Price And Quality Determination Under Perfect Competition

EQUILIBRIUM IN THE SHORT-RUN

The short run is the period in which a firm can vary its output by changing the variable factors of production. In the short-run, a firm can make abnormal profit. Since the market determines the prices at which goods should be sold, a firm can choose the quantity that will maximize its profits.

Equilibrium occurs when the following conditions are satisfied:

1. Marginal cost is equal to marginal revenue (MC=MR)
2. Marginal cost should cut the marginal revenue from below at the point of equality.

In the figure below, at point b price is greater than marginal cost; therefore it is better to increase output. The firm is at equilibrium at point S where MC=MR=P=AR. At this point, the firm is making abnormal profit. This is represented by rectangle PORS.

EQUILIBRUM IN THE LONG- RUN

The long run is a period in which all cost varies with the level of output. During the period, firms can adjust their scale of operation. In order to enjoy the abnormal profit, new firm are likely to enter the market with the entrance of new firms, supply will increase and price may fall if demand remains constant, therefore both the new and old firms will adjust their output to the new price. In the long run, the firms will make normal profit because all the firms will just be covering average cost. Equilibrium will be reached when marginal cost equal to marginal revenue and price (MC=MR=AC=AR=P=D+).

The firm produces Oqi and sell at OP. The producer will be making normal profit because the average cost is tangential to average revenue.

LOSS OF A COMPETITIVE FIRM

A perfect firm will be making loss if the price is below the average cost.

In the figure above, at price P, the firm suffers losses since price is below the average cost. Loss is therefore represented by apbc. If the firm cannot cover its average cost it may close down. This may be the point of exit from the market.

QUESTIONS (USE THE COMMENT BOX BELOW TO POST YOUR ANSWER FOR DISCUSSION AND EVALUATION)

1. In what two ways do consumers benefit from perfect competition?
2. Outline any two differences between monopoly and perfect competition.