PERFECT

COMPETITION
Economics – Course Companion

Blink & Dorton, 2007, 95-104

 Introduction to Perfect Competition

• 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.
• It is very important, because once we
understand the theoretical assumptions it
makes it easy to move towards models of
markets that are more realistic.
 The Assumptions of
Perfect Competition
• The industry is made up of a very large number of firms.
• Each firm is so small, relative to the size of the industry,
that it is not capable of altering its own output to have a
noticeable effect upon the output of the industry as a
whole.
• A firm cannot affect the supply chain of the industry and
so cannot effect the price of the product.
• Individual firms have to sell at whatever price is set by
demand and supply in the industry as a whole. The
individual firms are “price takers”
 The Assumptions of
Perfect Competition
• The firms all produce exactly identical
products. Their goods are “homogeneous”.
• It is not possible to distinguish between a
good produced in one firm and good produced
in another.
• There are no brand names and there is no
marketing to attempt to make good different
from each other.
 The Assumptions of
Perfect Competition
• Firms are completely free to enter or leave
the industry.
• This means that firms already in the industry
do not have the ability to stop new firms from
entering it and are also free to leave the
industry, if they wish.
• There are no barriers to entry or barriers to
exit.
 The Assumptions of
Perfect Competition
• All producers and consumers have a perfect
knowledge of the market.
• The producers are fully aware of market price,
costs in the industry and the workings of the
market.
• The consumers are fully aware of prices in the
market, the quality of the products and the
availability of goods.
Perfect Competition in the Real World

• Although we generally say the perfect

competition is completely theoretical, there
are some industries in the world, that get
quite close to be perfectly competitive
markets.
• The industries most often used an examples
by economists are usually agricultural
markets.
 Agricultural Markets and
Perfect Competition
Case Study: Wheat European Union
• There are some large wheat farms in the EU, but they are
very small in relation to the whole wheat-growing industry.
• An individual farm could increase its output many times over
without have any noticeable effect on total supply of wheat in
the EU.
• A single farm is not able to affect the price of wheat in the EU,
since it cannot shift the industry supply curve.
• The farm has to sell at whatever the industry price is.
• In addition wheat is wheat, and so there is no way to tell one
farm’s wheat from another.
 Agricultural Markets and
Perfect Competition
Case Study: Wheat European Union
Where the Perfect Competition model fails:
• Although firms are relatively free to enter or leave the
wheat industry, there are significant costs in doing
either and these may affect the decisions of firms.
• Although information is fairly open in the industry, it is
unlikely that producers and consumers will have perfect
knowledge.
• The wheat industry in the EU may be close to being a
perfectly competitive market, but not a precise one.
 Demand Curves for the Industry and the
Firm in Perfect Competition
• 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.
• It is possible to make assumptions about the
demand curve for both the firm and the
industry.
The industry in perfect competition will face normal demand and supply curves. We
would expect producers to wish to supply more at higher prices and we would expect
consumers to demand less as price rises. The industry price would be P and the quantity
demanded Q. For individual firms they have to sell at the industry price P, because they
are price-takers. If they try and sell at a higher price, then consumers buy the product
from another firm, since the goods are homogenous and there is no difference in looks or
quality. If they sell at the industry price, the firm can sell as much as it wants, because it
will not affect the industry price. The firm has to take the price set by the industry. The
firm selling at the industry price, faces perfectly elastic demand at this price.
 Profit Maximisation for the firm in Perfect
Competition
• Firms maximise profits when they
produce at the level of output where
MC = MR.
• For perfect competition, it possible
to examine the marginal cost curve.
PROFIT MAXIMISATION FOR THE FIRM IN PERFECT COMPETITION
The firm takes the price P from the industry and because the demand is
perfectly elastic P=D=AR=MR. Profit is maximised where MC=MR, which is at
the level of output q. 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. If it could, it would be large enough to shift the
supply curve and thus alter the industry price.
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
2. Short Run losses
SHORT RUN ABNORMAL PROFITS IN PERFECT COMPETITION

