Demand Curve in Perfect Competition

Marginal Revenue and Demand Curve in Perfect Competition

Marginal revenue and the demand curve in perfect competition are equal when we look at them from an individual firm's perspective. Because a firm's demand curve is perfectly elastic in perfect competition, demand is equal to the market price for every quantity they produce.

The marginal revenue is the additional revenue a firm earns from producing one more unit, so as consumers buy one more unit at the market price, the firm's total revenue will rise by exactly the amount the unit sold for, which is the market price! Therefore, if we plot the marginal revenue curve on the same graph as demand, the two curves are the same.

Table 1 shows us how marginal revenue is equal to price, no matter the quantity demanded. If we plot the demand curve, like in Figure 1 below, using the price and quantities from Table 1, the marginal revenue curve would be plotted right over the top. Hence why the market price, a firm's marginal revenue, and its demand curve are equal in a perfectly competitive market.

Fig. 1 - The market price is equal to a firm's marginal revenue and demand in perfect competition

The Shape of Demand Curve Under Perfect Competition

The shape of the demand curve under perfect competition depends on whether we are looking at an individual firm's demand curve or the entire market. In the case of an individual firm, the demand curve will be horizontal. But why is that?

Well, since the firms are price takers, meaning they cannot influence the price of their goods, no matter how much they supply, the price will not change. Also, because there are many consumers in the market, the quantity a firm supplies into the market does not affect the quantity demanded. This results in a constant level of demand. If the firm faces consistent demand at the market price, no matter how many units they produce, its demand curve will be flat. Its sales do not impact market price.

Fig. 2 - Individual firm's demand curve in perfect competition

Figure 2 shows the horizontal demand curve of a firm when it participates in a perfectly competitive market. The demand curve is flat, and the price that the firm charges for all of the goods it supplies is P_M, which is the market price. As seen in Figure 2, the price the firm can charge at Q₁ and Q₂ is identical since the firm's supply in the market does not affect the whole market.

However, if we look at the demand curve for the whole market, it will have a negative slope to it. This is because, unlike with an individual firm, the entire market includes all consumers, not just the ones willing to pay the market price. At a given market price, the firm only considers those who are willing to pay the market price, whereas when we look at the whole market, we must consider all of the consumers who want the good. Even given the market price, there will be some consumers who would still buy the good if the price was higher or lower. If the price was higher, fewer would buy the good, and if it was lower, more would buy it.

Fig. 3 - Market demand curve in perfect competition

Figure 3 depicts the demand curve of the whole market in perfect competition. In this case, unlike with the individual firm, we consider all the consumers in the market, not just those looking to buy the goods. If the market price (P_M) was lower, consumers who were unwilling to join the market at the higher price are now willing to join. Conversely, if the market price were higher, some consumers would exit the market, reducing the quantity demanded.

The Slope of the Demand Curve in a Perfectly Competitive Market

The slope of the demand curve in a perfectly competitive market is negative, and the curve slopes downward. This is different from the demand curve of the individual firm. In a perfectly competitive market, the market demand curve slopes downward because it measures how much of a good all the consumers in the market will demand at each price. In this case, the market follows the law of demand, where the quantity demanded increases as the price falls.

Fig. 4 - Market demand curve in perfect competition

Since the market is made up of individual people and households, the market demand curve is derived by adding together all the individual and household demand curves. Because everyone has different incomes and levels of tolerance for prices, as the price decreases, the quantity demanded increases, as we can see in Figure 2.

Once the market settles on its equilibrium levels of supply and demand and the market price is established, the firms accept these market prices, which is what makes them price takers.

Firm's Demand Curve in Perfect Competition

A firm's demand curve in perfect competition is perfectly elastic, meaning it is horizontal as opposed to the downward-sloping demand curve we are accustomed to. Since an individual firm's demand curve is horizontal, it is perfectly elastic, which tells us that the firm is a price taker. Being a price taker, the firm will produce as many units of a good as it wants to and will be able to sell them all for the same market price.

Fig. 5 - Individual firm's demand curve in perfect competition

In Figure 3, we can see that the firm's demand curve is horizontal. For every quantity the firm produces, it can sell it at the same price. So how does the firm know how much to produce? The firm has its marginal cost curve (MC), which is equivalent to its supply curve. Where the marginal cost curve intersects the demand curve is where the firm should produce to maximize its profits.

If the firm were to try to raise its prices in a perfectly competitive market, the firm's demand for its product would immediately fall to zero because consumers would be able to adapt instantly to buy from a different firm that still charges the lower market price. The firm would also not gain anything by charging a lower price than its competitors. The firm will be able to sell any quantity of its goods for the same market price because demand at that price is infinite. Therefore, all that would happen for the firm if they decreased their price is a decrease in revenue since they would still be selling the same quantity of goods, just at a lower price.

Now, if the firm's demand curve itself changes, then the firm would still produce the same quantity demanded, but its profit would change.

Fig. 6 - Increase in demand for an individual firm in perfect competition

Figure 6 sees an increase in the firm's demand curve. This happens when the market demand and market price increase. In Figure 6, this means the market price rises from P_M1 to P_M2. At first, the firm charged P_M1, where the average total cost (ATC) curve intersected with the marginal cost (MC) curve. Then, as the market price increased, the firm was able to charge a higher price than its average total cost to produce. When a firm can change a price that is above its average total cost, these profits are called supernormal profits and are shaded in Figure 6. Supernormal profits are not sustainable in the long run because the lack of barriers to entry makes it easy for other firms wanting to cash in on those profits to enter the market, which would increase the market supply and push prices down. The price would then return to a level where the firms are only earning normal profit again.

If the firm were to experience a decrease in the market price, its demand curve would shift down because, in perfect competition, any and all quantities are demanded at the given market price. This would cause the ATC curve to sit above the demand curve, which is also an unsustainable position for the firm because it means that it is below its break-even point and only just covering its variable and fixed costs. As long as the price stays above the average variable cost (AVC) curve, the firm has not yet reached its shut-down price.