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Perfect Competition Graphs

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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.

In order for an industry to be in perfect competition, the following structural requirements have to exist:

  1. There are many small independent firms in the industry;
  2. The product or service sold is standardized insofar as there is little or no difference between one firm's offering and the next;
  3. There are no barriers to entry or exit for the industry; and,
  4. All firms in the industry are price-takers - any firm that deviates from the market price would lose all of its business to its competitors.

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 most cases, there is no level of output where MR is exactly equal to MC, so just remember that a firm will continue production for as long as MR > MC, and will not produce beyond a point where that is not the case, or at the first instance where MR < 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

Quantity (Q)Variable Cost (VC)Total Cost (TC)Avg Total Cost (ATC)Marginal Cost (MC)Marginal Revenue (MR)Total Revenue (TR)Profit
0$0$100-$0-$100
1$100$200$200$100$90$90-$110
2$160$260$130$60$90$180-$80
3$212$312$104$52$90$270-$42
4$280$380$95$68$90$360-$20
5$370$470$94$90$90$450-$20
6$489$589$98$119$90$540-49
7$647$747$107$158$90$630-$117
8$856$956$120$209$90$720-$236

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 perfect competition. it's always true that:

  1. If P > ATC, Profit is > 0
  2. If P < ATC, Profit is < 0
  3. If P = ATC, Profit = 0, or is break-even

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.

Why is the ATC so important in determining economic profit? Recall that profit is TR minus TC. If you think about the fact that ATC is calculated by taking TC and dividing by Q, then you'll quickly realize that ATC is simply the per-unit representation of TC. Since MR is the per-unit representation of TR in perfect competition, it's a great "cheat" to quickly see how TR compares to TC in this market.

Now we can look at some graphs.

Perfect Competition Graph Characteristics

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.

perfect competition graphs profit maximization studysmarterFigure 1. Perfect Competition Graphs - Profit Maximization StudySmarter Originals

Figure 1 illustrates that the profit-maximizing level of output is QM given the market price and MR of PM 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.

perfect competition graphs economic loss studysmarterFigure 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 QM. 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.

Consider Figure 3. In our first example we will stick with the firm in Table 1. We will do so to calculate exactly what the economic profit is without having to look at the table.

perfect competition graphs economic loss calculation studysmarter

Figure 3. Perfect Competition Graphs - Economic Loss Calculation, StudySmarter Originals

You can see that losses are minimized where MR = MC which occurs at unit 5. Since this firm is producing 5 units, and its ATC at this level of production is $94, you immediately know that its TC is $94 x 5, or $470. Similarly, at 5 units of production and a P and MR level of $90, you know that its TR is $90 x 5, or $450. Hence you also know that its economic profit is $450 minus $470, or -$20.

There's a faster way to do this, however. All you have to do is look at the per-unit difference between MR and ATC at the loss-minimizing point, and multiply that difference by the quantity produced. Since the difference between MR and ATC at the loss-minimizing point is -$4 ($90 minus $94), all you have to do is multiply -$4 by 5 to get -$20!

Let's consider another example. Imagine that this market sees a positive shift in demand because a celebrity was captured consuming this product on social media. Figure 4 illustrates this scenario.

perfect competition graphs economic profit calculation studysmarterFigure 4. Perfect Competition Graphs - Economic Profit Calculation, StudySmarter Originals

What's the first thing you notice about Figure 4? If you're like me, you noticed that the new price is higher than ATC! That should immediately tell you that, all of a sudden, this firm is profitable. Yay!

Now without creating a detailed table, like Table 1, can you calculate the economic profit?

Since you know that this firm will maximize profits at the level of production where MR = MC, and MR just increased to $100, that new level of production is 5.2 units (the math behind this calculation is beyond the scope of this article). And, since the difference between MR or P, and ATC is $6 ($100 minus $94), that must mean the economic profit for this firm is now $6 multiplied by 5.2, or $31.2.

In summary, Figure 5 below demonstrates the three possible scenarios in a perfect competition market:

  1. Positive Economic Profit where P > ATC at the profit-maximizing level of production
  2. Negative Economic Profit where P < ATC at the profit-maximizing level of production
  3. Break-even Economic Profit where P = ATC at the profit-maximizing level of production

perfect competition graphs different economic profit scenarios studysmarterFigure 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.

In perfect competition markets, if the MR or P in the industry drops to the point where it equals a firm's AVC, this is the shut-down price level where a firm should discontinue its operations.

