Price and Output - Perfect Competition




Under perfect competition, prices are established by the forces of demand and supply beyond control of any single seller or buyer.  The supply of an individual firm is negligibly a very small part of the total supply to the market, so the individual firms are powerless to influence the price.    The firm can sell only its entire output at the ruling market price.  So the demand curve of a firm is a horizontal line at the ruling market price, which is a perfectly elastic demand curve.  But the market demand curve of the industry will be of the normal shape. 
If consumers want to buy more of a good, there will be more demand, the excess demand push the prices upwards which result in rise in profits of firms.
Since there is perfect information, the industry will observe the increase in price and profits.
Freedom to entry and exit allow new firms outside will enter the market, produce and sell to make profit.
Eventually, profits will fall to a level just high enough to keep existing firms in the industry. [Not too high to attract firms outside or too low to exit the existing firms] 
At this situation, firms in the industry are said to be earning a normal profit. 

The pricing of a firm under perfect competition is as shown below. 
 

 Firms in business will aim to maximize profits. When price (AR) exceeds the cost of production (AC) the firm will be making profits.  Profits are maximized when output is at the point where MR = MC    It is applicable to all firms whatever market structure they are operating 


When price is OP, the firm will be making profits in the range of output OQ to OQ3   because in this range AR is greater than AC.    Up to OQ output the Average Cost is greater than Average Revenue (AC > AR).  At OQ1 output will yield the maximum profit per unit but the firms want to maximize the total profit.    
From OQ1   to   OQ2   the total revenue is greater than total cost (MR > AC).  From OQ2    to    OQ3 the increase in total revenue is greater than the increase in total cost. When output increases beyond OQ2 the total profit will be decreasing because for each additional unit produced, the increase in the total revenue (MR) is less than the increase in the total cost (MC).   
In case of perfectly competitive firm, demand is perfectly elastic and so that AR = MR. Thus here the maximum profit will be earned where   AR = MR = MC  Normal profits are included in Average cost at AC curve.  Therefore when price exceeds Average, the firm is said to be earning abnormal profits.  Super normal profit is illustrated by the shaded area in the above diagram.  Although the firm is in equilibrium, the industry is not in equilibrium. The assumption of freedom of entry and exit will not allow the firm to remain at this situation in the long run. The entry of new firms moves the industry’s supply curve to the rights which lower the price, to cause a new equilibrium at lower price.  
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