in equilibrium. That is, when all firms are producing at the minimum
point of their LAC curve and making just normal profits, the industry is said to

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be in the long-run equilibrium. Under these conditions there is no further entry
or exit of firms in the industry (since all the firms are getting only normal
profit), so that the industry supply remains stable.
The long-run equilibrium of the industry is shown by fig 5.13.At the market
price, P, the firms produce at their minimum LAC, earning just normal profits.
At this price all firms are in equilibrium because, LMC=SMC=P=MR and they
get only normal profit because LAC=SAC=P. While the industry is in the short
run equilibrium, we have seen that, individual firms can earn positive, normal or
negative profits depending on the level of their AC s relative to the equilibrium
market price. However, this is not the case in the long-run. That is, while the
industry is in the long run .equilibrium all firms earn only normal profit.

5.8 Perfect competition and optimal resource allocation

In the perfect competition, the market mechanism leads to an optimal allocation
of resources. The optimality is shown by the following conditions all of which
prevail in the long run equilibrium of the industry;
a) The output is produced at the minimum feasible cost. That is all firms
produce at the minimum of their LAC.
b) Consumers pay the minimum possible price which just covers the marginal
cost of production, that is, price equals just opportunity cost so that the
consumers are not exploited.
c) Plants are used at full capacity in the long- run so that there is no waste of
resources. That is, at the long run equilibrium the short run average cost is also
minimum.
d) Firms earn only normal profits.
These conditions justify the fact that perfect competition results in optimal
resource allocation.

Industry equilibrium Firm’s equilibrium

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Fig5.13: long-run equilibrium of the industry is defined by the price at which all individual
firms are in equilibrium, marking just normal profit.

Summary
A perfectly competitive market is a market structure characterized by large number of
buyers and sellers, homogenous product, free entry and exit, no government regulation and
perfect knowledge of the market conditions,. Each buyer and seller in this market structure
is a price taker due to the large number of buyers and sellers and homogeneity of the
product.

Since an individual seller is a price taker, profit maximization in perfect competition

involves determination that level of output which maximizes the firm’s profit for the given
market price. In the short run, the equilibrium (profit maximizing) level of output is that
level of output which satisfies the condition: MC = MR and MC is rising

The fact that a perfectly competitive firm is in equilibrium doesn’t necessarily mean that
the firm enjoys a positive profit. Whether the firm gets positive or negative profit depends
on the firms average cost (AC) production with respect to the market price (P). If AC>P,
AC < P or AC = P at equilibrium the firm will get negative, positive or zero profit
respectively. When the market price of the commodity lower than the minimum AVC, the
firm should shut down to minimize its losses. Thus, the firm would supply a commodity to
the market only if price of the commodity is at least sufficient to cover the average variable
cost. Hence, a firm’s short run supply curve is that portion of MC curve which lies above
the minimum AVC.

Short run equilibrium of the industry is defined by the intersection of market demand and
industry supply curves. In the long run, profit maximizing completive firms chooses the
output at which price is equal to long- run marginal cost and long –run average cost. In the
long run, a firm can get only a normal profit.

Perfect competition results in efficient allocation of resources.

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