Perfect Competition

The Concept of Perfect Competition

Assumptions: Many Buyers and Sellers, Perfect Information, Homogenous Product, No barriers to
entry or exit

Many Buyers and Sellers: infinitely many buyers and sellers, each buyer and seller is small, any action
from a buyer or seller is too small to affect the market

Perfect Information: buyers and sellers know the market price. Firms raises price above market
price. All buyers know that the price is lower at other firms so that firm loses all customers.

Homogenous Product: all firms produce exactly the same product. There is no non-price
competition. Buyers chose where to buy based solely upon price. Firms face exactly the same costs
of production.

No barriers to entry and exit: firms can enter and leave the industry without cost. When there are
supernormal profits, firms enter the market. When firms are making a loss, some will leave the
market. Entry and exit controls market supply.

Implications: firms are price takers – firms accept the market price, can sell as much as they want at
this market price

E.g. Firm charges more than market price – customers buy from other firms or if Firm charges less
than the market price – why? Make more profit from charging the market price

Firms face a perfectly elastic demand curve – perfectly elastic – any change in price causes an infinite
change in demand. Perfect Competition – increasing price above market price reduces demand to
zero.

In the long-run, firms make only normal profits

Supernormal Profits – incentivises firms to enter the market – increasing the market supply –
decreases market price – reduces profits – normal profits

Economic Loss – in the long-run, firms leave the market – reducing market supply – increasing
market price – increasing profits – normal profits

In reality, perfect competition is a theoretical concept only – some markets approximate it, but
never perfectly – useful as a comparison tool

Diagrammatic Analysis of Perfect Competition

Each firm is too small to affect the market price. Firms do not differentiate to encourage demand.
Consumers have perfect information.

Short Run – Effect – Long-Run

Firms make normal profits – firms neither leave nor join market – firms make normal profits

Firms make supernormal profits – firms join market – firms make normal profits

Firms make economic loss – firms leave market – firms make normal profits

Rise in costs – increase in price due to change in costs – supply shifts inwards – market price rises
Demand shifts outwards – supernormal profit – supply shifts outwards – market price falls – normal
profit

Demand shifts inwards – economic loss – supply shifts inwards – market price rises – normal profit

Horizontal MR=AR Curve – derived from market equilibrium price

Profit Maximising – firms produce when MR=MC

Supernormal profits and Economic losses – incentivises firms to leave or enter the market

Changes in number of firms – shift in supply curve

Assessing Perfect Competition

Productive Efficiency – producing at the lowest possible average cost – produces at the bottom of
the AC curve – productively efficient in the long run

Allocative Efficiency – occurs where there is an optimal allocation of resources – occurs when P = MC
– Allocative Efficient in the long run

In reality, industries are never perfectly competition – some may approximate perfect competition –
useful for measurement

The closer an industry is to perfect competition, the closer it is to the efficiency results.

In real competitive markets – competition encourages firms to be ‘better’ – reduces prices to normal
profits – encourages firms to reduce costs – improve service – improve products

Where there are externalities present, private costs and benefits do not equate to social costs and
benefits. P = MC, MB = MC, MPB = MPC, MSB ≠ MSC – where there are externalities present, perfect
competition is not allocatively efficient

Long Run Economic Growth – R&D promotes innovation and invention – drives long-run economic
growth

firms only make normal profits – little money for R&D – P.C. may not encourage innovation and
invention – may not drive economic growth through investment