Module-1,Price and Output Determination Under Different
Market Structures
Perfect Competition
Perfect competition is a market structure in which there exist large number of sellers and
buyers in the market. The products are homogeneous are identical and there are no barriers to
enter and exit of firms from the industry. Perfectly competitive market structure has the
following characteristics.
1. Large number of sellers and buyers
The industry or market includes large number of sellers and buyers. Therefore the individual
seller and buyer will supply or demand only a small portion of the total quantity offered in
the market or the total market demand of the product. Thus the decision of an individual
buyer or seller alone does not affect the market price of the commodity.
2. Product homogeneity
The products produced by firms in perfectly competitive market structure are homogeneous
in nature. Therefore the buyers failed to differentiate the product of one firm from other
firms.
The assumptions of large number of sellers existed in the market and product homogeneity
implies that the individual firm in perfect competition is a price taker. The individual firm
cannot determine the price of the commodity. However, it can sell any amount of output at
the prevailing market price. Thus the individual firms face a demand curve which is
horizontal straight line parallel to OX axis. The demand curve faced by an individual firm in
perfectly competitive market is shown in the following diagram.
YP
P=AR=MR
X
O
The demand curve of an individual firm is also considered as the average and marginal
revenue curves of the firm.
3. Free entry and exit of firms
In perfect competition, there exist no barriers to enter or exit of firms from the industry. This
assumption is supplementary to the assumption of existence of large number sellers in the
market. If barriers exist, the number of firms in the industry may be reduced. In such as a
situation each firm can acquire power to influence the price of the commodity.
4. Profit maximisation
The firms have a single goal both in short run and long run i.e., profit maximisation.
Dr Ratheesh C, Dept. of Economics, FMN College, Kollam Page 1
, Module-1,Price and Output Determination Under Different
Market Structures
5. No government regulations
There is no government intervention exists in the market in the forms of impose tariff,
subsidies, rationing of production or demand. A market structure which shows the above
mentioned characteristics is called pure competition. A pure competition is changed to
perfectly competitive market structure if it satisfies the following additional characteristics.
6. Perfect mobility of factors of production
The factors of production are free to move from one firm to another, from one occupation to
another throughout the economy. In short, there exists perfect competition in the market of
factors of production.
7. Perfect knowledge
All buyers and sellers are assumed to have complete knowledge about all the market
conditions. Information is assumed to be free and costless.
I. Short run Equilibrium or Short Run Price Output Determination
a) Equilibrium of the firm in the short run
In a perfectly competitive market structure, a firm is in equilibrium when it maximises its
profit (π). Profit shows the difference between total cost and total revenue. Thus
𝜋 = 𝑇𝑅 − 𝑇𝐶
The firm is in equilibrium when it produces output which maximises the difference between
total receipts and total cost. The short run equilibrium of a firm in perfect competition can be
explained with the help of the following figure.
Y SMC
SATC
P
e P=MR
A
B
O X
xe
In the above diagram both SATC and
EE SMC are “U” shaped curves reflecting the law of
variable proportions. The short run marginal cost (SMC) cuts the SATC at its minimum
point. In a perfectly competitive market, the demand curve is also considered as the average
and the marginal revenue curves of the firm. Under these conditions, the firm reaches
equilibrium at the level of output at which MC = MR and MC curve cuts MR curve from
below or the slope of MC curve is greater than MR curve at the point of equilibrium. Thus
in the above figure point “e’ shows the equilibrium point at which the firm maximises its
Dr Ratheesh C, Dept. of Economics, FMN College, Kollam Page 2
, Module-1,Price and Output Determination Under Different
Market Structures
profit. Therefore OXe is the equilibrium level of output and OP is the equilibrium price. At
this price the firm earns profit is equal to the area ‘APeB’ (Which shows the difference
between total revenue (OPeXe) and total cost (OABXe) to produce OXe level of output.
A firm is in short run equilibrium does not necessarily mean that it makes excess profit.
Whether the firm makes excess profits or losses or normal profit depends on the level of the
ATC at the short run equilibrium. If the ATC curve is below the price (demand curve of the
firm) at equilibrium, the firm earns excess profit as shown in the above figure. However, if
the position of SATC curve is above the demand curve, the firm makes loss (equal to the area
FPeC). This is shown in the following figure 1. If the demand curve is tangent with the SATC
the firm earns only normal profit which included in the SATC (Shown in Figure 2).
Figure 1 Figure 2
MC SATC
P P =AR =MR
F C e
P P=AR=MR
e
O Xe Q
Xe
If the firm experiences loss in the short run, it will continue production only if the revenue
covers the average variable cost (SAVC). This is shown in the following figure.
SMC SATC
SAVC
w
Pw
AFC
O XW
If the firm failed to cover average variable cost (SAVC), it discontinuous the production to
minimises its loss. Thus the point at which the firm covers its variable costs is called “the
closing down point” (denotes point “w” in the above figure). If the price falls below P w,
production does not cover its variable cost, thus it is better off it closes down the production.
b) The supply curve of the firm and the industry
The supply curve of the firm may be derived by the points of intersection of its MC curve
with successive demand curves. Given the positive slope of the MC curve, each higher
demand curve cuts the MC curve to a point which lies to the right the previous intersection
point. This implies that the quantity supplied by the firm increases as price rises. Given its
cost structure, the firm will not supply any quantity if the price falls below the average
variable cost i.e., below point Pw in the above figure. If we plot the successive points of
Dr Ratheesh C, Dept. of Economics, FMN College, Kollam Page 3
Market Structures
Perfect Competition
Perfect competition is a market structure in which there exist large number of sellers and
buyers in the market. The products are homogeneous are identical and there are no barriers to
enter and exit of firms from the industry. Perfectly competitive market structure has the
following characteristics.