The firms in the industry are making abnormal profits in the short
run. This mean they are more than covering their total costs,
including opportunity costs. The firm is selling at the industry price,
P, and maximising profits by producing at the quantity q, where
MC=MR. A q, the cost per unit, average cost, is C and the revenue
per unit, average revenue, is P. Average cost is less than the
average revenue and the firm is making an abnormal profit of P-C
on each unit. The shaded area shows the total abnormal profits.
SHORT RUN LOSSES IN PERFECT COMPETITION

In this graph the firms in the industry are making losses in the short run. This
means they are not covering their total costs. The firm is selling at the
industry price P, and is maximising 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-maximising” level of output, because any other output would
create a greater loss. In effect they are loss minimising.
 Movement from Short Run to Long Run in
Perfect Competition
• If firms are making either short-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 Profits
• When abnormal profits are being recorded, firms
outside the industry that could also produce the
good will start to enter the industry.
• At first this will have no real effect, 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.
THE MOVE FROM SHORT RUN ABNORMAL PROFIT TO LONG RUN NORMAL PROFIT

As the industry supply curve starts to shift from S towards S 1. the industry price will begin to
fall from P towards P1 . As the firms in the industry are price-takers, the price that they
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”. The
process will continue as long as there are abnormal profits in the industry. Eventually the
industry supply curve reaches S1. At this point, the firms are taking the price of P1 and the
demand curve is D1 = AR 1 = MR1 As a result firms are making normal profits with the price
per unit equal to the cost per unit. Eg: P1 = C1 Entrepreneurs of the firms in the industry are
satisfied because they are covering their opportunity costs.
 Normal Profits lead to
Market Equilibrium
• As there is now NO abnormal profits to attract
more firms into the industry, the industry is in
a long run equilibrium situation.
• Non one will now enter the and non one will
now leave.
• The output is a much bigger industry
producing at Q1 units, with smaller firms, each
producing Q1 units.
 Short Run Losses to
Long Run Normal Profits
• Some firms in the industry will, after a time,
start to leave the industry.
• Aft 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 normal profits, the
industry supply curve will shift to the left.
THE MOVEMENT FROM SHORT RUN LOSSES TO LONG-RUN NORMAL PROFIT

As the industry supply curve starts to shift from S towards S1 the industry price
will start to rise from P towards P1. As the firms in the industry are price-takers,
the price that they can charge will start 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. This process will continue as along as there are losses being made in
the industry. Eventually the industry supply curve reaches S 1 where the price is
P1. At the point the firms are `taking` the price of P1 and the demand curve is
D1=AR1 = MR1. Firms are now making normal profits, where the price per unit
equal to the cost per unit, eg: P = C
 Normal Profits lead to
Market Equilibrium
• Just as in the previous example, normal profits
lead to market equilibrium because firms are
covering all their costs, including opportunity
costs.
• There would be no reason to leave the industry
as the firm could not do better elsewhere.
• The outcome will be a smaller industry producing
only Q1 units, with slightly larger firms, each
producing q1 units.
 Long-Run Equilibrium in
Perfect Competition
Summary
• In the long run firms in perfect competition
will make normal profits.
• This is because, even if they are making short-
run abnormal profits or short-run losses, the
industry will adjust with firms entering or
leaving the industry until a normal profit
situation is reached.
LONG RUN EQUILIBIRUM IN PERFECT COMPETITION – SUMMARY
Firms are selling at P, which are they are taking from the industry.
MC is equal to MR, so they are maximising profits by producing q
and, at that output P is equal to AC, so they are making normal
profits.
 Why would equilibrium change?
• If the industry demand curve changes or their
is a change in the costs that the firm faces,
short run abnormal or profits or losses may
result. BUT...
• The industry will once again adjust, with firms
entering or leaving until long run equilibrium
is established.
 Productive and Allocative Efficiency in
Perfect Competition
• One of the efficiency measures used by
economists is that of productive efficiency.
What is productive efficiency?

