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Perfect competition

By the end of this

.9
rl explain the
E nl distinguish between
firm in perfect
p HL explain how
.9
HL explain and
competition
HL explain and

HL explain and
perfect competition
xl define and illustrate
xl define and illustrate
xl explain and
and long run

HL As we already know, social scientists, especially economists, are

model builders. We use models to try to explain how things work and
what might be the possible outcomes oI certain economic situations.
Perfect competition is a model used as the starting point to explain
how firms operate. It is a theoretical model, based upon some very
precise assumptions. However, although it is purely theoreticai, it is
very important because once we have built our model oI a perfectly
competitive market we can then begin to relax the theoretical
assumptions that we have made and move towards models of
markets that are much more realistic.

The assumptions of pedect competition

Perlect competition is based upon a number of assumptions.
o The industry is made up of a very large number of firms.
o Each firm is so small, relative to the size of the industry that it is
not capable oI altering its own output to have a noticeable effect
upon the output of the industry as a whole. This means that a firm
cannot affect the supply curve of the industry and so cannot affect
the price of the product. Individual lirms have to sell at whatever
price is set by demand and supply in the industry as a whole. We
say that the individual firms are "price-takers".
r The firms all produce exacdy identical products. Their goods are
"homogeneous". It is not possible to distinguish between a good
produced in one firm and a good produced in another. There are
no brand names and there is no marketing to attempt to make
goods different from each other.
 7. perfect competit'on IIIE
o Firms are completely free to enter or leave the industry. This
means that the lirms already in the indusfy do not have the
ability to stop new firms frorn entering it and are also free to leave
the industry, if they so wish. We say that there are no barriers to
entry or barriers to exit.
r All producers and consumers have a per{ect knowledge of the
market. The producers are fully aware oI market prices, costs in
the industry, and the workings of the market. The consumers are
fully aware of prices in the market, the quality of products, and d
o
Lhe availability of the goods. o
o
Although we say that it is completely theoretical, there are some l-'
industries in the world that get quite close to being perfectly
competitive markets. The industries most often used as examples by
economists are usually agricultural markets.
For example, let us consider the growing of wheat in the European
Union (EU). There are some large wheat farms in the EU, but they
are very small in relation to th€ whole wheat-growing industry. An
individual farm could increase its output many times over without
having a noticeable effect on the total supply of wheat in the EU.
Thus a single larm is not able to alfect the price of wheat in the EU,
since it cannot shift the industry supply cuwe. The farm has to sell at
whatever the existing industry price is. In addition, wheat is wheat,
and so there is no way to tell one farm's wheat from another.
So far so good for tJle assumptions of perfect competition. However,
although firrns are relatively free to enter or leave the wheat
industy, there are significant costs in doing either and these may
affect the decisions of firms. Also, although inlormation is fairly open
in the industry it is unlikely that producers and consumers will have
"perfect knowledge". We can say that the wheat industry in the EU
may be close to being a perfectly competitive market, but is not
precisely one.

The demand curves for the industry and the firm in

pedect competition
We have said that the individual firms in perfect competition will be
price-takers, since they cannot affect the price of the industry and so
must sell at whatever the market price is. This means that we can
make certain assumptions about the demand curves for both the firm
and the indusfiy.

The industy The fim

Quantity
Quantity Quantity
103
Figure 71 The demand curves for the industry and the llrm in perfect comPetition
!!!!! 7 . perfect competitron

As we can see in Figure 7.1, the industry in perlect competition

will face normal demand and supply curves. We would expect
producers to wish to supply more at higher pdces and we would
I{ thati the Ptice
in the inlustry,
expect consumers to demand less as price rises. we would expect
demand to be donnward sloping and supply to be upward sloping. then that'r the
The industry price would therefore be p and the quantiry demanded Pric€ I't( have
would be Q.
.9
E For the individual firms we know that they will have to sell ar the
industry price, P, because they are pdce-takers. If they try to sell at
I
.9
a higher price then consumers will simply buy the product from
another 1im, since the goods are homogeneous and so there is no
dilference in looks or qualiry. If they sell at the industry price the
firm can sell as much as it wants, because as it increases output it
does not affect the industry supply curve and so it does not alter
the industry pdce.
If the firm can sell all that it wishes at the price P rhen it must face a
perfectly elastic demand at that price. In Figure 7.1 we can see that
the firm dedves its price of P from the equilibrium pdce in the
industry, where the industry supply equals the industry demand. This
is another explanation of the term "price-taker", because the firm has
to take the price set in the indusuy.

