Competitive Markets

The Meaning of Competition

A competitive market, sometimes called a perfectly competitive market, has three characteristics:

  • There are many buyers and many sellers in the market.
  • The goods offered by the various sellers are largely the same.
  • Firms can freely enter or exit the market.

At Qa, MC < MR. So, increase Q to raise profit.

At Qb, MC > MR. So, reduce Q to raise profit.

At Q1, MC = MR. Changing Q would lower profit.

Firms in Competitive Markets

A Firm’s Short-run Decision to Shut Down

If the firm shuts down temporarily,

revenue falls by TR

costs fall by VC

So, the firm should shut down if TR < VC.

Divide both sides by Q:     TR/Q < VC/Q

So, we can write the firm’s decision as:

Shut down if P < AVC

A Firm’s Long-Run Decision to Exit

If a firm exits the market,

revenue falls by TR

costs fall by TC

So, the firm should exit if TR < TC.

Divide both sides by Q to rewrite the firm’s decision as

Exit if P < ATC

A competitive firm's revenue is related to the amount of production it produces since it is a price taker. The cost of the good is equal to both the average and marginal revenue of the company.

A company selects a volume of output so that marginal revenue and marginal cost are equal to maximize profit. Because a competitive firm's marginal revenue is equal to the market price, the firm decides on quantity so that the price is equal to the marginal cost. As a result, the firm's supply curve is its marginal-cost curve.

If the price of the good is less than the average variable cost in the short term, a firm that cannot recover its fixed costs will decide to temporarily close. In the long run, if the price is less than the average total cost and the company can recover both fixed and variable costs, it will decide to quit.

Profit is eventually driven to zero in a market with unfettered entry and exit. In this long-term equilibrium, all businesses operate at their most productive scale, the price is set at the average total cost's minimum, and the number of businesses changes to accommodate the quantity required at this price.

Over various time horizons, variations in demand have distinct implications. In the short run, rising prices and profits result from rising demand, whereas falling prices and losses result from falling demand. However, if businesses are allowed to enter and leave the market, eventually the number of businesses adjusts, and the market returns to the zero-profit equilibrium.

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