Perfect competition markets

Perfect competition is at one extreme of the market structure spectrum and involves a large
number of firms and homogeneous products.

Perfect competition is an economic term that refers to a theoretical market structure in which
all suppliers are equal and overall supply and demand are in equilibrium. For example, if
there are several firms producing a commodity and no individual firm has a competitive
advantage, there is perfect competition. In this ideal market, quality is comparative across
firms, and buyers can purchase the product for the lowest possible price.

The key characteristics of perfect competition are that there are a large number of firms, and
the products are homogeneous and identical. The consumer has no reason to express a
preference for any particular firm because of this. There is freedom of entry and exit into and
out of the industry or market. Firms are price takers and have no control over the price they
charge for their products. Each producer supplies a very small proportion of the total industry
output. Finally, consumers and producers have perfect knowledge about the market. If one
firm changes an aspect of the product, everyone knows.

Characteristics of Perfect Competition

Perfect competition is a theoretical market structure with several characteristics. Economists
studying macroeconomics and microeconomics use these ideal constructs as benchmarks to
compare the operation of real markets:

1. Homogenous products: In perfect competition, all firms produce the same product,
making it a commodity. The basic aspects of the product are consistent, including the
overall quality.
2. Price takers: The market price is equal to the marginal cost of production, and no
single firm has the power to charge more. The other firms will undercut any firm
charging higher prices. Market demand is stable over the long run, so all producers
have similar market share.
3. Profitability: While there may be short-run profits for individual firms quicker to
market, the long-run equilibrium of perfectly competitive markets means that,
eventually, no firm makes economic profit. New producers entering the market bring
down the demand curve, and no firm is able to increase product prices to sustain
profits.
4. Free entry: There are no barriers to entry or exit in a perfect competition. Any startup
firm can be a competitive firm by producing the product at the same marginal cost as
others. Moreover, leaving the market incurs no cost to producers.
5. Rational buyers: In this theoretical market, all buyers make rational purchases to
maximize their economic utility and seek a lower price. Also, these buyers have
perfect information about the products they are purchasing, meaning they know the
price points across different firms.
6. Mobile resources: The labor and the capital involved in a perfect competition are
mobile and can move wherever they need or want to, with no associated cost.
7. Regulation: In a perfectly competitive market, the process of making, selling, or
using goods does not affect any third party. Thus, there is no need for government
licensing or regulation.

1
3 Examples of Perfect Competition
Real markets are usually somewhere between perfect competition and its theoretical
opposite, monopolies, where a single producer has complete control of a market. Real-world
examples that resemble the perfect competition ideal include:

1. 1. Farmers’ markets: The average farmers’ market is perhaps the closest real-life

example to perfect competition. Small producers sell nearly identical products for
very similar prices. The entry and exit of some vendors does not change the overall
marketplace, and the prices and product information is clear and fairly uniform.
2. 2. Emergent tech: Often, as in the case of early online retailers, there are no clear
market advantages, and many tech companies offer basically the same services for
similar prices. An example is early social media companies—several new firms
offered comparable services for virtually the same price.
3. 3. Discount brands: There may be cheaper versions of the same product in
supermarkets, such as cereal made by the different brands. None of these substitutes
will be significantly different in quality or price, so they resemble a perfectly
competitive market.

Now, let’s look at perfect competition graphically. The industry price is determined by the
demand and supply of the industry as a whole. The firm is a very small supplier within the
market and has no control over price. They will sell each extra unit for the same price.
Therefore price = MR = AR, which is represented by perfectly elastic demand (ie a horizontal
curve).

AC – Average cost AR – Average revenue MC – Marginal cost MR – Marginal revenue P –

Price Q1 – Quantity produced
The MC is the cost of producing additional (marginal) units of output. It falls at first due to
the law of diminishing returns, then rises as output rises. The average cost curve is the
standard U-shaped curve. MC cuts the AC curve at its lowest point because of the
mathematical relationship between marginal and average values. Given the assumption of
profit maximisation, the firm produces at an output where MC = MR (marked as Q1 on the
graph). This output level is a fraction of the total industry supply, because every firm in the
market is also doing this. At this output, the firm is making normal profit. This is a long-run
equilibrium position.

2
Conditions of Price and Output Determination Under Perfect Competition

1.) A marginal income must be at least equal to the marginal cost, that is, MR=MC. If MR is
higher than MC, there is always a reason for the company to increase production even more
and profit after selling extra costs instead of reducing output, as the additional unit is more to
the cost than revenue. Profits are maximum only at the point where MR=MC.

2.) The MC Curve should cut the MR curve below.

Price Determination and Equilibrium of the Firm in the Short Run

A company is a cost taker instead of an individual price maker in the marketplace. The
difference in the role of industry competitive to the role of a company in determining price
and output determination under perfect competition is apparent in the below diagram:

1) Abnormal Profit/Supernormal Profit

A business may make unusual profits at the equilibrium level of output when its average
earnings exceed the cost of production by an average. In diagram 6.7, the firm’s equilibrium
is at point E when the MC curve meets with the MR curve. When the firm is at OP prices, the
3
company generates OQ output. The company’s average income (AR) equals EQ when it
produces OQ output. Its average cost (AC) will be BQ because AR is higher than AC. Firms
get abnormal profits. In the end, companies experience abnormal profits (EB) in unit output.
It is the total profits (PABE), the per-unit profit divides by total output.

2) Losses

In the event of an equilibrium output, firms can suffer losses. A seller might not recoup a
portion of fixed costs in the short term. Despite these losses, the company may choose to
produce to cover its average variable costs. In figure 6.8. The equilibrium value and, at this
point, AR=EQ while AC=BQ as BQ is greater than EQ. The firm earns BE per loss unit, and
the total loss is the amount of ABEP.

3) Normal profits or Break-Even

If the company only covers its total costs, it makes normal profits.
Here AR = ATC

Figure 6.9 illustrates how MR=MC at E. The final output of the equilibrium is called OQ.
Since AR=ATC or OP=EQ, the company gets normal profits.

4
Conclusion of Price and Output Determination Under Perfect Competition:

I) If AR is equal to AC, the company will earn normal profits (i.e., break-even)
II) IfAR > AC, the firm will receive normal profits.
II) If AR is less than AC the company will incur a loss.
IV) If AR is less than AVC the company will cease production.

Price and Output Determination Under Perfect Competition and Equilibrium in the
Long Run

The ability to enter or leave firms is not a problem in a highly competitive market. The firms
that are inefficient are then able to lose money and close the business or improve their
effectiveness. New companies attract profit-driven firms to establish because of the entrance
of new producers, the quantity of the commodity rises, and the cost of the commodity falls.

All firms are at break-even because of the loss of profits. It results from the long-term
equilibrium between the industry and firm in a perfect market. Also, price and output
determination under perfect competition, whereas all firms break even and make regular
profits in the long term. Firms operate in a zero-loss-no-profit scenario where AR=AC is
graphically plots in Figure 6.10.

In figure 6.10, in this output stage, the price and output determination under perfect
competition is as the average revenue and average cost are the same as QS, while OQ
represents the equilibrium value. Because of this, the firm will only earn regular profits. In
this case, as the average cost is low, the average and marginal costs will remain the same, so
the long-term equilibrium conditions for a business will be: MR=LMC=LAC= Price.