Chapter 7 · Market failure and socially undesirable outcomes III: Market power (HL only)
Perfect competition
Read a price-taking firm’s costs and revenue in perfect competition. Compare profit, normal profit and losses using the MR = MC output rule.
The economic idea
Perfect competition is a market structure with many small firms, a homogeneous product, freedom of entry and exit, and widely available information. Each firm supplies such a small share of total market output that it cannot influence the market price.
The firm is therefore a price taker. It can sell any feasible quantity at the market price, but it cannot charge more for an identical product. Its demand curve is perfectly elastic and is also its average-revenue and marginal-revenue curve, so P = AR = MR.
A profit-maximising firm produces the output where marginal revenue equals marginal cost, provided marginal cost is rising through marginal revenue. Producing the previous unit adds more to revenue than cost; producing beyond that point adds more to cost than revenue.
Economic profit is total revenue minus total economic cost, including implicit costs and normal profit. Price above average cost gives abnormal profit, price equal to average cost gives normal profit, and price below average cost gives a loss.
In the long run, abnormal profit encourages entry and losses encourage exit. In the standard model this process moves the market toward normal profit, with the representative firm producing at minimum average cost and P = MC, giving productive and allocative efficiency.
Reading a price-taking firm earning abnormal profit
“Price, costs, revenue” is measured vertically and the firm’s “Output” horizontally. This is the output of one representative firm, not total market quantity.
“P = AR = MR” is horizontal because the firm takes the market price. Every unit adds the same amount to total revenue, so price, average revenue and marginal revenue coincide.
“MC” records the additional cost of the next unit. “AC” records total economic cost per unit and is used to identify the profit position.
Output choice: E
“E” is where “P = AR = MR” meets “MC”. The firm therefore produces “Q” and receives “P” per unit.
Cost and profit at Q
“P” lies above “AC” at “Q”, so the firm earns abnormal profit. The profit rectangle has a height equal to price minus average cost and a width equal to output.
Short run versus long run
The displayed abnormal profit is a short-run outcome. With free entry, new firms increase industry supply, lowering the market price until economic profit is removed, ceteris paribus.
Profit is a rectangle, not a price–cost gap alone
At “Q”, total revenue is “P” multiplied by output. Total economic cost uses the height of “AC” at that same output, multiplied by output. The difference between those rectangles is economic profit or loss. Comparing price with MC would not calculate total profit.
Producer surplus and economic profit are different: producer surplus covers fixed cost as well as profit. A firm can earn normal profit while still receiving producer surplus. Also keep two efficiency tests separate: P = MC tests allocative efficiency, while production at minimum AC tests productive efficiency.
How the firm reaches its displayed outcome
The industry supplies the price shown by “P = AR = MR”; the individual firm accepts it.
For outputs below “Q”, marginal revenue exceeds marginal cost, so expanding output adds to profit or reduces loss.
At “E”, “P = AR = MR” equals “MC”, establishing “Q”.
The firm then compares “P” with “AC” at that output. “P” lies above “AC” at “Q”, so the firm earns abnormal profit. The profit rectangle has a height equal to price minus average cost and a width equal to output.
What the current state establishes
The diagram shows the firm’s short-run output and profit position. Industry consumer surplus and the market equilibrium quantity cannot be inferred from this firm panel alone.
Common mistakes to avoid
- The horizontal firm demand curve is not the market demand curve. Market demand remains downward sloping.
- The firm does not choose its price. It chooses “Q” after accepting “P”.
- MR = MC identifies the profit-maximising output even when the firm makes a loss; it does not guarantee abnormal profit.
- A price below AC does not by itself prove immediate shutdown because average variable cost is not displayed.
How to draw this diagram
- Title the diagram “Perfect competition”. Label the horizontal axis “Quantity” and the vertical axis “Price, costs, revenue”.
- Draw P = AR = MR first and label it clearly.
- Draw MC next and label it clearly.
- Draw AC next and label it clearly.
- Mark each relevant intersection and distinguish the initial, market and socially optimum or policy outcomes where applicable.
- Add the relevant guide lines and shade the economic area only after its boundaries are established.
- Check that every symbol used in the explanation appears on the diagram and add arrows showing the direction of change.
Assumptions and limitations
- The model assumes a homogeneous product, many small firms, free entry and exit, and strong information—conditions rarely satisfied perfectly.
- The panel does not display average variable cost, so the short-run shutdown decision cannot be determined.
- Static efficiency does not prove dynamic efficiency; thin profit margins may limit research and innovation.
- Externalities, taxes and subsidies would make private price and cost an incomplete measure of social efficiency.
- The diagram represents one firm and cannot measure industry concentration or consumer surplus.