Perfect Competition: Optimal Price and Output | CFA Level I Economics

PREREQUISITE LESSON

This lesson is a prerequisite for the course. While you won’t be directly tested on its content in the exam, it’s assumed you’ve gained this knowledge or skill during your university studies. We strongly recommend reviewing this lesson, as its content may be essential for understanding subsequent parts of the curriculum.

In this lesson, we’ll delve into how to determine the optimal price and output for firms operating under perfect competition. So, let’s dive in and learn all about it.

Understanding Perfect Competition

In case you need a refresher, perfect competition refers to a market with numerous firms producing identical products, low barriers to entry, and firms competing solely on the basis of price. These firms are price takers and have no influence over market price. Market demand and supply determine the price at which firms sell.

Remember, it’s crucial to distinguish between market demand and supply, and a firm’s demand and supply. The demand and supply curves for the market and a firm can look similar, but they have important differences:

• Market Demand: Usually downward sloping, with consumers demanding less when the price is high and more when the price is low.
• Market Supply: Upward sloping, with producers wanting to supply more as the price increases and less as it decreases.

Firm’s Demand and Marginal Cost

Firms in a perfectly competitive market face a perfectly elastic demand curve at the market price. This means the marginal revenue curve is also horizontal at this level, and the average revenue curve is the same line. The marginal cost curve for a firm is generally upward sloping due to decreasing marginal productivity.

A profit-maximising firm will continue to expand production until marginal revenue equals marginal cost. Let’s call this optimal level of production Q*. At this level, the total economic profit earned is the shaded area, with profit per unit being the average revenue minus the average total cost.

Short-Run and Long-Run Equilibrium

Under economic theory, neither economic profit nor economic loss is sustainable in the long run in a perfectly competitive market. If existing firms are making economic losses in the short run, some will eventually shut down or reduce scale, thus reducing supply, driving prices up, and eliminating any economic losses.

Conversely, if there are economic profits to be made, new firms will enter the industry in the long run, increasing supply, driving the market price down, eliminating any economic profit. In essence, market price will converge to a level where no economic profit or loss is expected in the long run.

Firm and Market Supply

Your firm’s supply curve should be the marginal cost curve above the average variable cost’s minimum point. As the market price increases, you would want to supply more according to your marginal cost.

For the market, no firms will want to produce anything below a certain price point, resulting in zero output. As the price increases, firms want to supply more, creating an upward-sloping short-run market supply curve.

Permanent Increase in Demand

When there’s a permanent increase in demand, the long-run market demand curve shifts upwards and to the right. This results in a corresponding increase in the market price. At this new price point, all firms will earn an economic profit. Positive economic profits will cause new firms to enter the market. As these new firms increase total industry supply, the industry supply curve will gradually shift downwards and to the right, and the market price will decline back to the original level. So, a permanent increase in demand can cause market price to increase and firms to enjoy economic profits in the short run. In the long run, however, price converges back to the equilibrium where no economic profits can be made. The only difference is the increased level of overall output to cater to the increased demand.

Permanent Decrease in Demand

What if there’s a permanent decrease in demand? The arguments can all be reversed:

• Short Run: The market demand curve shifts left and downwards, resulting in a decrease in market price. Firms make economic losses in the short term.
• Long Run: Some firms shut down or reduce scale, resulting in a reduction in supply. The market supply curve shifts left and up, bringing the market price back to the equilibrium level. In the long run, there is no change in market price. The only thing that has changed is that overall supply has been reduced.

And there you have it! We’ve covered perfect competition and its implications for optimal price and output. Next up, we’ll discuss monopolistic competition.