Perfect

Competition
Group 5
What is Perfect Competition?
Perfect competition describes a market structure where competition is at its greatest possible level.
To make it more clear, a market which exhibits the following characteristics in its structure is said
to show perfect competition:

 Homogenous Products (all perfect substitutes)

 All firms have access to factors of production
 Large number of buyers & sellers
 Free entry and exit to/from the market
 Perfectly elastic demand curve
 Perfect knowledge/information
 Profit maximization assumed as key objective
Main features of Perfect Competition
Large number of buyers and sellers
Homogenous products
Free entry and exit
• Each sellers sell a small portion total
• Single sellers has no influenced on
market
• Sellers are price takers
• Identical products
• Same price and cost
• There is no government or other
control
Perfect knowledge about market • Perfect knowledge about the
prevailing price.

• Large number of firm, so no

Absents of selling cost and transport or selling cost
Advertising cost • Homogenous product, so no
advertising needed

A single price of product • A price is determined in the industry

Example: Agricultural Products

Conditions for Perfect
Competition
Firms are in perfect competition when the following conditions occur:

1. Many firms produce identical products;

2. Many buyers are available to buy the product, and many sellers are available to sell the product;
3. Sellers and buyers have all relevant information to make rational decisions about the product
that they are buying and selling;
4. Firms can enter and leave the market without any restrictions—in other words, there is free
entry and exit into and out of the market;
5. Price Takers: Individual firms in a perfectly competitive market are price takers, meaning they
accept the market price as given and have no influence over it;
6. Perfect Mobility of Resources: Resources, such as labor and capital, can move freely between
industries and firms, allowing for the efficient allocation of resources across the economy;
7. Short-Run Profit Maximization: Firms in a perfectly competitive market aim to maximize short-
run profits; and
8. Zero Economic Profit in the Long Run: In the long run, due to free entry and exit, firms in a
perfectly competitive market will earn zero economic profit (normal profit).
Short Run Equilibrium: Perfect
Competition
In the short run, a firm operating under perfect competition can achieve equilibrium at a point where it
maximizes its profit or minimizes its losses. Short-run equilibrium in perfect competition is characterized
by several key conditions:
1. Profit Maximization or Loss Minimization:
 The firm selects its output level to maximize profit or minimize losses.
 This occurs where marginal cost (MC) equals marginal revenue (MR), which is also equal to the market
price (P).
 Mathematically, the condition for profit maximization or loss minimization is: MC = MR = P.

2. Price-Taking Behavior:
 The firm accepts the prevailing market price as given and does not have the ability to influence it.
 The firm can sell any quantity of its product at the market price, but it cannot charge a higher price
without losing all its customers.

3. Shutdown Point:
 The firm will continue to produce in the short run if it can cover its variable costs, even if it is incurring
losses.
 The shutdown point occurs when price (P) falls below the minimum average variable cost (AVC). At this
point, the firm covers its variable costs but does not cover its total fixed costs.
4. Economic Profit or Loss:
 If the price (P) exceeds average total cost (ATC) at the profit-maximizing output level, the firm is
making an economic profit.
 If the price (P) is less than ATC but greater than AVC at the profit-maximizing output level, the firm is
incurring a loss but will continue to produce.
 If the price (P) falls below AVC at the profit-maximizing output level, the firm is incurring a loss greater
than its total fixed costs and may choose to shut down in the short run.

5. Variable Output Level:

 The firm can adjust its output level in the short run to respond to changes in market conditions.
 The firm will produce as long as P > AVC to cover variable costs and potentially contribute toward
covering fixed costs.