Profit maximization for the firm in perfect

competition
Firms maximize profits when they produce at the level ol output
where MC = MR. For pedect competition, we now have to add the
marginal cost curve, shown in Figure 7.2.

The industry

Quantity Quantity

Figure 72 The profit-maximizing level of output in perfect competition

We can see that the lirm takes the price P from the industry and,
because the demand is perfectly elastic, P:D =AR:MR. Profit is
maxirnised where MC:MR, which is at the level oI output q. We
must remember that although the scale of the price axes is the same
for the firm and the industry, this is not the case for output. The
quantity q is very small in relation to the total industry output, Q,
and it would not even register on the output axis for the industry. II
it could, then it would be large enough to shift the supply cuwe and
thus alter the industry price.
t04
 7 s. perfect competit'on l!!E
Possible short-run profit and loss situations in
perfect competition
In the short run in perfect competition, there are two possible profit/
loss situations:

1 Short-run abnormal profits : In this case, which is show{r in Figure 7.3,

the firms in the industry are making abnormal profits in the short
run. This means that they are more than covering their total costs,
including the opportunity costs. =
8
fhe ndustry fnn o
The
:
l.
]\,1C MR
detemines
the quant ty.

Quantity Quantity

Figure 7.3 Short-run abnormal profits in perfect competition

As we can see in Figure 7.3, the firm is selling at the industry

price, P, and is maximizing profits by producing at the quantity q,
where MC:MR. At q, the cost per unit, average cost, is C, and the
revenue per unit, average revenue, is P, so average cost is less than
average revenue and rhe firm is making an abnormal profit of P-C
on each unit. The shaded area shows the total abnormal profit.
Short-run /osses: In this case, shown in Figure 7.4, the firms in the
industry are making losses in the short run. This means that they
are nol covering their total costs.

The industry Ihe f/rm AC determines

the cost per Lrnit

Quantity Quantity

Figure 7.4 Shortrun losses in perfect competition

In Figure 7.4 the firm is selling at the industry price, R and is

maximizing profits by producing at the quantity q, where
MC=MR. However at output q, the cost per unit is C, which is
greater than the price and so the firm is making a loss of C-P on
each unit. The shaded area shows the total loss. Although making
a loss, the firm is still producing at the "profit-maximizing" level
of output, because any other output would create a greater loss. t05
In effect, they are loss minimizing.
!!!!! r,. peffect competition

The movement flom short run to long run in perfect

competition
If firms are making either sho -run abnormal profits or short-run
losses, other firms begin to react and the situation starts to change
until an equilibrium point is reached in the long run.

Short-run abnormal profits to long-run normal plofits

E Let us look first at the situation of short-run abnormal profits. The
o
o process is shown in Figure 7.5. The firm is making abnormal profits
I shown by the shaded area, but this situation will not continue for long.
Since there is perfect knowledge and no barriers to entry, firms
outside oI the industry that could also produce the good will stan to
enter the industry, attracted by the chance to make abnormal profits.
At fi$t, this will have no real e{fect, because the firms are relatively
small. However, as more and more firms enter the industry, attracted
by the abnormal profits, the industry supply curve will start to shift
to the right.
As the industry supply curve starts to shift lrom S towards 51, the
industry price will begin to Iall from P towards pr. Because the firms
in the industry are price-takers, the price that they can charge will
start to fall and their demand curves will start to shift downwards.
This means that the abnormal profits that they had been making will
start to be "competed away".

c
D:AR:A,ilR

0 q,q
Quantity Quantity

Figure 75 The movement from short-run abnormal profit to long-run normal profit

This process will continue as long as there are abnormal profits in

the industry. Eventually the industry supply curve reaches S,,
where the price is Pr. At this point, the firms are "taking" the
price of Pr and the demand curve is Dr=AR1:MR1. We now find
that the firms are making normal profits with the price per unit
equal to the cost per unit, i.e. P,:C1. The entrepreneurs of the
firms in the industry are satisfied, because they are exactly
covering their opportunity costs. However, there is now no
abnormal profit to attract more firms into the industry and so the
industry is in a long-run equilibrium situation. No one will now
enter and no one will now leave. The outcome is a much bigger
industry producing Qr units, with smaller firms each producing
qr units.
l06
 7 o perfect competition l!l!!
Short-run losses to long-run normal profits
Now take the situation of short-run losses. The process is shown in
Figure 7.6. As we can see, the firm is making losses shown by the
shaded area, but this situation will not remain the same.

