Perfect Competition is one of four possible ways in which a market is structured. The others are; imperfect, or monopolistic competition; oligopoly; monopoly. The structure of the market will influence the way in which firms behave: for instance their pricing and output decisions and how they compete with each other (eg advertising, branding). The market structure also determines the opportunity to make abnormal profit.
Each of the market structures we describe in 3.4.2, 3.4.3, 3.4.4 and 3.4.5 is really an ‘ideal type’; a model we can use to compare against the real world market conditions. Many firms and markets do not fit easily into any of the four categories, but are likely to display most, if not all of the characteristics. This enables economists to understand and predict the behaviour of firms. It also helps governments decide how markets may need to be regulated.
Characteristics of Perfect Competition
A perfectly competitive market is assumed to have the following characteristics:
- There is a large number of small sellers (firms) of similar size
- There is a large number of buyers
- All firms produce an identical (homogeneous) product; it is not possible for firms to differentiate their product from that of competitors
- There is no possibility of collusion between either sellers or buyers to control or influence price
- There is freedom of entry and exit to the market; it is not possible for existing firms to create barriers to new firms.
- Buyers and sellers have complete or perfect knowledge of all prices in the market.
The firm will be in short-run equilibrium provided that MC=MR and that MR is above minimum AVC. In Fig 3 below, the price (and therefore MR) is above ATC, and therefore the firm is making abnormal profit.
The equilibrium output is at Q. Price, MR and MC are equal to OP and ATC is equal to OC.
CP is therefore the abnormal profit per unit, an CPAB is the total abnormal profit.
Average and Marginal Revenue
It follows from the above assumptions that firms in perfectly competitive markets are price takers. The market price is determined by the overall demand from consumers and the overall supply of all firms in the market. Because the product is homogeneous, and there is perfect knowledge of prices in the market, a firm can’t sell any of its product at any price above the market price.
But an individual firm can sell as much as it likes at the market price. This is because its output is very small compared to the overall market supply, so any change in its output has no measurable effect on market equilibrium. This situation is illustrated in Fig 1 below:
Suppose the market is for rice, in a developing country. There are thousands of small farms growing no more than a few hundred kilos each per year. The overall market quantity is many thousands of tonnes.There may be several million consumers.
The market situation is shown on the left. Initially the market is in equilibrium at a price of PA, with S and D representing respectively the supply and demand curves. The situation facing the individual producer is shown on the right; it can sell all its output at the market price PA.
The demand curve for the individual firm is therefore perfectly elastic at the market price. This also means that price, average revenue and marginal revenue are equal and constant at all outputs.
If market conditions change, the price will also change. If all farmers increased their output (or new farmers entered the market, supply would shift to S1, pushing price down to PB. If market demand increased, price would rise to PC.
A firm maximises profit when it produces at an output where MC=MR (see notes on 3.3.4). As MR is also equal to price under conditions of perfect competition, it follows that the MC curve is also the firm’s supply curve.
But note that a firm will not produce any output in the short-run if price is less than AVC, and in the long-run it will not produce at any price below ATC (see notes on 3.3.4).
The short-run supply curve is therefore the section of MC above minimum AVC, and the long-run supply curve is the section of MC above minimum ATC. This is shown in Fig 2 below:
The MC curve above point A is the short-run supply curve, and above point B is the long-run supply curve.
If firms are earning abnormal profit, new firms will enter the market resulting in an increase in market supply. This will drive price (and therefore AR/MR) down. Firms will continue to enter the market, attracted by abnormal profit, until price is driven down to a level where normal profit only is earned.
If the short-run price is below ATC, so that losses are being made, some firm will leave the market, causing market supply to decrease. This will result in a rise in price/AR/MR. Firms will continue to leave the market until price rises to the level where normal profit can be earned.
Long-run equilibrium also occurs where firms are producing at the lowest point on the long run average cost curve (in other words at the minimum efficient scale). Any firm that is not at minimum LRAC will make a loss, since competition will force price down to that level.
In the long run therefore, firms can only make normal profit. The long run equilibrium is shown in Fig 4 below:
We can see from the diagram that in long run equilibrium (at output Q):
- The firm makes normal profit only.
- Price, MC, MR, SRAC, LRAC are all equal at OP.
- SRAC and LRAC are at the minimum.
Evaluation of Perfect Competition
It therefore follows that in the long-run under conditions of perfect competition:
- All firms are productively efficient, since they produce at minimum average cost.
- All firms are allocatively efficient, since price = marginal cost.
- Therefore perfect competition is statically efficient.
However, it should be remembered that:
- Perfect competition rarely exists in the real world, although some markets, such as agricultural markets in developing countries come close to the assumptions of perfect competition.
- Perfect competition may not be dynamically efficient, because firms may be too small to have the resources to invest in research and development to bring about innovative technology or products.
- Explain in a paragraph why agricultural markets in developing countries may be considered as examples of perfect competition.
- Your answer should include: price takers / collusion / absence of / homogeneous / free entry