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

perfect competition graphs shut down price studysmarter

Figure 6. Perfect Competition Graphs - Shut Down Price, StudySmarter Originals

As you can see from Figure 6, if the market price in this firm's market ever drops to PSD 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.

perfect competition graphs short run initial state studysmarterFigure 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.

perfect competition graphs intermediate state studysmarterFigure 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 QA to QB while each individual firm has decreased its output from QD to QE. 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.

perfect competition graphs long run equilibrium perfect competition studysmarterFigure 9. Perfect Competition Graphs - Long-Run Equilibrium in Perfect Competition, StudySmarter Originals

Perfect Competition Graphs - Key takeaways

  • In order for an industry to be in perfect competition the following structural requirements have to exist:
    • There are many small independent firms in the industry;
    • The product or service sold is standardized insofar as there is little or no difference between one firm's offering and the next;
    • There are no barriers to entry or exit for the industry; and,
    • All firms in the industry are price-takers - any firm that deviates from the market price would lose all of its business to its competitors.
  • In perfect competition. it's always true that:

    • If P > ATC, Profit is > 0

    • If P < ATC, Profit is < 0

    • If P = ATC, Profit = 0, or is break-even

  • In perfect competition markets, if the MR or P in the industry drops to the point where it equals a firm's AVC, this is the shut-down price level where a firm should discontinue its operations.

  • In the long run, firms will enter a perfect competition market until all positive economic profit has been consumed. Therefore in the long run in a perfect competition market, profit levels are all break-even, or zero.

Frequently Asked Questions about Perfect Competition Graphs

Yes. A perfect competition graph takes into account all implicit and explicit costs incurred by the firm.

To draw a perfect competition graph, you start with a horizontal market price, which is also equal to each firm's marginal revenue since all firms are price-takers. You then add the firm's marginal cost curve which looks like a swoosh. Below the marginal cost curve you draw a wide u-shaped average total cost curve and below that an average variable cost curve which is lower than the average total cost curve by the amount of average fixed costs. You then set the level of output at the intersection of the marginal cost curve and the horizontal marginal revenue curve.

The perfect competition graph is characterized by a horizontal market price, which is also equal to each firm's marginal revenue since all firms are price-takers, plus each firm's marginal cost curve which looks like a swoosh. Below the marginal cost curve you'll find a wide u-shaped average total cost curve and below that an average variable cost curve which is lower than the average total cost curve by the amount of average fixed costs. The level of output will be set at the intersection of the marginal cost curve and the horizontal marginal revenue curve.

The long run graph for perfect competition includes rightward shifts in market supply, and corresponding reduced market prices, for as long as firms in the market are experiencing positive economic profits. The long run equilibrium state is reached when new firms no longer enter the market at the point where all firms are experiencing break-even economic profit, or zero economic profit.

Final Perfect Competition Graphs Quiz

Question

Which of the following are not industry requirements for perfect competition:


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Answer

Economic profits are positive.

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Question

Prodit maxmization always occurs at the level of production where ________ ____ equals _______ _______.

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Answer

marginal cost, marginal revenue

Show question

Question

A firm in perfect competition will continue production for as long as:

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Answer

MR > MC

Show question

Question

 An _________ market is one where prices reflect all important information about a product and one in which this information is communicated instantly at no cost.

Show answer

Answer

efficient

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Question

Economic cost is the sum of ________ and ________ costs of a firm's activity.

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Answer

explicit, implicit

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Question

________ costs are the costs in dollar terms of a firm's next best alternative activity.

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Answer

Implicit

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Question

In perfect competition, If P > ATC Profit is:

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Answer

positive

Show question

Question

In a perfectly competitive market, if the profit-maximizing level of output occurs where Average Revenue is equal to $10 and Average Total Cost is $11, then profit is:

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Answer

negative

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Question

In a perfectly competitive market, if the profit-maximizing level of output is 5 units, and ATC is $94 while MR is $90 at this level of output, then economic profit is:

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Answer

-$20

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Question

Economic Profit is positive if:

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Answer

P > ATC

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Question

Break-even Economic Profit occurs where P = 

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Answer

ATC, Average Total Cost

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Question

In perfect competition, if P drops to the point where it equals a firm's AVC, this is called the ____-____ price level.

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Answer

shut-down

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Question

When firms enter a perfectly competitive industry, this will result in a _________ shift in the market supply curve.

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Answer

rightward, increase

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Question

The long-run economic profit of firms in a perfectly competitive market is:

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Answer

zero

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Question

Average Total Cost is the per-unit representation of:

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Answer

Total Cost

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