Some firms in the industry will, after a time, start to leave the
industry. At first this will have no real effect, because the firms are
relatively small. However, as more and more firms leave the industry,
unable to achieve norrnal profit, the industry supply curve will start
=
d
to shift to the left.
8
f
As the industry supply curve starts to shift from S towards S,, the o
3
industry price will begin to rise from P towards Pr. As the firms in -
the industry are pdce-takers, the price that they can charge will stafi
to rise and their demand curves will start to shift upwards. This
means that the losses that they had been making begin to get
smaller.

The industry

a Sr

g
t-),:AR':MR,
"1
P

qi-o qq,
Quantity Quantity
Figure 76 The movement from short-run losses to long+un normal profit

This process will continue as long as there are losses being made in the
industry. Eventually the industry supply curve reaches Sy, where the
price is Pr. At this point, the firms are "taking" the price of P1 and
the demand curve is Dr=ARr=MRr. We now find that the firms are
making normal profits, with the price per unit equal to the cost per
unit, i.e. Pr=Cr. Now the entrepreneurs of the firms in the industry
are satisfied, because they are exactly covering all of their costs,
including their opportunity costs. There would be no reason to leave
the industry as the firm could not do better elsewhere. However.
there is now no abnormal prolit to attract more firms into the
industry and so the industry is in a long-run equilibrium situation.
No one will now enter and no one will now leave. The outcome will
be a smaller industry producing only Q1 units, with slightly larger
firms, each producing qr units.

Long-run equilibrium in perfect competition

We can conclude that, in the long run, firms in perfect competition
will make normal profits. This is because, even if they are making
short-run abnormal prolits or short-run losses, the industry will
adjust with firms entering or leaving the industry until a nomal
profit situation is reached.
107
llIE 7 . Perfect competition

Ihe industry

Student workpoint 7.1

Be a thinker-explain and
illustrate
I Why is a firm in perfect
competition a "price-taker"?
2 Draw the following
E
o diagrams. Be sure to use a
o Quantity ruler and include accurate
Quantity
I
.9 Figure 77 Long-run equilibrium in perfect competition
labels. Also be sure that
your MC curves cross at
the minimum of AC.
In Figure 7.7, the firms are making normal profits in the long run. a A firm in perfect
They are selling at the price P, which rhey are taking ftom the competition earning
industry. MC is equal to MR so they are maximizing profits by abnormal profits
producing q, and at that output P is equal to AC so they are making b A firm in per{ect
normal profits. competition making
economic losses
In this situation there is no incentive for firms to enter or leave the
industry and so the equilibrium will persist until there is a change in c A firm in perfect
competition in its long-
either the industry demand curve or in the costs that the firms face. If
run equilibrium earning
this does happen, then firms will be making either short-run abnormal
normal profits
profits or short-run losses and the industry will once again adjust,
with firms €ntering or leaving until long-run equilibrium is restored.

Productive and allocative efficiency in

perfect competition
Productive efficiency
One of the efficienry measures used by economists is that o{ productive
efficiency. A firm is said to be productively efficient if it produces its
product at the Iowest possible unit cost (average cost). This is shown
in Figure 7.8.
At the output q, the firm in Figure 7.8 is able to produce at the most
efficient level of output, i.e. the lowest average cost of production.
This is the cost c. So q is known as the productively efficient level of
output.
We know fuom chapter 6 that MC always cuts AC at its lowest point, Output
and so we can say that the productively efficient level is where:
Figure 7.8 Productive efficiency
MC:AC
Productive efficiency is important in economics, because if a firm is
producing at the productively efficient level of output then they are
combining their resources as efficiently as possible and resources are
not being wasted by inefficient use.