It's important to note that in the short run, a firm's fixed costs are considered sunk costs, meaning they
cannot be recovered. Therefore, a firm may continue to operate and incur losses as long as it covers its
variable costs, as shutting down would not recover the fixed costs already incurred. However, in the long
run, firms in perfect competition will adjust their production levels or exit the market if they consistently
incur economic losses. In the long run, firms aim for zero economic profit, as discussed in the conditions
for perfect competition.
 Short Run Equilibrium of the firm under Perfect Competition
The short-run is a period of time within the firms can change their level of output only by increasing
or decreasing the amounts of variable factors such as labour and raw material, while fixed factors like
capital equipment, machinery, etc. remain unchanged.
In other words, the short run is the conceptual time period where the firm changes in variable factors
and fixed remain unchanged.
A firm in short run is in equilibrium at a point where Marginal Revenue(MR) is equal to Marginal Cost
(MC) i.e. MR=MC and where MC is increasing at the point or MC is cutting MR from below.
The firm under perfect competition operates under the U-shaped cost curve. Since marginal revenue is
the same as price or average revenue under perfect competition, the firm will equalise marginal cost
with the price to attain the equilibrium level of output.
A firm under perfect competition in short run being in equilibrium does not necessarily earn profit. The
firm determines the equilibrium level of output and price and tries to earn as excess profit, normal
profit, or may even incur a loss
In the above fig Level of output is determined on the X-axis and price on the Y-axis. The firm
may excess profit, normal profit or even loss can be understood by the given fig above.
Long-run Production:
Perfect Competition
In the long run, firms operating under perfect competition aim to achieve a state of
equilibrium where they earn zero economic profit, which is also known as normal profit. Here's
how long-run production works in perfect competition:

• Zero Economic Profit: Firms aim to earn zero economic profit in the long run. Zero
economic profit means that the total revenue (TR) is equal to total cost (TC), including
both explicit costs (e.g., variable costs, fixed costs) and implicit costs (e.g., the opportunity
cost of the owner's time and capital). Mathematically, this equilibrium can be expressed as:
TR = TC.

• Adjustment of Output Levels: Firms have the flexibility to adjust their output levels in
the long run based on market conditions and profitability. They do this to ensure that they
are operating at the point where marginal cost (MC) equals the market price (P). This
ensures efficient resource allocation.
• Entry and Exit of Firms: Firms can freely enter or exit the market in the long run. If there are
economic profits to be made, new firms will enter the industry to compete, increasing market supply
and driving down prices. This process continues until economic profits disappear. Conversely, if firms
are consistently incurring losses, some firms may choose to exit the industry. This reduces market
supply, causing prices to rise until remaining firms break even.

• No Excess Capacity: In the long run, firms in perfect competition operate at their minimum
efficient scale (MES), where they produce at the lowest possible average total cost (ATC) given their
production technology and scale. There is no excess capacity in the long run, meaning firms are
using their resources efficiently to produce the quantity of output demanded by consumers at the
lowest possible cost.

• Continuous Adjustment: The process of entry and exit of firms, as well as the adjustment of
output levels, continues until all firms in the market are earning zero economic profit. At this
equilibrium point, price (P) equals both average total cost (ATC) and marginal cost (MC), and firms
are operating efficiently.
The Long Run Supply
Curve: Perfect
Competition
Before directly jumping into the long-run supply curve definition, let's have a quick refresher on
perfect competition. In perfect competition, the firms in the market are each other's direct
competitors, sell identical products, and operate in a market with low entry and exit barriers.

We know the long run is a period where numerous firms can enter and exit the market. All of
the firm's inputs, including the fixed ones, are variable in the long run. This causes fluctuations
in the market price, which makes it hard to determine the shape of the long-run supply curve
in a perfectly competitive market.

In a perfectly competitive market, there are three types of industries depending on the long-run
supply curve.
The three types of industries are:
1. Increasing cost industry;
2. Decreasing cost industry;
3. Constant cost industry.
Long-run supply curves in a perfectly competitive market are determined by the industry's
price. If the price rises as the industry expands, it is referred to as an increasing cost
industry in a perfectly competitive market. Similarly, a constant cost industry is one in
which the price remains constant during a long period of industry expansion. Finally, a
decreasing-cost industry is one in which the price drops over time as the industry
expands.
 Properties of the
Equilibrium of a Perfectly
Competitive Market
Several central properties of the perfectly competitive market equilibrium deserve to be pointed out.
These properties are the primary reasons why many economists (normatively) view a high level of
competition as a good thing.

The equilibrium is efficient. The market price will be at the same level as the long-run average cost of
production. There is consequently no other way to produce the same quantity of goods that is cheaper.
There is, in other words, no waste of resources.
All firms have normal profits, i.e. no profits. The consumers, consequently, pay only what the production
costs.
Total utility is maximized Note also that these results, that are positive for society, are achieved without
any form of central planning or ruling. This phenomenon, that the resources automatically are allocated
such that these results are achieved, is often called the invisible hand.

However, remember that to reach these results, we have assumed a perfectly competitive market.