3.4.2 Perfect Competition

• The characteristics of perfect competition are as follows

1. There are many buyers and sellers: due to the number of market participants sellers are price takers
2. There are no barriers to entry & exit from the industry: firms can start-up or leave the industry with relative ease which increases the level of competition
3. Buyers & sellers possess perfect knowledge of prices: this assumption presupposes perfect information e.g if one seller lowers their price then all buyers will know about it
4. The products are homogenous: this means firms are unable to build brand loyalty as perfect substitutes exist & any price changes will result in losing customers
   
   

• In order to maximise profit, firms in perfect competition produce up to the level of output where marginal cost = marginal revenue (MC=MR)
  
  
• The firm does not have any market power so it is unable to influence the price & quantity
  • The firm is a price taker due to the large number of sellers
  • The firm's selling price is the same as the market price, P₁ = MR = AR = Demand

A diagram that illustrates how an individual firm in perfect competition has to accept the market/industry price (P₁)

• In the short-run, firms can make supernormal profit or losses in perfect competition
• However, they will always return to the long-run equilibrium where they make normal profit
  
  

Short-run Profit Maximisation

• Firms in perfect competition are able to make supernormal profit in the short-run
  
  
• The MC curve is the supply curve of the firm

A diagram illustrating a perfectly competitive firm making supernormal profit in the short-run as the AR > AC at the profit maximisation level of output (Q₁)

Diagram Analysis

• The firms is producing at the profit maximisation level of output where MC=MR (Q₁)
  • At this point the AR (P₁) > AC (C₁)
  • The firm is making supernormal profit
    

Short-run Losses

• Firms in perfect competition are able to make losses in the short-run
  
  

A diagram illustrating a perfectly competitive firm making losses in the short-run as the AR < AC at the profit maximisation level of output (Q₁)

Diagram Analysis

• The firms are producing at the profit maximisation level of output where MC=MR (Q₁)
  • At this level of output, the AR (P₁) < AC (C₁)
  • The firm's loss is equivalent to
    
    

Moving From Short-run Profits to the Long-run Equilibrium

• If firms in perfect competition make supernormal profit in the short-run, new entrants are attracted to the industry
  • They are incentivised by the opportunity to make supernormal profit
  • There are no barriers to entry
    • It is easy to join the industry
      
      

A diagram illustrating how new entrants shift the industry supply curve to the right (S₁→S₂ ) which changes the industry price from P₁→P_2. The firm can now only sell its products at P₂ and supernormal profits are eliminated

Diagram Analysis

• The firm is initially producing at the profit maximisation level of output where MC=MR (Q₁)
  • At this level of output, the AR (P₁) > AC (P₂) & the firm is making supernormal profit
    
    
• Incentivised by profit, new entrants join the industry & supply increases from S₁→S₂
  • Overall quantity in the industry increases from Q₁→Q₂
  • The industry price falls from P₁→P₂
    
    
• The firm now has to sell its products at the industry price of P₂
  • The output of the firm falls from Q₁→Q₂ as it now has a smaller market share of the larger industry
    
    
• At the profit maximisation level of output (MC=MR) the firm is now producing at the point where AR= AC
  • The firm is making normal profit
    
    
• In the long-run, firms in perfect competition always make normal profit
  • Firms making a loss leave the industry
  • Firms making supernormal profit see them slowly eradicated as new firms join the industry

 
Moving From Short-run Losses to Long-run Equilibrium

• If firms in perfect competition make losses in the short-run, some will shut down
  • The shut down rule will determine which firms shut down
  • There are no barriers to exit, so it is easy to leave the industry
    
    

A diagram illustrating how firms leaving the industry shifts the industry supply curve to the left (S₁→S₂ ) which changes the industry price from P₁→P_2. The firm can now only sell its products at P₂ which returns it to a position of normal profit

Diagram Analysis

• The firm is initially producing at the profit maximisation level of output where MC=MR (Q₁)
  • At this level of output, the AR (P₁) < AC (C₁) & the firm is making a loss
    
    
• Some firms leave the industry & supply decreases from S₁→S₂
  • Overall quantity in the industry falls from Q₁→Q₂
  • The industry price increases from P₁→P₂
    
    
• The firm now has to sell its products at the industry price of P₂
  • The output of the firm increases from Q₁→Q₂ as it now has a larger market share of the smaller industry
    
    
• At the profit maximisation level of output (MC=MR) the firm is now producing at the point where AR= AC
  • The firm is making normal profit
    
    
• In the long-run, firms in perfect competition always make normal profit
  • Firms making a loss leave the industry
  • Firms making supernormal profit see them slowly eradicated as new firms join the industry