Perfect Competition
Economics: Edexcel A A Level, topic 6.1.2
Perfect Competition
A market being perfectly competitive has a number of implications for firms in the industry.
Characteristics of perfect competition
- Firms are in perfect competition when the following conditions hold:
- Lots of firms produce identical (homogenous) products.
- Many buyers and many sellers.
- Sellers and buyers have perfect and relevant information to make rational decisions.
- Firms can enter and leave the market without restrictions (no barriers to entry or exit).
- Firms aim to maximise profit.
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Market price in perfect competition
- The market price is determined solely by supply and demand in the entire market.
- A perfectly competitive firm must be a very small player in the overall market so that it can increase or decrease output without noticeably affecting the overall quantity supplied and price in the market.
- So, firms are price takers.
Allocative efficiency in perfect competition
- The demand curve is equal to marginal utility (MU) under perfect competition.
- The supply curve is equal to the marginal cost (MC).
- So, if the forces of demand and supply determine equilibrium, the equilibrium price and quantity will be where MU=MC.
- This is allocatively efficient.
- If there are externalities, perfect competition may not be allocatively efficient, if the long run equilibrium is price is equal to the marginal private cost.
Productive efficiency in perfect competition
- Firms in perfect competition are productively efficient, assuming there are no economies of scale.
- They will produce where the average cost is minimised because this is the only place normal profit can be made.
- But if economies of scale exist, a monopoly could be more efficient than a perfectly competitive industry with many firms.
Dynamic efficiency in perfect competition
- Firms do not make supernormal profits in perfect competition.
- They may not be able to invest in R&D and in new technologies, so this may not be dynamically efficient.
Illustrating Perfect Competition
The sequence of diagrams below illustrates how a market in perfect competition might respond to changes to return to its long-run equilibrium.
1) Initial equilibrium
- Here, the market is in equilibrium.
- Firms are profit maximising where MR = MC and normal profit is being made by producers because AR = AC at this point.
- Firms are price takers as they must accept the price reached at the industry equilibrium.
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2) A change
- Here, the average cost for firms has fallen.
- The cost of a space at the market has fallen, for example, meaning AC would fall but MC would not.
- Firms are now making supernormal profit in the short-run.
3) Returning to equilibrium
- Supernormal profits and very low barriers to entry would attract new firms to the market.
- This would shift supply to the right and reduce the equilibrium price.
- So the supernormal profit is 'eroded' away very quickly and firms in the industry return to making normal profit, albeit at a lower price.
Test yourself on Perfect Competition
Which of the following are characteristics of perfect competition?
Which of these are characteristics of perfect competition?
Assuming a firm is a price taker in perfect competition, which of the following is true in the short-run and long-run?
Which of these is perfect competition unlikely to achieve?
In perfect competition, an increase in the market price would eventually lead to what happening for the market to return to a long-run equilibrium?