Perfect Competition or Pure Competition (PC) is a type of market structure, which doesn’t actually exist and is considered to be theoretical. We will look at Perfect Competition Short Run and then in the next post, the Perfect Competition in the long run.
Characteristics of Perfect Competition
1. Number of Firms
There are very many small firms (think of a grain of sand on a beach), too many to count.
All producers of a good sell the same product, i.e. they are homogenous/identical.
3. Barriers to Entry
There are no barriers to enter or exit the market (sometimes high costs or strict regulations prevent firms from entering)
4. Perfect Information
All consumers and producers have ‘perfect information’, i.e. everyone knows the price of the product, the demand & supply
5. Price Takers
No single firm can influence the market price, or market conditions. Firms sell all they produce, but they cannot set a price. They are said to be ‘price takers’
Total Revenue Curve
Total Revenue is Total Quantity x Price. Since producers can sell all they produce, and the price is fixed, revenue will increase with each good sold at a constant rate. That explains the shape of the Total Revenue curve (TR).
Marginal & Average Revenue Curve
A. Marginal Revenue
The revenue earned by selling one more unit. In perfect competition, every unit is sold at the same price, so revenue earned from each new unit would be the same as before. That explains why the Marginal Revenue curve (MR) is completely horizontal.
B. Average Revenue
Average Revenue is Total revenue/Quantity. Since all the units are the same price, each new unit would have the same average revenue, so the Marginal Revenue = Total Revenue.
Price (P) = AR = MR (in Perfect Competition)
Firm as a Price Taker
To understand what ‘Price Taker’ means, look at the diagram below. The first diagram is the industry supply & demand, while the one below it is the individual firm. If a firm tries to lower or increase the price, then either everyone will buy from them or no one will buy from them, but they have no incentive to sell lower than the industry since they are already selling everything they produce.
Perfect Competition Short Run
Perfect Competition Short Run Industrial Equilibrium
In the diagram below, the firm is making supernormal profits. The total cost to the firm is in blue, and the profit is in the red. We can intuitively tell it makes profit because its average costs are lower than the average revenue. To calculate the cost, see where the quantity hits the average cost line, and then draw a horizontal line to the Y axis. Whatever area is above the cost is the profit or the loss.
Since we assume that all individual firms are profit maximizers, we take MC = MR for profit maximization. If a company is loss-making, the rule still applies, so the loss is minimized. Similarly, the least Total Cost is taken to maximize profit or minimize loss.
Perfect Competition Short Run Equilibrium: Supernormal Profits
Perfect Competition Short Run Losses
Perfect Competition Short Run Equilibrium Loss Making
Perfect Competition Short Run Zero Economic Profits
Leaving the Industry
In the Perfect Competition short-run, the firm will continue to produce if he can recover the average variable cost, as fixed costs are paid regardless of production.