1. Large number of sellers and buyers
The industry or market includes large number of sellers and buyers. Therefore the individual
seller and buyer will supply or demand only a small portion of the total quantity offered in
the market or the total market demand of the product. Thus the decision of an individual
buyer or seller alone does not affect the market price of the commodity.
2. Product homogeneity
The products produced by firms in perfectly competitive market structure are homogeneous
in nature. Therefore the buyers failed to differentiate the product of one firm from other
firms.
The assumptions of large number of sellers existed in the market and product homogeneity
implies that the individual firm in perfect competition is a price taker. The individual firm
cannot determine the price of the commodity. However, it can sell any amount of output at
the prevailing market price. Thus the individual firms face a demand curve which is
horizontal straight line parallel to OX axis. The demand curve faced by an individual firm in
perfectly competitive market is shown in the following diagram.
YP
P=AR=MR
X
O
The demand curve of an individual firm is also considered as the average and marginal
revenue curves of the firm.
3. Free entry and exit of firms
In perfect competition, there exist no barriers to enter or exit of firms from the industry. This
assumption is supplementary to the assumption of existence of large number sellers in the
market. If barriers exist, the number of firms in the industry may be reduced. In such as a
situation each firm can acquire power to influence the price of the commodity.
4. Profit maximisation
The firms have a single goal both in short run and long run i.e., profit maximisation.
Dr Ratheesh C, Dept. of Economics, FMN College, Kollam Page 1
, Module-1,Price and Output Determination Under Different
Market Structures
5. No government regulations
There is no government intervention exists in the market in the forms of impose tariff,
subsidies, rationing of production or demand. A market structure which shows the above
mentioned characteristics is called pure competition. A pure competition is changed to
perfectly competitive market structure if it satisfies the following additional characteristics.
6. Perfect mobility of factors of production
The factors of production are free to move from one firm to another, from one occupation to
another throughout the economy. In short, there exists perfect competition in the market of
factors of production.
7. Perfect knowledge
All buyers and sellers are assumed to have complete knowledge about all the market
conditions. Information is assumed to be free and costless.
I. Short run Equilibrium or Short Run Price Output Determination
a) Equilibrium of the firm in the short run
In a perfectly competitive market structure, a firm is in equilibrium when it maximises its
profit (π). Profit shows the difference between total cost and total revenue. Thus
𝜋 = 𝑇𝑅 − 𝑇𝐶
The firm is in equilibrium when it produces output which maximises the difference between
total receipts and total cost. The short run equilibrium of a firm in perfect competition can be
explained with the help of the following figure.
Y SMC
SATC
P
e P=MR
A
B
O X
xe
In the above diagram both SATC and
EE SMC are “U” shaped curves reflecting the law of
variable proportions. The short run marginal cost (SMC) cuts the SATC at its minimum
point. In a perfectly competitive market, the demand curve is also considered as the average
and the marginal revenue curves of the firm. Under these conditions, the firm reaches
equilibrium at the level of output at which MC = MR and MC curve cuts MR curve from
below or the slope of MC curve is greater than MR curve at the point of equilibrium. Thus
in the above figure point “e’ shows the equilibrium point at which the firm maximises its
Dr Ratheesh C, Dept. of Economics, FMN College, Kollam Page 2
, Module-1,Price and Output Determination Under Different
Market Structures
profit. Therefore OXe is the equilibrium level of output and OP is the equilibrium price. At
this price the firm earns profit is equal to the area ‘APeB’ (Which shows the difference
between total revenue (OPeXe) and total cost (OABXe) to produce OXe level of output.
A firm is in short run equilibrium does not necessarily mean that it makes excess profit.
Whether the firm makes excess profits or losses or normal profit depends on the level of the
ATC at the short run equilibrium. If the ATC curve is below the price (demand curve of the
firm) at equilibrium, the firm earns excess profit as shown in the above figure. However, if
the position of SATC curve is above the demand curve, the firm makes loss (equal to the area
FPeC). This is shown in the following figure 1. If the demand curve is tangent with the SATC
the firm earns only normal profit which included in the SATC (Shown in Figure 2).
Figure 1 Figure 2
MC SATC
P P =AR =MR
F C e
P P=AR=MR
e
O Xe Q
Xe
If the firm experiences loss in the short run, it will continue production only if the revenue
covers the average variable cost (SAVC). This is shown in the following figure.
SMC SATC
SAVC
w
Pw
AFC
O XW
If the firm failed to cover average variable cost (SAVC), it discontinuous the production to
minimises its loss. Thus the point at which the firm covers its variable costs is called “the
closing down point” (denotes point “w” in the above figure). If the price falls below P w,
production does not cover its variable cost, thus it is better off it closes down the production.
b) The supply curve of the firm and the industry
The supply curve of the firm may be derived by the points of intersection of its MC curve
with successive demand curves. Given the positive slope of the MC curve, each higher
demand curve cuts the MC curve to a point which lies to the right the previous intersection
point. This implies that the quantity supplied by the firm increases as price rises. Given its
cost structure, the firm will not supply any quantity if the price falls below the average
variable cost i.e., below point Pw in the above figure. If we plot the successive points of
Dr Ratheesh C, Dept. of Economics, FMN College, Kollam Page 3
