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Chapter 8
Perfect
Competition
© Edco 2012. Positive Economics
Assumptions/Characteristics of
Perfect Competition
 There are many buyers in the market.
 There are many competitive sellers in the market.
 Each firm is a price taker, i.e. it accepts the price as
it is set on the market, and each firm supplies such a
small fraction of the market that it cannot influence
the market price.
 The goods are homogenous.
© Edco 2012. Positive Economics
Assumptions/Characteristics of
Perfect Competition (Continued)
 There is freedom of entry to and exit from the
industry/there are no barriers to entry or exit within
the industry.
 Perfect knowledge exists as to prices and profits.
 Each firm seeks to maximise profits (where MC = MR).
 No collusion exists on the market.
 Firms face a perfectly elastic supply of factors of
production.
© Edco 2012. Positive Economics
Why Don’t Firms in Perfect Competition
Engage in Advertising?
 Homogenous goods
 Increased cost and no additional revenue
 Benefits the entire industry
 Perfectly elastic demand
© Edco 2012. Positive Economics
Perfect Competition:
The Short Run
 Average revenue is equal to marginal revenue,
which is the same as price.
 This is the horizontal, perfectly elastic demand
curve of a firm in perfect competition.
 A company will produce the quantity where MC =
MR because at this stage, the company covers its
variable cost and is making extra profits
(supernormal profit). This happens because AR is
greater than AC.
© Edco 2012. Positive Economics
Perfect Competition:
The Short Run (Continued)
 The SNP earned in the short run will attract new
firms to enter the market.
 As more firms enter the industry, the market
supply curve will shift to the right.
 Market price will fall from P1 to P2, eliminating SNP
to a point where only normal profit is being
earned.
© Edco 2012. Positive Economics
Perfect Competition:
The Long Run
 There will be sufficient time for new firms to enter
or leave the market.
 New firms will be attracted because of
supernormal profits. Existing firms will leave if
normal profits are not being earned.
© Edco 2012. Positive Economics
Perfect Competition:
The Long Run (Continued)
 Eventually there will be the right number of
firms in the industry with each firm in
equilibrium where AC = AR.
 The AR curve will be tangent to the AC curve,
indicating that all costs are covered and only
normal profit is being earned.
© Edco 2012. Positive Economics
Supply Curves
in Perfect Competition
 A profit-maximising firm will supply output where
MC = MR and MC is increasing at a faster rate
than MR.
 The short run supply curve of a firm in perfect
competition is that part of the MC curve which lies
above the lowest point of the average variable cost
curve.
© Edco 2012. Positive Economics
Supply Curves in Perfect
Competition (Continued)
 The long run supply curve of a perfectly
competitive firm is that portion of its marginal
cost curve which lies above the lowest point of
its average cost curve.
 In the long run, marginal cost is equal to price
(MC = P). This is unique to perfect competition
only.
© Edco 2012. Positive Economics
Benefits of Perfect Competition
 Produces at point of lowest cost
 Minimum prices
 No advertising
 Efficiency is encouraged
© Edco 2012. Positive Economics
Disadvantages of
Perfect Competition
 No scope for economies of scale
 Little choice for consumers
 No research and development
 No incentive to develop new technology
© Edco 2012. Positive Economics
Summary
Short run
Long run
Produces where MC = MR
Produces where MC = MR
Must cover AVC
Must cover all costs, i.e. AC
SNP may be earned
(AR > AC)
Normal profit earned
(AR = AC)
Produces where
MC = MR = AC = AR
© Edco 2012. Positive Economics