Perfect competition is a market structure in which many firms sell identical products, and no barriers to entry into the market exist for new potential sellers.
Many sellers: each seller represents a very small portion of the overall market. Since supply and demand in the overall market set the equilibrium price and quantity, one small firm cannot influence the market price. Each firm must accept whatever market price exists. Because of this, firms in perfect competition are called price takers.
Identical products: you may see this referred to as standardized products, or homogeneous products. Consumers have no preference for a product from one firm over the product of any other firm. The products of each firm are perfect substitutes for one another. There is no difference in quality. Consumers would always choose to purchase the product from the lowest priced source. Firms cannot differentiate products in any way, including packaging or advertising.
Easy entry and exit: new firms can enter the market freely. This implies that economies of scale do not exist. Existing firms can just as easily stop production and exit the market.
Buyers know where the product is being sold, and at what price. Sellers know the strategies used by their competitors, including price and quantity decisions.
Perfect competition is considered to be the most efficient market structure within any given equilibrium situation. Other market structures have some long term advantages over perfect competition, such as: economies of scale, consumer choices, and incentives for advances in technology.
Within any given equilibrium, perfect competition is the most efficient market structure. The reasons for this efficiency can be seen by understanding how economists define efficiency.
Types of efficiency:
Productive efficiency: using the least cost combination of resources to produce a specific output level.
Allocative efficiency: producing what the consumers want at a price equal to marginal cost.
Economic efficiency: a situation in which both productive efficiency and allocative efficiency exist.
Efficiency means having the maximum benefit at the least cost.
In a market (as opposed to an individual firm) supply and demand diagram, the intersection of the supply and demand curves will set the equilibrium price and quantity.
In perfect competition, with each firm being a price taker, firms cannot stray from this equilibrium price. The individual firm will produce a quantity so that the sum of all firms will produce the quantity that equals market equilibrium. The least cost component of efficiency will be a product of this market equilibrium.
The maximum benefit component of efficiency can be seen from the market supply & demand diagram. Benefit in this context refers to the concept of surplus:
Consumer surplus refers to the difference between what consumers are willing to pay and the amount that they actually pay. The amount that they are willing to pay is based on the demand curve. The amount that they actually pay is based on the market equilibrium price. On a supply & demand diagram, consumer surplus is measured by the area that lies both below the demand curve and above the market price.
Producer surplus refers to the difference between the price the sellers are willing to sell the product for and the price that the sellers actually receive. The amount that they are willing to sell for is based on the supply curve. The amount that they actually receive is based on the market equilibrium price. On a supply & demand diagram, producer surplus is measured by the area both above the supply curve and below the market price.
Total surplus is the sum of consumer surplus and producer surplus. Efficiency is achieved by maximizing total surplus.
On the market supply & demand diagram, the only area that can potentially be a part of total surplus is the area defined by the triangle formed by these three points: market equilibrium, the point where the demand curve intersects the price axis, and the point where the supply curve intersects the price axis. Perfect competition is the only market structure that includes this entire area in total surplus. This makes perfect competition the most efficient market structure.
The most noticeable distinguishing characteristic of an individual firm in perfect competition is the shape of the demand curve it faces. The demand curve is a horizontal line set at the market price.
Even though the market demand curve is downward sloping, each individual firm is too small to influence the market price. Since the firm is a price taker, and must accept the market price instead of setting its own price, the demand curve is set at the market price.
The individual firm will set its quantity of output at the level that will maximize profits at the given market price.
**Note: the following discussion assumes some knowledge of terminology defined in the section entitled Revenue, Costs, & Profit. **
Why is the individual firm in perfect competition a price taker?
Refer back to the characteristics of perfect competition as a market structure: many sellers, identical products, ease of entry, and perfect information.
If an individual firm tries to sell at a price higher than the given market price, it would lose its customers. Given these characteristics, the customers would buy from the sellers who are selling at the lower market price. The firm that sets a price that is above the market price will sell nothing.
An individual firm also would not set a price that is below the market price. The individual firm can set its quantity at an output level that maximizes profit. It can sell all that it wants at the market price. It would have no reason to sell the same quantity at a lower price. Besides, a lower price would mean that the profit maximizing output level would be lower, not higher. This is because of the shape of the marginal cost curve.
In any market structure, profit is maximized at the output level where marginal revenue (MR) is equal to marginal cost (MC). The relevant portion of the marginal cost curve is the upward-sloping portion above average variable cost.
The marginal revenue curve is identical to the horizontal demand curve. This is because a price taker will accept the same price regardless of the level of output.
In perfect competition, then, price equals marginal revenue. Since profits are maximized when marginal revenue is equal to marginal cost, the profit maximizing equation for a perfectly competitive firm becomes:
Perfect competition is the only market structure where this equation holds true.
Why is the relevant portion of the marginal cost curve above average variable cost (AVC) instead of average total cost (ATC)? After all, if a firm doesn't cover total costs, it suffers a loss.
Because fixed costs cannot be avoided in the short run.
Fixed costs do not exist in the long run. In the long run, average variable cost equals average total cost, and the firm will produce only if it can cover all costs.
But in the short run, with the existence of fixed costs, average variable cost will be below average total cost. If the market price (same as marginal revenue) is between AVC and ATC, the firm will suffer more losses by shutting down than it would if it continued to produce. This is because fixed costs do not vary with the level of output. They have to be paid whether the firm produces or not.
Fixed costs become irrelevant to the decision of whether to shut down or not. For example, suppose the market price is $1.00, the current output level is 1,000, fixed costs are $500, and variable costs are $0.75 per unit.
At this output level, total revenue is $1,000. Variable costs are 1,000 x $0.75, or $750. With fixed costs at $500, total cost is $1,250. The firm is losing $250 by producing this level of output ($1,000 minus $1,250). But if it shut down, it would still have to pay the entire fixed cost of $500. It would lose $500 by shutting down. Producing and losing $250 is preferable to shutting down and losing $500.
A competitive firm should shut down in the short run if it cannot find an output level that will allow it to cover total variable costs. Otherwise, it should continue to produce.
This makes the minimum point of the AVC curve the shutdown price. The breakeven price is the minimum point of the ATC curve.
The supply curve for a competitive firm, then, is the portion of the marginal cost curve that lies above the average variable cost curve.
Long run equilibrium in perfect competition is reached when no economic profits exist. Economic profits equal zero.
To understand this, remember that equilibrium is a situation in which no incentives for change exist. Also remember that normal profits represent an opportunity cost.
Normal profits are required in order to keep a firm from choosing a different option than the current one.
If economic profits (profits above normal profits) exist, then the market becomes more profitable than other markets or opportunities. With ease of entry as a condition of perfect competition, this will be an incentive for new firms to enter the industry.
If economic losses (profits less than normal profits) exist, then the market becomes less profitable than other markets or opportunities. With ease of exit, this becomes an incentive for existing firms to exit the industry.
Only when economic profits are equal to zero will no incentives for change exist, allowing equilibrium to occur.
With ease of entry and exit a characteristic of perfect competition, economic profits will cause new firms to enter the market. The market supply curve will shift to the right, indicating an increase in supply. This will create a new market price that is lower than the previous market price. The lower market price will eliminate the economic profits, and equilibrium can be reached.
Economic losses will cause existing firms to exit the market. The market supply curve will shift to the left, indicating a decrease in supply. This will create a new market price that is higher than the previous market price. The higher market price will eliminate economic losses, and equilibrium can be reached.