Perfectly Competitive Markets

We will now discuss a certain type of market, called a perfectly competitive market. We
consider this to be an extreme, and most markets are not perfectly competitive.
However, we do see features of this model in the real world, and some markets are very
close to perfectly competitive. Understanding perfectly competitive markets will help
you understand markets in general.

Assumptions

As with any model, we make assumptions about the world. In a perfectly competitive
market, we assume:

1) There are many sellers in the market.

2) Firms sell a homogeneous product, meaning the product that one producer
sells is no different from the product that another producer sells.
3) Firms can freely enter or exit in the long run.
4) Firms are price takers, meaning that they take price as given, and cannot
change the market price by changing their quantity.

Generally, we don’t find markets that satisfy all of these assumptions perfectly, but many
are extremely close, we may call these markets nearly perfect. There are many examples
of nearly perfect markets.

Another important assumption is that firms will maximize profit, meaning that they will
enter a market if there is profit to be made, and exit a market if they are losing money.

Timing in Perfectly Competitive Markets

We separate time in perfectly competitive markets into two periods, the ​Short Run,​ and
the ​Long Run​. In the short run, fixed costs are fixed, firms must pay them no matter how
much they produce. Also, in the short run, firms cannot enter or exit the market. In the
Long Run​, firms can enter or exit the market if they want, meaning that their fixed costs
are no longer fixed. The length of time that the short run lasts could vary. An example of
the short and long run could be a coffee shop with a lease. They are required to pay rent
for a year, no matter how many cups of coffee they sell. In this case, their fixed cost is
their rent, and the short run lasts a year. Even if the coffee shop is losing money, they
still have to pay rent. After a year has passed, they no longer have the lease, no longer
have to pay rent, and can leave the market if they are losing money.
 Diagramming Perfectly Competitive Markets

Like we did with supply and demand, we will often diagram competitive markets. We will
do this with a two-sector diagram. On the left set of axes, we will diagram the entire
market supply and demand. The entire market quantity, Q is on the x-axis. The price is
on the y-axis. The supply curve on this graph represents the sum of all the supply curves
of all the producers in the market.

One the right set of axes, we plot the cost structure for an individual firm. This cost
structure will dictate firm behavior. Price is determined in the market, on the left, by
supply and demand. Since firms are price takers, they will make decisions based on price,
including how much to make, and whether or not to leave the market in the long run.
Remember, in the short run, firms cannot exit the market, they must pay fixed costs. In
the long run however, they can exit. When firms shutdown, enter, or exit the market, the
number of firms changes. This will shift the supply curve on the left (the number of
sellers affects supply), changing price.
 Long Run-Competitive Equilibrium

Based on entry and exit decisions for firms, we will find that if price is above P​LR,​ firms
will be making a profit. In the long run, we will find that firms enter the market. This
shifts supply to the right, decreasing price. If price is below P​LR​ firms will be losing money
(no matter how much they produce). This gives them incentive to exit the market, which
pushes supply to the left, increasing price. We thus find that in the long run, price will
always be at PLR
​ ​ since any other price would lead to firm entry or exit. Firms will be
making zero economic profit (though they could be making accounting profit). If supply
dips below P​SD​ some firms will shut down. This will cause supply to shift to the left,
raising price back up to P​SD.​

Important Elements

When analyzing a shock to a perfectly competitive market, there are some important
things to remember.

1) Firms have a rule for profit maximization, if price is above the shutdown point
(the minimum of AVC), they will produce individual firm quantity q that sets MC =
MR, where in this case, MR = P, so MC = P. If price is below the shutdown point,
they will produce q = 0.

2) The supply curve in the entire market (on the right in a diagram) is generated by
the sum of all of the individual firm supply curves (if you don’t remember the short
run supply curve, review the cost notes). If incentives on that side don’t change,
the supply curve will not shift.

3) The only thing that changes in the long run is that firms can enter or exit the
market. Whether firms enter or exit the market in the long run will drive the
changes that occur in the long run

Efficiency

Importantly, if you look at the equilibrium in the market, you can see that competitive
markets are efficient, in that they maximize total surplus. All units where marginal cost is
below marginal willingness to pay are produced, with no units produced where marginal
cost is above marginal willingness to pay.