Theme Two:

Perfect Competition
 Perfect Competition
Perfect competition is the market structure
where there are many buyers and many
sellers. Information on market conditions
such as prices and costs is always
costless, instant, perfect and symmetric.
Firms face a horizontal demand curve and
have no influence or power whatsoever in
the market. Also, a monopoly is viewed as
a ‘special case’.
 The role of Technology
The role of technology is important to the
firm in terms of the input requirement set:
V(y)={K,L on the R+ : (y, -K, -L) is in the Y}
This is the set of all positive inputs such that
net output is at least the value of Y.
Subsequent analysis views technology as
important for the growth of the firm and the
possibility of gaining monopoly power.
 Market Constraints
Perfect Competition implies free entry and
exit since the firm (and the industry) is
producing a homogeneous product. This
is because there is perfect mobility of the
factors of production.
Therefore, the firm is a price-taker for output
and inputs and will try to maximise profit
(π) as the one and only goal of the firm.
 Combine Motivation
The firm has an objective with a constraint.
Namely, maximise profits (one output)
subject to the technology and market
structure. Thus:
π(p) = Max py subject to y=f(K,L)
p = row vector of prices, (p, w, r)
y = column vector of outputs/inputs
NB The technology constraint can be
subsumed by substitution.
 Welfare Maximisation
Taking Max py-c(y) as the generic form of the profit
maximisation problem then the First Order
Condition (FOC) is that:
p = dc/dy
SOC is that:
d²c/dy² > 0
As a result marginal costs are increasing. The
supply function y(p) thus depends on price
according to marginal costs and the industry
supply is the sum of all suppliers.
 Competitive Equilibrium
Competitive equilibrium implies price
equates supply and demand:
Σx(p) = Σy(p)
(or excess demand sums to zero).
By implication:
p = du/dx = dc/dy
This maximises welfare as the area under
the demand curve and above the supply
curve which generalises across markets.
 Profit Function (1)
The profit function is the set of maximum
profits given a structure of prices. The
formal proof is via the ‘envelope theorem’
which implies comparative static analysis.
Thus the profit function is:
Max pf(L)-wL; δπ/δp = f(L)
According to Hotelling’s Lemma. Thus
supply depends on prices according to its
effect on profits.
 Profit Function (2)
Likewise: δπ/δw = -L, inputs demands
depend on the effect of wages on profit,
which are negative.
The consumer scenario can be examined in
exactly the same way. Diminishing
marginal utility plays the same role as
diminishing productivity. Utility can be
maximised and expenditure minimised
according to work by Marshall and Hicks.
 The First Order Condition
The first order condition is necessary, such
that:
π(p) = Max pf(K,L)-(wL+rK)

dπ/dK = pδf/δK – r = 0
dπ/dL = pδf/δL – w = 0
That is, the marginal revenue equals the
factor prices.
 The Second Order Condition
The second order condition is sufficient,
such that:
dπ = [pδf/δK – r]dk + [pδf/δL – w]dL
d²π=d(dπ)=d{[pδf/δK–r]dK + [pδf/δL–w]dL}
=(δ(dπ)/δK)dK + =(δ(dπ)/δL)dL
Where the first and second order conditions
are necessary and sufficient.
 Equilibrium in the Short Run
The firm is in equilibrium when in max profits which
is defined as π = TR – TC.
Hence, the efficient firm maximise short run profits
where MC = MR.
If MC < MR, then total profit has not been
maximised and it is in the interest of the firm to
expand output.
If MC > MR then the level of total profit is being
reduced so production should be reduced.
 Equilibrium in the Long Run
The condition for long run equilibrium of the
firm is that MC be equal to the price and
the long-run average cost:
LMC = LAC = P
At equilibrium:
SMC = LMC = LAC = LMC = P = MR
This implies that at the minimum point of the
LAC the factory is worked at optimal
capacity so that LAC and SAC coincide.
 The Production Function
The production function is shown as:
f(x) = {y in R: y is the maximum output
associated with –K, -L in Y}
This describes the first best production plans
that comply with Pareto efficiency.
In turn, there can be decreasing, increasing
and constant returns to scale using the
Cobb Douglas production function.
 Conclusions
The rational firm under perfect competition
has to set prices where MC = MR so that
short run profits are maximised.
The behaviour of the firm is optimisation for
example, profit maximisation.
There are constraints on the firm, both
technological and market constraints.
The mode of assessing firm is using
equilibrium analysis.