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Perfect competition

Assumptions of the model

Perfect competition is considered as the ideal or the standard against which everything is judged. Perfect competition is characterised as having:

  • Many buyers and sellers. Nobody has power over the market.
  • Perfect knowledge by all parties. Customers are aware of all the products on offer and their prices.
  • Firms can sell as much as they want, but only at the price ruling. Thus sellers have no control over market price. They are price takers, not price makers.
  • All firms produce the same product, and all products are perfect substitutes for each other, i.e. goods produced are homogenous.
  • There is no advertising.
  • There is freedom of entry and exit from the market. Sunk costs are few, if any. Firms can, and will come and go as they wish.
  • Companies in perfect competition in the long-run are both productively and allocatively efficient.

Equilibrium under perfect competition

In perfect competition, the market is the sum of all of the individual firms. The market is modelled by the standard market diagram (demand and supply) and the firm is modelled by the cost model (standard average and marginal cost curves). The firm as a price taker simply 'takes' and charges the market price (P* in Figure 1 below). This price represents their average and marginal revenue curve. Onto this we superimpose the marginal and average cost curves and this gives us the equilibrium of the firm.

Figure 1 Equilibrium of the firm and industry in perfect competition

Firms in equilibrium in perfect competition will make just normal profit. This level of profit is just enough to keep them in the industry and since profits are adequate they have no incentive to leave.

Normal profits

Normal profit is the level of profit that is required for a firm to keep the resources they are using in their current use. In other words it is enough profit to keep them in the industry. Anything in excess of normal profits is called abnormal or supernormal profits.

Any profit above normal profit is a 'bonus' for the firms, as it is more than they need to keep them in the industry. We call this supernormal (or abnormal) profit. However, this supernormal profit will be a signal to other firms and will attract more firms into the industry. If firms are making consistently below normal profits then they will choose to leave the industry.

What does this mean for prices and competition? Consider the following case.

A firm enters a perfectly competitive market with a product. It sells Q1 units of its product at price P1. It is able to make supernormal profits at this stage. It sells at P1 but has a cost of only C. It makes SNP's of P1 to C per unit sold. This is shown below.

Figure 2 Firm in perfect competition making supernormal profit

Competition is perfect. New firms enter the market. Supply increases (the supply curve shifts to the right - S2 in Figure 3 below) and prices fall. The original firm has to lower its price or it will sell nothing. It charges P2 (the same as the market price) and so now sells Q2. The market size expands from Q1 to Q2. Look at the modified diagram below.

Figure 3 The impact on a market of supernormal profit

The presence of SNP's has attracted more firms to the market and this has led to the price falling. The supernormal profits were competed away and equilibrium was reached where only normal profit was earned. Each of the firms will now be in long run equilibrium earning only normal profit. The long run equilibrium is where MC = MR = AC = AR. This can be seen in Figure 4 below.

Figure 4 Long run equilibrium in perfect competition

The falling prices put pressure on the less efficient firms. They may be forced to close and transfer their assets elsewhere.

Short-run losses

A firm with high costs may face a short-term loss-making situation. It is not at risk in the short-run provided price at least covers its variable cost, i.e. its day-to-day running costs, so that a contribution is made towards the fixed costs. This is shown below. The price, P*, covers variable costs and some fixed costs. A loss of C - P* is made.

Figure 5 Short-run losses

The firm will have to become more efficient. If it does not, it will be forced to leave the industry. As a number of firms leave the industry, the market supply curve will shift to the left, and price will rise until losses are eliminated and normal profits are again being made. The long run equilibrium will occur where no firms are making losses and no firms are making SNP's. It will be in equilibrium, as shown earlier. Look at the diagram again. You must know it and be able to explain its development.

Figure 6 Long-run equilibrium of firm and industry in perfect competition

So, perfect competition is a model of an efficient form of competition. Efficient firms face well informed consumers. Only normal profits are made, so prices are not excessive. Resources are used effectively and efficiently. Sounds too good to be true.

Shut down price, break-even price

The break-even price in perfect competition is where normal profits are made and AR = P = ATC = MC = MR. This is shown in Figure 7 below.

Figure 7 Perfect competition - break-even price

Shut down price

A firm may make a loss in the short run, providing AVC is being covered and some contribution is being made to the fixed costs. If a firm is unable to cover its AVC's, i.e. its day-to-day running costs, it will shut down immediately. This is illustrated in figure 8 below.

Figure 8 Shut down point

Here output is OQ*, where MC = MR. A loss of PBCE is being made, as ATC is greater than AR. The fixed costs are given by the area ABCD.

Thus if the firm receives a price of OP it will not cover all its costs but will contribute the area APED towards its fixed costs which have to be met even if output is zero. It will therefore be worth remaining in the business at least in the short run.

However, if the price were to fall to OP1 (the lowest point on the AVC curve, where AVC = MC), the firm would shut down immediately as it would be covering neither its fixed nor its variable costs.

Do perfectly competitively industries exist?

No 'perfect' perfectly competitive industries exist. Ironically, one of the closest today is probably the market for shares. However, as we mentioned before, it is still an important model as it provides a benchmark against which other markets can be judged. It can help in formulating appropriate policies to improve uncompetitive markets.