Perfect Competition Graphs

When someone hears the word "perfect" it conjures up images of historical Olympic games performances, incomparable musical performances, mesmerizing works of art, or getting 100% on your next economics exam.

However, economists think of the word "perfect" in somewhat different terms. In fact, if you were considering starting a business in an industry with "perfect" competition, you might feel that it's about as far away from perfection as anything could be.

Continue reading to find out why.

Perfect Competition Graphs Theory

Before we jump into the graphs, let's set the stage with some necessary conditions.

If you think that these conditions seem quite restrictive, you would be right. But regardless of the structure of the industry, all firms will set their targets directly on maximum profit, or the level of output which produces the highest possible difference between total revenue and total cost.

This always occurs at the level of production where Marginal Revenue (MR) equals Marginal Cost (MC).

In economics, an efficient market is one where prices reflect all the important information about the economic fundamentals associated with a product or industry and one in which this information is communicated instantly at no cost. Since perfect competition markets have this characteristic, it is the most efficient type of market.

As a result, since firms in a perfectly competitive industry are price-takers, they immediately know that the market price is equal to marginal and average revenue and that they occupy a perfectly efficient market.

Please take care to know that a firm's profit is the difference between its revenue and the economic costs of the goods or services the firm provides.

What exactly is the firm's economic cost? The economic cost is the sum of the explicit and implicit costs of a firm's activity.

Explicit costs are costs that require you to physically pay money, while implicit costs are the costs in dollar terms of the firm's next best alternative activity, or its opportunity cost. Make sure to keep this in mind going forward.

Consider Table 1 for a numerical example of the perfect competition profit maximizing

theory.

Table 1. Perfect Competition Profit Maximization

What can you infer from Table 1?

First, you can quickly determine that the market price for this good or service is $90 per unit since the MR at every level of production is $90.

Second, if you look carefully, you can see that since MC initially decreases but then starts increasing at an accelerating rate, which is due to diminishing marginal returns of production. If you're not sure about this, just look at how quickly MC changes as production increases.

Third, you might have noticed that the profit-maximizing level of output is at exactly the 5th unit of output because this is where MR=MC. Therefore, the firm should not produce beyond this level. However, you might have also noticed that at this "optimal" level of production, profit is negative. Your eyes are not deceiving you. The very best this firm can do is at a negative profit, or at a loss. One quick look at the firm's Average Total Cost (ATC) will reveal this right away.

In one quick look at a table like Table 1, you can immediately determine if the profit-maximizing level of production for a firm in perfect competition is positive, negative, or break even depending on what its ATC is relative to MR or Market Price (P).

This is important because it can tell a firm whether or not to enter a market in the short-term, or whether or not to exit the market if already in it.

Now we can look at some graphs.

As you know, regardless of the market structure a firm is in, the point of profit maximization is at the level of production where MR = MC. Figure 1 below illustrates this in general terms.

Figure 1. Perfect Competition Graphs - Profit Maximization StudySmarter Originals

Figure 1 illustrates that the profit-maximizing level of output is Q_M given the market price and MR of P_M and given the firm's cost structure.

As we saw in Table 1, sometimes the profit-maximizing level of output actually generates a negative economic profit.

If we were to use graphs to illustrate the MR curve, the MC curve, and the ATC curve of the firm in Table 1 it would look something like Figure 2 below.

Figure 2. Perfect Competition Graphs - Economic Loss, StudySmarter Originals

As you can see, the firm's MC curve looks like a swoosh, while its ATC curve looks more like a wide u-shape.

Since we know the best this firm can do is at the point where MR = MC, that's where it sets its level of production. However, we also know that the firm's MR curve is below its ATC curve at every level of production, including the optimal output level Q_M. Therefore the best this firm can do is a negative economic profit, or an economic loss.

The actual size of the loss is illustrated by the green shaded area in the area between points A-B-P-ATC₀. Recall that you can tell in an instant whether this market is profitable by comparing the MR line to the ATC line.