Allocative efficiency
This measure o{ efficiency is sometimes also called the socially
optimum level of output.
Allocative efliciency occurs where suppliers are producing the
IOA optimal mix of goods and services required by consumers.
 7 :r, Perfect competition llIE
Price reflects the value that consumers place on a good and is shown
on the demand curve (average revenue). Marginal cost rellects the
cost to society of all the resources used in producing an extra unit of
a good, including the normal profit required for the lirm to stay in
business. If price were to be greater than marginal cost, then the
consumers would value the good more than it cost to make it. If both
sets of stakeholders are to meet at the optimal mix, then output
would expand to the point where price equals marginal cost.
Similarly, if the marginal cost were to be greater than the price, then =
d
society would be using more resources to produce the good than the
value it gives to consumers and output would fall.
3_.

Allocative efficiency occurs where marginal cost (rhe cost of producing

one more unit) is equal to average revenue (the pdce received for a
unit). Thus the allocatively efficient level of output is where:

The cost
tt _ The
-
valLre
to producers to consurners

Output Output

Figure 7.9 Allocative efficiency

In Figure 7.9, we can see the allocatlvely efficient level of output for
a firm with a normal demand curve and for a firm with a perfectly
elastic demand curve. In both cases we are looking for the output
where MC:AR -q, for the firm with a normal demand curve and
q2 when the demand is perfectly elastic.

Allocative efficiency is important in economics, because if a firm is

producing at the allocatively efficient l€vel of output there is a
situation of "Pareto optimality" where it is impossible to make one
person better off without making someone else worse off. We will
look at this in more detail when we consider market failure in
Chapter 12.

Productive and allocative efficiency in the short run in perfect

comPetition
If a lirm is making abnormal profits in the short run in perfect
competition, we can see from Figure 7.10 that although they are
producing at the profit-maximizing level of output, q (where
MC:MR), and the allocatively ellicient level of output, q, (where
MC:AR), the firm is not producing at the most efficient level of
output, qr (where MC:AC).

t09
!!!! t . Perfect competition
The industry

tE

D=AR=l\ilR

E
o Quantity
Quantity
.9
Figure 710 Productive and allocative e{ficiency with short-run Profits in perfect comPetition

In the same way, if a firm is making losses in the short run in perfect
competition, we can see from Figure 7.1 1 that although they are
producing at the profit-maximising level of output, q (where
MC=MR), and the allocatively efficient level of output, q, (where
MC:AR), once again the firm is not producing at the most efficient
level of output, qr (where MC=AC).
The industry The firm

Quantity Quantity

Figure 7ll Productive and allocatjve efficiency with short-run losses in perfect competition

Productive and allocative efficiency in the long run in Perfect

competition
As we can see in Figure 7.12, profit-maximizing firms in the long
run in perfect competition all produce at the lowest point of their
long-run average cost curves. Because we assume that there is pedect
knowledge in the industry, all of the firms will lace the same cost
curves, and so they are all selling at the same price and minimizing
their average costs by producing where MC=AC.
The indunry

ll=AR:MR

Quantity Quantlty
Quantity
I l0
Figure 712 Productive and allocative efficiency in the long run in perfect competition
 7, Perfect competit'on !l!E
Also shown in Figrre .12 is the fact that all oI the profit-rnaximizing
7

firms in the long run in perfect competition are also producing at the
allocatively efficient level of output, because they produce where
MC=AR.

Student workpoint 7.2

Fill in the spaces in the table below with either a yes or a no. =
6

@ffi@ryry
Short run

LonS run
3.

EXAMINATION QUESTIONS
Paper l, part (a) questions
t With the help of a diagram, explain how it is possible for
a firm in perfect competition to earn abnormal profits in
the short run. [10 morks]
2 With the help of a diagram, explain how it is impossible
for a firm in perfect competition to earn abnormal profits
in the long run. [to morks]
5 Explain whether or not a firm in perfect competition earning
abnormal profits is productively and allocatively efficient. [lo morks]

Paper l, essay question

I a Explain the characteristics of a perfectly comPetitive
market structure. [10 morks]
b Evaluate the extent to which it is possible for a firm in
perfect competition to earn abnormal profits. fi5 morksl

lll