• A firm is said to be productively efficient if it

produces its product at the lowest possible
unit cost (average cost)
PRODUCTIVE EFFICIENCY

At the output q, the firm

is able to produce at the
most efficient level of
output – the lowest
average cost of
production. This is the
cost c. So q is known as
the productively efficient
level of output. We know
that MC always cuts the
AC at its lowest point.
The Productively Efficient
Level is MC=AC.
 Productive Efficiency
• 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.
• Resources are not being wasted by inefficient
use.
 Allocative Efficiency OR
The Socially Optimum Level of Output (102)
• Allocative efficiency occurs when suppliers are
producing the optimal mix of goods and services
required by consumers.
• Price reflects the value that consumers place on a
good and is shown on the demand curve (average
revenue)
• Marginal cost reflects the costs to society of all the
resources used in producing an extra unit of a good,
including the normal profit required for a firm to stay
in business.
 Allocative Efficiency OR
The Socially Optimum Level of Output (102)
• 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 society would be using more
resources to produce the good than the value it gives
to consumers and output would fall.
 When does allocative
efficiency occur?
• Allocative efficiency occurs where marginal
cost (the cost of producing one more unit) is
equal to average revenue (the price received
for a unit).
ALLOCATIVE EFFICIENCY

The above graphs show the allocatively efficient level of output for a
firm with a normal demand curve and for a firm with a perfectly
elastic demand curve. For both case the required output will be
MC=AC.
 Allocative Efficiency
• Allocative efficiency is important in Economics,
because if a firm is producing at the
allocatively efficient level 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.
PRODUCTIVE AND ALLOCATIVE EFFICIENCY WITH SHORT RUN
PROFITS IN PERFECT COMPETITION

If a firm is making abnormal profits in the short run, they are

producing at the profit maximising level of output q (where in
MC=MR) and the allocatively efficient level of output q 2 (where
MC=AR) . However, the firm is not producing at the most
efficient level of output, q1 (where MC=AC).
PRODUCTIVE AND ALLOCATIVE EFFICIENCY WITH SHORT RUN LOSSES
IN PERFECT COMPETITION

If a firm is making losses in the short run, they are producing at

the profit maximising level of output q (where in MC=MR) and
the allocatively efficient level of output q 2 (where MC=AR) .
However, the firm is not producing at the most efficient level of
output, q1 (where MC=AC).
PRODUCTIVE AND ALLOCATIVE EFFICIENCY IN THE LONG RUN IN PERFECT COMPETITION

Profit maximising firms in the long run in perfect competition all produce at the
lowest point of their long run average cost curves. As we assume that there is
perfect knowledge in the industry, all of the firms will face the same cost curves.
They are all selling at the same price and minimising their average costs by
producing where MC=AC. It should also be noted that all of the profit maximising
firms in the long run are also producing at the allocatively efficient level of output,
where MC=AR.
 CHECK LIST:
SHORT RUN VS LONG RUN – PERFECT COMPETITION

Perfect Abnormal Looses Allocatively Productively

Competition Profits possible? efficient? efficient?
possible?
Short
Run
Long
Run
 EXAMINATION QUESTIONS
Short Response Questions
1. With the help of a diagram, explain how it possible
for a firm in perfect competition to earn abnormal
profits in the short run.

2. With the help of a diagram, explain how it is possible

for a firm in perfect competition to earn abnormal
profits in the long run.

3. Explain whether or not a firm in perfect competition

earning abnormal profits is productively and
allocatively efficient.
 EXAMINATION QUESTIONS
Essay Questions
1a. Explain the characteristics of a
perfectly competitive market
structure.

1b. Evaluate the extent to which it is

possible for a firm in perfect competition to
earn abnormal profits.