Chapter 7 · Market failure and socially undesirable outcomes III: Market power (HL only)
Perfect competition: industry & firm
Link industry demand and supply to the price-taking firm. Explain market price, the firm’s profit-maximising output and welfare in perfect competition.
The economic idea
Perfect competition is a market structure with many small price-taking firms selling a homogeneous product under free entry and exit. The interaction of all buyers and sellers determines the industry equilibrium price and quantity.
An individual firm is too small to alter that price. Its demand is therefore perfectly elastic at the market price, making price, average revenue and marginal revenue equal.
The firm chooses output where P = MR = MC, provided MC is rising. This firm output is not the same variable or scale as total industry output: industry output is the sum produced by all firms.
A change in industry demand or supply changes the market price. The entire horizontal demand line facing the firm then moves, creating a new firm output where the new price meets MC.
Profit still depends on price relative to average cost. In the long run, entry or exit changes the number of firms and industry supply until representative firms earn normal profit, ceteris paribus.
Reading the market-to-firm transmission
The industry panel contains “D (industry)” and “S (industry)”; their intersection sets market price and total market quantity.
The same market price appears in the firm panel as the horizontal “P = AR = MR” curve.
The firm chooses its output where “P = AR = MR” meets “MC” and then compares price with “AC”.
The industry and firm horizontal axes use different quantity scales. They must never be read as the same output.
Industry equilibrium
“D (industry)” and “S (industry)” establish the price that coordinates the whole market. An individual competitive firm cannot select another price without losing its customers or revenue.
The representative firm’s response
“P = AR = MR” carries the industry price into the firm panel. Where it crosses “MC”, the next unit would add equally to revenue and cost, so the firm has reached its profit-maximising output.
The current profit position
At the firm’s chosen output, “P = AR = MR” lies above “AC”, so the representative firm earns abnormal profit.
Read market surplus in the market panel
In the industry panel, consumer surplus is below “D (industry)” and above the market price, up to industry output. Producer surplus is above “S (industry)” and below that price. These areas belong to the whole market, whereas a profit rectangle using “AC” belongs to one firm.
Do not multiply the firm’s output or profit by an assumed number of firms. The panels use different output scales and do not tell you how many identical firms exist. Explain the transmitted price first, then the individual firm’s response.
How a market change reaches the firm
“D (industry)” and “S (industry)” determine a market-clearing price and total industry output.
That price becomes the height of “P = AR = MR” for every price-taking firm.
The firm moves along “MC” until P = MC, changing its own output rather than shifting MC.
The firm compares the transmitted price with “AC”. At the firm’s chosen output, “P = AR = MR” lies above “AC”, so the representative firm earns abnormal profit.
Over time, profit encourages entry while losses encourage exit, shifting industry supply and feeding a new price back into the firm panel.
What the current state establishes
The market panel explains where price comes from; the firm panel explains how one price taker responds. Neither panel can replace the other.
Common mistakes to avoid
- The firm does not face the downward-sloping industry demand curve. It faces a horizontal demand curve at the market price.
- Market quantity and firm quantity are not comparable distances because the panels use different scales.
- A higher market price increases marginal revenue, so the firm chooses a larger output where MR equals MC on the rising section of MC. This is a movement along MC, not a shift of the cost curve.
- Industry consumer surplus must be read from the market panel, not from the individual firm’s horizontal demand line.
How to draw this diagram
- Title the diagram “Perfect competition: industry & firm”. Label the horizontal axis “Quantity” and the vertical axis “Price”.
- Draw D (industry) first and label it clearly.
- Draw S (industry) next and label it clearly.
- Draw P = AR = MR next 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 that one firm is too small to affect price and that products are homogeneous.
- The number and cost structures of firms are not displayed, so industry output cannot be divided mechanically into identical firm outputs.
- Entry and exit take time and may be restricted by finance, regulation, location or capacity.
- The firm panel omits average variable cost and therefore cannot establish the shutdown condition.
- A market can contain many sellers yet fail to be perfectly competitive if buyers possess market power.