Perfect Competition

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.

2. Homogenous

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 supply and demand.

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

Normal Profit/Break-even

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.

Perfect Competition in the Long Run

In the long run, we assume that all Factors of Production are variable, which means that the entrepreneur can adjust plant size or increase their output to achieve maximum profit. Perfect Competition Long Run equilibrium results in all firms receiving normal profits or zero economic profits.

Perfect Competition Long Run Factor Mobility

The Short Run Average Cost (SAC) curves that are above the Average Revenue curve (AR), i.e. the two curves to the extreme left and the extreme right are loss makers that will either leave the industry or change plant size in the long run. The three lower Short Run Average Cost (SAC) curves are making supernormal profits. Supernormal profits occur when total revenues exceed total cost (including the compensation of risk undertaken by the entrepreneur). These supernormal profits will attract outer firms into the industry.

Perfect Competition Long Run Equilibrium

In the long run, with the entry of new firms in the industry, the price of the product will go down as a result of the increase in supply of output and also the cost will go up as a result of more intensive competition for factors of production. The firms will continue entering the industry until the price is equal to average cost so that all firms are earning only normal profits.

The short-run cost curves that lie at the lowest point of the long run average cost curve has no incentive to leave the industry.

The firms will continue leaving the industry until the price is equal to average cost so that the companies remaining in the field are making only normal profits. Normal Profits, also known as the break-even or zero economic profit, includes the profit paid to the entrepreneur (included in the total cost, for bringing in scarce resources and taking on risk), and the total cost is equal to total revenue. A firm making normal profits will remain in the industry.

In the Perfect Competition Long Run, the loss-making firms will exit the industry, and new firms will enter the market. Losses are the key to establishing Long Run equilibrium.

In the long run equilibrium, firms enjoy market efficiencies, which leads to scarce resources not being wasted.

Perfect Competition Long-Run Profit Maximization Formula

Where Long Run Marginal Cost (Long Run MC) = Short Run Marginal Cost (SMC) = Marginal Revenue (MR)

1. Productive Efficiency

When the firm produces at the lowest short-run average cost, they can achieve productive efficiency, where price equals minimum average total costs. Therefore, any firm that cannot produce at the minimum Average Total Cost will be forced to leave the industry.

2. Technical Efficiency

Technical Efficiency is when the firm produces the maximum average product. This efficiency is also a consequence of productive efficiency.

3. Allocative Efficiency

Allocative Efficiency is when the price is equal to marginal cost. The firm achieves the greatest allocative efficiency when there is no other combination of goods and services that would be more desired by society.

Disadvantages of Perfect Competition

1. Firms do not have an incentive to innovate or spend on research and development because other firms can easily copy their products. This disincentive is a characteristic of the perfect competition market.

2. Since they produce the same product, there is less variety.

3. Firms would not enjoy economies of scale if they did then only a few large firms would remain in the industry.

Perfect Competition Rise in Demand

Perfect Competition or Pure Competition (PC) is a type of market structure, which doesn’t exist and is considered to be theoretical. There are very many small firms that produce an identical product. They sell whatever they can produce, and no single firm affects the market price.

In the long run, with the entry of new firms in the industry, the price of the product will go down as a result of the increase in the supply of output and also the cost will go up as a result of more intense competition for factors of production. The firms will continue entering the industry until the price is equal to average cost so that all firms are earning only normal profits. Now we will see the Perfect Competition Rise in Demand.

Perfect Competition Rise in Demand Industry

A rise in demand for a good would shift the industry demand curve from D1 to D2. Quantity produced increases to Q2, which results in an upward shift for the Average Revenue and Marginal Revenue curves for individual firms, from D1=AR1=MR1 to D2=AR2=MR2. This increases profits since the average revenue curve lies above the average cost curve. The profits are represented by the box between P1 and P2 and 0 to Q2. The firms are now making supernormal profits. This profitability will encourage outside firms to enter the market.

Perfect Competition Rise in Demand Individual Firm

Perfect Competition Industry (Leads To Rise in Supply)

Since there are no barriers to entry, more and more firms will enter the market, which will increase supply from S1 to S2. This will continue till every firm competing in the industry is making zero economic profits. Then no other firms will have incentive to enter the industry and everyone is back to making zero economic profits in the long run. This makes firms more competitive and decreases inefficiency in the market.

Perfect Competition Individual Firm (Leads To Rise in Supply)