For the Firm in Table 1, if it is considering entering the market, it has to think very carefully about whether to enter an industry where it will be consistently losing money.

Alternately, if the firm in Table 1 is already in this industry, and is facing this situation because of a sudden decrease or leftward shift in market demand, it needs to think about whether to stay in this industry, as opposed to entering a different industry. As it turns out, however, it's important to note that there are situations in which a firm would accept this negative profit position. Remember, just because the economic profit in this industry is negative doesn't mean the economic profit in another industry won't be positive (recall the definition of economic cost).

Perfectly Competitive Market Graph Examples

Let's consider some different examples of perfectly competitive market graphs.

Figure 5. Perfect Competition Graphs - Different Economic Profit Scenarios, StudySmarter Original

Perfect Competition Graph Short Run

As you have seen, in some cases firms in perfect competition experience an economic loss in the short run. Why would a firm stay in an industry in the short-run if it was experiencing a negative economic profit?

The reason why a firm would in fact stay in a market where it was incurring economic losses, is because of its fixed costs. You see, the firm is incurring these fixed costs regardless of the amount of output it's producing, and can only alter them in the long run. In other words, the firm is going to have to pay its' fixed cost no matter what.

Therefore since fixed costs can not be changed in the short-run, they should be ignored when making short-run decisions. Alternately stated, if a firm can at least cover its variable costs at the level of production where MR equals MC, then it should stay in business.

This is why it's also important to consider a firm's short-run Average Variable Cost (AVC), or its short-run Variable Cost per unit. In fact, this is the key variable in deciding whether the firm should close its doors.

You see, if the MR or Market Price P gets down to the same level as its Average Variable Cost (AVC), it's at that point that the firm should discontinue its operations since it's no longer covering its short-run variable costs per unit or its AVC. This is called the shut-down price level in a perfect competition market.

Figure 6 illustrates the shut-down price level in a perfect competition market.

As you can see from Figure 6, if the market price in this firm's market ever drops to P_SD it is at this point that the firm should shut down and take as its final loss the amount of fixed cost it has incurred.

Perfect Competition Graph Long Run

If you've been wondering if perfect competition graphs change in the long run, the answer is yes and no.

In other words, the fundamental structures don't change in terms of what the graphs look like, but the profitability of firms in perfect competition does change,

In order to understand this, imagine that you are a firm in a perfect competition market as depicted in Figure 7 below.

Figure 7. Perfect Competition Graphs - Short Run Initial State, StudySmarter Originals

As you can see, even though this firm is in a perfect competition market, all the firms in the market are making a nice positive economic profit. What do you suppose might happen now? Well, in all likelihood, other firms not in this market might be very attracted to this sizeable profit being enjoyed by firms in their current state. As a result, firms will enter this market which shouldn't be a problem since, by definition, there are no barriers to entry.

The end result will create a rightward shift in the market supply curve as seen in Figure 8.

Figure 8. Perfect Competition Graphs - Intermediate State, StudySmarter Originals

As you can see, and likely expected, the influx of firms into the market increased supply at every price level and has had the effect of driving the market price down. While the entire market has increased total output due to the increase in the number of producers, each individual firm that was previously in the market has decreased its output since they're all behaving efficiently and rationally due to the decline in price.

As a result, we see market output increase from Q_A to Q_B while each individual firm has decreased its output from Q_D to Q_E. Since all the firms in the market are still enjoying a reduced but still positive economic profit, they're not complaining.

However, as you've seen any market demonstrating positive economic profit is surely to attract more and more entrants. And this will surely happen. but only to the point where the market price, or MR, is equal to each firm's ATC since we know that, at that level of individual production, firms in this market are breaking even. It is only at this point that long-run equilibrium has been achieved in a perfect competition market as illustrated in Figure 9, where price equals both MC and minimum ATC.

Figure 9. Perfect Competition Graphs - Long-Run Equilibrium in Perfect Competition, StudySmarter Originals