Download Perfect Competition

Perfect Competition
Assumptions/Features
1. A very large number of buyers and sellers, all of whom are small-scale relative to the size of
the market.
There is an extremely large number of buyers and sellers, each of whom contributes only a small
fraction of market supply/demand.
2. No one firm can dominate the market
This means that no individual firm can significantly affect the market price. Each firm is a price
taker and must accept the prevailing market price.
This means that the firm faces a horizontal Demand/AR curve.
3. Products are homogenous – completely identical
There is absolutely no difference between the products on sale. The closest example in real life is
unpackaged agricultural produce – one stick of celery is pretty much the same as another.
4. Freedom of Entry and Exit.
There are no restrictions preventing firms moving easily into and out of the industry.
5. Perfect Knowledge
Producers and consumers are fully aware of prices, profits being made and production technologies.
6. Profit Maximisation
Each firm will try to maximise profits (by producing where MC = MR)
Diagrams
NOTE!!
The actual diagrams are deliberately too small (so the whole thing fits on a single A4 page). In an exam draw them much bigger!
Short Run
AR/MR Curves
In Perfect Competition, the average revenue (AR)/demand curve facing the firm is horizontal. The reason for
this is that the firm can sell any output at the prevailing market price. And because each additional unit can
be sold at this price, the AR curve also equals the marginal revenue (MR) curve.
AC/MC Curves
These are as usual, with the U-shaped AC curve, and MC cutting AC at its lowest point.
Equilibrium Output
Because we assume each firm tries to maximise profits, they will produce where MC = MR. This gives the
equilibrium quantity, Q. Reading up from this point to the AC curve gives the cost per unit at this point, and
similarly reading up to the AR curve gives the revenue per unit.
Profit Levels
The difference between AC and AR is Super Normal Profit. The total Super Normal Profit earned is marked
by the shaded rectangle in the graph below. SNP is any profit over and above the minimum profit needed to
make it worth the firm’s while staying in the industry.
Transition from Short to Long Run
The market price for the whole industry is determined by the intersection of the market demand and supply
curves (as normal)
The Super Normal Profits from the Short Run attract more firms into the market. They know about these
profits, and there is nothing to stop them entering the industry. As a result, the supply increases (from S1 to
S2 in the graph below). This causes the prevailing market price to fall (from P1 to P2)
If too many firms enter the industry, the price falls so far that firms fail even to earn Normal Profit and some
firms leave the industry. Eventually market supply settles at a level that gives a price where firms can earn
Normal Profit, but no more than that.
Long Run
In the long run, the AR/MR/demand curve has fallen to a level where it intersects with the intersection point
of AC and MC.
The firm produces at this quantity because MC = MR here. At this point AC = AR, so Normal Profit, but no
more is being earned.
Thus, in Long Run Perfect Competition:
MC = MR = AR = AC
This is the only market in which this situation occurs.
(This is also extremely efficient because AC is at its minimum)