Perfect competition

Characteristics of perfect competition

1. There are many buyers and sellers: due to the number of market participants, sellers are price takers

2. There are no barriers to entry and exit from the industry: firms can start-up or leave the industry with relative ease, which increases the level of competition

3. Buyers and sellers possess perfect knowledge of prices: this assumption presupposes perfect information, e.g if one seller lowers their price, then all buyers will know about it

4. The products are homogenous: this means firms are unable to build brand loyalty as perfect substitutes exist and any price changes will result in losing all customers. Demand is therefore perfectly price elastic

Profit Maximising Equilibrium in the Short and Long-run

• In order to maximise profit, firms in perfect competition produce up to the level of output where marginal cost = marginal revenue (MC=MR)

• The firm does not have any market power so it is unable to influence the price and quantity

  • The firm is a price taker due to the large number of sellers

  • The firm's selling price is the same as the market price, P₁ = MR = AR = Demand

A diagram that illustrates how an individual firm in perfect competition has to accept the market/industry price (P1)

• In the short-run, firms can make supernormal profit or losses in perfect competition

• However, they will always return to the long-run equilibrium where they make normal profit

Short-run profit maximisation

Diagram analysis

• The firms is producing at the profit maximisation level of output where MC=MR (Q₁)

  • At this point the AR (P₁) > AC (C₁)

  • The firm is making supernormal profit

  • = (P1-C1)XQ1

Short-run losses

• Firms in perfect competition are able to make losses in the short-run

Diagram analysis

• The firms are producing at the profit maximisation level of output where MC=MR (Q₁)

  • At this level of output, the AR (P₁) < AC (C₁)

  • The firm's loss is equivalent to (P1-C1)XQ1

Moving from short-run profits to the long-run equilibrium

• If firms in perfect competition make supernormal profit in the short-run, new entrants are attracted to the industry

  • They are incentivised by the opportunity to make supernormal profit

  • There are no barriers to entry

    • It is easy to join the industry

• Diagram analysis

  • The firm is initially producing at the profit maximisation level of output where MC=MR (Q₁)

    • At this level of output, the AR (P₁) > AC (P₂) and the firm is making supernormal profit

  • Incentivised by profit, new entrants join the industry and supply increases from S₁→S₂

    • Overall quantity in the industry increases from Q₁→Q₂

    • The industry price falls from P₁→P₂

  • The firm now has to sell its products at the industry price of P₂

    • The output of the firm falls from Q₁→Q₂ as it now has a smaller market share of the larger industry

    • At the profit maximisation level of output (MC=MR) the firm is now producing at the point where AR= AC

      • The firm is making normal profit

    • In the long-run, firms in perfect competition always make normal profit

      • Firms making a loss leave the industry

      • Firms making supernormal profit see them slowly eradicated as new firms join the industry

Moving from short-run losses to long-run equilibrium

• If firms in perfect competition make losses in the short-run, some will shut down

  • The shut down rule will determine which firms shut down

  • There are no barriers to exit, so it is easy to leave the industry

Moving from short-run losses to long-run equilibrium

Diagram analysis

• The firm is initially producing at the profit maximisation level of output where MC=MR (Q₁)

  • At this level of output, the AR (P₁) < AC (C₁) and the firm is making a loss

• Some firms leave the industry and supply decreases from S₁→S₂

  • Overall quantity in the industry falls from Q₁→Q₂

  • The industry price increases from P₁→P₂

• The firm now has to sell its products at the industry price of P₂

  • The output of the firm increases from Q₁→Q₂ as it now has a larger market share of the smaller industry

• At the profit maximisation level of output (MC=MR) the firm is now producing at the point where AR= AC

  • The firm is making normal profit

• In the long-run, firms in perfect competition always make normal profit

  • Firms making a loss leave the industry

  • Firms making supernormal profit see them slowly eradicated as new firms join the industry