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Price Determination Under Perfect Competition In Short Run And Long Run Pdf

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Published: 29.05.2021  Refers to a time period in which quantity supplied of a product cannot be increased with increase in its demand. In simple terms, in very short period of time, the supply of a product is fixed.

In economics , specifically general equilibrium theory , a perfect market , also known as an atomistic market , is defined by several idealizing conditions, collectively called perfect competition , or atomistic competition. In theoretical models where conditions of perfect competition hold, it has been demonstrated that a market will reach an equilibrium in which the quantity supplied for every product or service , including labor , equals the quantity demanded at the current price. This equilibrium would be a Pareto optimum.

9.2 Output Determination in the Short Run

Under perfect competition, price determination takes place at the level of industry while firm behaves as a price taker. It produces a quantity depending upon its cost structure. The industry under perfect competition is defined as all the firms taken together. Price determination will take place at this level only. As such, equilibrium under perfect competition has to be discussed at two levels: at the level of a firm and at the level of an industry.

Further, equilibrium has to be discussed both in short run and long run. Price determination in industry takes place through price mechanism, i. The first condition is known as first order condition, which is a necessary condition for equilibrium, while the second one is called as second order condition or sufficient condition. The conditions of equilibrium under MR-MC method can be understood as follows:. The first order condition implies that revenue received from the sale of an additional unit of a product should be equal to cost inclusive of normal profit incurred on its production.

The second order condition implies that at the equilibrium level of output, the MC curve should have a positive slope or it must be rising at the point of intersection. This is possible when the MC curve cuts the MR curve from below. In this situation, the firm will operate under increasing cost or diminishing return condition. In the Figure Given such behaviour, a profit maximizing situation will be in the output range OQ 2 to OQ 4 or between point R and R 1.

As we know, two parallel lines have same slope. Thus, the point at which tangent at TC is parallel to TR will be the profit maximizing position. We have not drawn a tangent on TR curve as it will be same as the TR curve itself for being a straight line.

If it is drawn, it will overlap the TR curve. Hence, the TR curve is also taken as a tangent on it. To find out such a profit maximizing output level, we draw tangent at each point on TC between R and R 1.

The tangent at point S 1 is found to be parallel to TR curve. Hence, it is the point of equilibrium, satisfying both the conditions. The firm will produce OQ 3 level of output and earn a maximum profit SS 1. Thus, it is a loss maximization position. One can see that as output increases from this level, per unit loss will decline and the breakeven will be reached at point R. Thus, the firm will not return back to output level OQ 1. Based on them, we may define break-even as a level of output or sales at which total revenue of a firm equalizes to total cost inclusive of normal profit.

The two break-evens are distinguishable on the basis of the fact that first one comes after a situation of loss and the second one comes after a situation of super normal profits.

Obviously, the firm will not stop at first break-even because it will not maximize the total profit. Similarly, the firm will not cross the second break-even point as beyond this TC will exceed TR. Loss Minimizing Equilibrium :. If the TC curve remains above the TR curve at all its points, no profit maximizing equilibrium level of output can be found at any level of output. This will depend upon the fact that the firm is able to generate revenue equal to or more than the fixed cost or not.

If the firm is unable to do so, it should stop production altogether. However, if the firm could do so, it should continue to produce, despite losses, at some loss minimizing level of output in short run. The MR-MC method is more often used to find out equilibrium of a firm since it is simpler and accurate. It does not require, as in the case of TR-TC method, drawing tangent and locating the output level where the tangent is exactly parallel to the TR curve.

There are two points, R and R 1 , at which first order condition, i. This shows that second order condition is not satisfied at point R.

Thus, equilibrium at this point or at the output level OQ 1 will be unstable. To show that the equilibrium is unstable, let us consider that output increases beyond OQ 1. As such, MC will further decline while MR will remain same and, hence, profit will rise. Thus, the firm will not return back to OQ 1 level of output. This shows that the equilibrium at point R will be unstable. This satisfies the second order condition.

Hence, the equilibrium at R 1 will be stable at which the firm will produce OQ 2 level of output. Hence, the firm will stick to point R 1 or OQ 2 output level. If the output level remains below OQ 2 , the firm will earn super normal profit and, hence, increase the output up to OQ 2. This shows that equilibrium once reached at point R 1 will be a stable one. Any deviation from it will lead market forces to work in a fashion so as to return to OQ 2 level of output.

The above discussion deals only with equilibrium of a firm but does not show the profit earned or the loss incurred by the firm. For this, we need to take into account the AC curves. In short run, a firm may earn super normal profit or normal profit or incur losses. Each of the three situations has been attempted in the following paragraphs:. Super Normal Profit :. A firm will earn super normal profit in short run if its SAC is less than the AR at the point of equilibrium.

