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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