Perfect Competition

Characteristics

 Large number of buyers and sellers – price takers

 Homogeneous product
 Free entry and exit
 Perfect information

Example: vegetable seller

Short run and Long run Profit Maximisation

 Principle of Profit Maximisation – choose that output which maximised profit

 First order condition implies: MR=MC
 Since perfectly competitive firm is a price taker (price is determined by market forces of
industry demand and supply), P=MR

Short Run

 Short run profit maximisation of a perfectly competitive firm gives the profit maximising
condition as P(=MR)=MC and the firm chooses the corresponding output level
 At that output level, the firm may break even (if P=AC), earn supernormal profit (P>AC) or
incur losses (P<AC)
 If the firm makes losses, the firm needs to decide whether it should continue to produce or
shut down
 The firm compares whether P may cover AVC. If P<AVC it should shut down. Since P=MC as
well, the shutdown point is P=min. AVC.
 Price is determined by forces of industry demand and industry ss.

Long Run

 In the long run, the firm may vary all inputs and choose the plant size.
 Entry and exit are possible in the long run
 Firm continues to equate P=LMC to get the profit maximising output
 If a typical firm earns supernormal profit, in the long run, new firms enter the industry. SS
increases and P starts falling. It falls till P becomes equal to LAC and supernormal profit
becomes zero
 Hence, P=LMC=LACmin is the profit maximisation condition and here, at this q, the firm
earns zero economic profit. However, it may earn accounting profit
 This implies that the firm earns a normal return, which it could have earned elsewhere

Efficiency and Deadweight Loss

 In a perfectly competitive setup, consumer and producer surplus is maximum and it is the
most efficient form of market
 If perfectly competitive price and output are not achieved or intervened (say, through taxes),
the efficiency is not achieved and there are deadweight losses.