Such a firm has been depicted in Figure At this point, both the equilibrium conditions are satisfied, i. Based on it, profit can be estimated as —. This is the profit which the firm earns over and above the normal profit and, hence, termed as super normal profit. It has been shown by the shaded area in the figure. Normal Profit :.

Figure The figure shows equilibrium at point R where the output is OQ 1. It is equal to the per unit revenue which is also RQ 1. It means that firm is making only normal profit which is a part of average cost. In this case —. Firm Incurring Losses :.

A firm can incur loss in short run. Such a firm is represented in Figure In this situation, one may ask what a firm should do to minimize its losses. Should it continue production and bear the losses or should it stop production and wait for higher price level to come for a re-entry in the market? Answer to such questions will depend upon the fact that, is the firm able to recover at least the variable cost from its revenue or not? If the firm is able to recover the variable cost, or a little more, it should continue production and bear the loss which will be equal to or less than its fixed cost.

In such a scenario, the firm will minimize losses by way of continuing production. It is because of the fact that its loss will be equal to the fixed cost whether it stops production or continue to produce. In such situation, the firm may be advised to continue the production and remain in the market.

If the firm continues production, in this situation, per unit loss will be —. Based on above, we can discuss two situations in which a firm will minimize losses i by continuing production and ii by stopping it altogether. The firm is in a state of equilibrium at point R at which output level is OQ 1.

It means that firm is not only able to cover the entire variable cost but also generating a part of fixed cost. In such situation, firm will be better off if it continues production at OQ 1 output level. Its total loss will be —. Minimizing Losses by Stopping Production :. Unlike the above case, we will now consider a firm which will minimize losses by way of stopping production.

In this situation, its losses would be equal to the fixed cost. But, if it continues production, its losses will be more than the fixed cost. Hence, the firm will be better off if it stops production. This is called as shut down situation.

In Figure It means that the AR is unable to cover even the variable cost. The firm should, therefore, stops production to minimize losses equal to the AFC. Industry in perfect competition is defined as a group of firms supplying homogenous product in market. Price determination takes place at the level of industry and every firm will follow the price so determined.

That is why industry in the perfect competition is known as price maker. The price determination by industry will follow the interaction of demand and supply forces. On the other hand, industry supply will be derived from the supplies made by all the firms in the industry.

For this purpose, we first derive the supply curve of each firm belonging to the industry. Short Run and Long Run Equilibrium under Perfect Competition (with diagram)

Perfect competition is a comprehensive term which includes the following conditions: 1. Free entry and exit of firms 2. Existence of a large numbers of buyers and sellers 3. Commodity supplied by each firm is homogeneous 4. Existence of single price in the market Under this condition, no individual firm will be in the position to influence the market price of the product. According to Bilas, The perfect competition is characterised by the presence of many firms; they all sell the same product which is identical. Price Determination Under Perfect Competition

Under perfect competition, price determination takes place at the level of industry while firm behaves as a price taker. It produces a quantity depending upon its cost structure. The industry under perfect competition is defined as all the firms taken together.

Perfect Competition which may be defined as an ideal market situation in which buyers and sellers are so numerous and informed that each can act as a price taker, able to buy or sell any desired quantity affecting the market price. According to A. K, Koutsoyianis ,"Perfect competition is a market structure characterized by a complete absence of rivalry among the individual's firms".

Our goal in this section is to see how a firm in a perfectly competitive market determines its output level in the short run—a planning period in which at least one factor of production is fixed in quantity. We shall see that the firm can maximize economic profit by applying the marginal decision rule and increasing output up to the point at which the marginal benefit of an additional unit of output is just equal to the marginal cost. Each firm in a perfectly competitive market is a price taker; the equilibrium price and industry output are determined by demand and supply. Figure 9. Price and output in a competitive market are determined by demand and supply. Perfect competition is a market structure that leads to the Pareto-efficient allocation of economic resources. Market structure is determined by the number and size distribution of firms in a market, entry conditions, and the extent of product differentiation. The major types of market structure include the following:.

Refers to a time period in which quantity supplied of a product cannot be increased with increase in its demand. In simple terms, in very short period of time, the supply of a product is fixed. For example, a confectioner has 20 pastries at a particular time. After an hour, a customer requires 40 pieces of pastries. In such a case, the confectioner cannot prepare 20 more pastries in an hour and can only supply 20 pastries.

Perfect competition is defined as a market situation where there are a large number of sellers of a homogeneous product. An individual firm supplies a very small portion of the total output and is not powerful enough to exert an influence on the market price. A single buyer, however large, is not in a position to influence the market price. Market price in a perfectly competitive market is determined by the interaction of the forces of market demand and market supply. Market demand means the sum of the quantity demanded by individual buyers at different prices.

Price Determination under Monopoly. Monopoly is that market form in which a single producer controls the whole supply of a single commodity which has no close substitute.