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Perfect Competition

Perfect Competition and Assumptions
Perfect competition is a market structure that in the long run produces allocative and productive efficiency. If all markets were operating with perfect competition then the best allocation of resources would occur for society.
There are a few assumptions to perfect competition:
  • Firms attempt to maximise their profits
  • There are many participants in the market (buyers and seller), this is important so that no individual buyer or seller represents a large enough share of the market to influence the market price. The market price is therefore determined by the market (it is the equilibrium point).
  • The product is homogenous (identical, for example sugar or water), if the product had a brand that consumers identified with then it may be able to charge a premium for the brand recognition.
  • There are no barriers to entry or to exit the market
  • There is perfect knowledge of the market conditions, all buyers know the prices that firms are charging and therefore will purchase the good at the cheapest going price.
  • There are no externalities
Perfect competition is a theoretical idea based on the assumptions stated above. It is very rare for a market to exist in reality that meets all the criteria and so very few markets can be described as perfectly competitive.
Friedrich von Hayek disputed the idea that perfect competition is the ideal market structure. He believed that supernormal profits encourage firms to invest in new technologies, research and development and innovation. He believed that if supernormal profits didn’t exist (like under perfect competition as they are competed away) that firms wouldn’t undertake such investment.

Likewise, Joseph Schumpeter argued that it was only firms that operated in monopoly or oligopoly markets that could afford to undertake research and development. This could be a reason why perfectly competitive markets may not be an ideal (as it may lead to technological stagnation which in the long run could mean society isn’t operating efficiently).
However the model still allows us to examine what an ideal market would look like, and the benefits it would bring and we can use this to measure against the benefits of other alternative market structures.

Perfect Competition in the Short Run
In the short run firms in a perfectly competed market will have a perfectly elastic demand curve (horizontal) for its product (AR=MR=D). This is because we assume that no one trader can influence the price of the product and hence firms are price takers meaning they accept the price that is set by the market (under equilibrium). If it tries to sell above the market price then it won’t sell anything (we are assuming perfect knowledge). This means that the total revenue curve will be upwards sloping.
In the short run it is possible for a firm to make a supernormal profit. The graph below shows a price that is higher than short-run average total costs. The firm will produce at MC = SRATC and hence will produce Q1, as profit equals total revenue minus total costs the profit will be the highlighted green line. Where π= (AR-AC).Q*.

The supernormal profit of π is made in the left graph. On the right a subnormal profit of π is made (a loss). This is because SRATC is higher than the revenue (at P2) and hence there will be a loss. This would result in the firm closing down if they aren’t making a normal profit.

If the market price were to increase/decrease the firm would change the amount of output it produces but will always supply at the level MR=MC. Therefore in the short run the firms (short-run) marginal cost curve represents the firms (short-run) supply curve at any given price. However if the price falls below short-run average variable costs then the firm will exit the market as it will be better off incurring its fixed costs rather than make losses on its variable costs. Therefore the firms (short-run) supply curve is the marginal cost curve above the point where it intersects the short-run average variable cost curve.

In the industry as a whole the demand curve will be negatively correlated (the demand curve for a firm is perfectly elastic because it is not a price maker and cant set above the price and they wouldn’t set a price below the demand curve because they wouldn’t be making a normal profit. For an industry it will be a normal demand curve set by the market) whilst the supply curve will be the sum of the short-run supply curves of individual firms. This is effectively the sum of firms’ short-run marginal cost curve above the short-run average variable cost curves. 
The industry equilibrium is shown where the price will be the intersection of the supply and demand curves.

Perfect Competition in the Long Run
In the short-run it is possible for a firm to make a supernormal profit, as has already been shown, however this profit may encourage other firms to enter the market (we assume easy access to entry). If other firms enter the market then supply will increase (a rightward shift) and therefore the price will fall. If this happens then the profit will begin to be eliminated until the firm is just making a normal profit. Similarly, if a firm is making a loss in the short-run then firms will begin to leave the industry and supply will fall (a leftward shift), thus prices would rise until the firm is just making a normal profit (supernormal profit = 0, subnormal profit = 0). 
Therefore in the long run the firm won’t make a supernormal profit and would produce Q*. The industry equilibrium is similarly shown, like the short-run equilibrium the demand curve is downward sloping and the supply curve is the sum of the individual firms’ supply curves (MC after AVC). 
The industry long run supply curve for a perfectly competitive industry is horizontal at the minimum point of the LRAC curve.

Efficiency under Perfect Competition

Productive efficiency – In an individual market productive efficiency is achieved when a firm is at the minimum point on its LRAC curve (Q1=MC=LRAC). In perfect competition firms are operating at this point so in the long run productive efficiency is achieved, however this isn’t the case in the short run when a firm needs to produce at the minimum average cost.

Allocative efficiency – In an individual market Allocative efficiency occurs when price is equal to marginal cost (P=MC). In a perfectly competitive market supernormal profits are competed away (as new firms enter the market and hence the price falls) therefore price is equal to marginal cost in the long run. This is also the case in the short run so allocative efficiency is achieved in both the long and short run for a firm that is perfectly competitive. 
Page last updated on 20/10/13