- Perfect Competition refers to that market situation in which there are large number of buyers and sellers of homogenous product.
- The price of such product is determined by the industry with the market forces of demand and supply. All firms sell their product at this price, thus there is only one price which prevails in the market.
- In words of D.S Watson, “In perfect competition of firms is large, their products are homogenous in addition. The firms have perfect knowledge of the market and resources are perfectly mobile.”
- A firm is just a price taker and cannot influence the price of the commodity. Perfect competition describes a market structure where competition is at its greatest possible level.
Characteristics or Features of Perfect Competition
1.Large Number of Buyers and Sellers: There are large number of buyers and sellers but have no effect on price. It means that no single buyer or seller can affect the price by changing his demand or supply as they all contribute a very small proportion to the entire market.Withdrawal by some of the buyers and sellers will not have any effect on the price of the commodity.
2. Homogenous Product: All the firms sell identical products. This means that the goods produced by each seller possess identical physical characteristics and are uniform in every way in colour, size, shape and quality. No Single seller’s product is preferred to that of any other seller because the product and producer are standardised.
3. Perfect Knowledge: All buyers and sellers in the market possess perfect knowledge. Both of them know that uniform price prevails for a homogenous product. Thus, no buyer will offer a price higher than the prevailing one and no seller will sell at a price lower than the prevailing price. Accordingly, a single price for the product must prevail in the market.
4. Free Entry and Exit of the firm: under perfect competition, in the long run any firm can enter if there are super normal profits or exit the industry if there are losses as there is no restriction on the entry or exit of the firm. There are no legal restrictions on the entry or exit of firm from the industry.
5. Perfect Mobility: There is perfect mobility of the factors of production within the market, which ensures uniform cost of the production in whole economy. There is no occupational restriction on the movement of factors. They can move to the industry which offers them maximum.
6. Lack of Transportation Cost: There is no transportation cost, as there is uniform price which prevails in the economy and thus producers prefer to sell in nearby areas and buyers prefer to buy from the nearest places.
7. Lack of Selling Cost: Selling cost refers to cost of advertisement of the product. As all firms sell identical product, there is no need for incurring selling cost by investing in advertising and publicity as buyers have perfect knowledge about the market conditions.
8. Shapes/Slopes of AR and MR curve: AR and MR curves are perfectly elastic.
- The AR and MR curve are perfectly elastic.
- It means price remains uniform.
- The curves are parallel to X-axis.
- The price is uniform as it is fixed by the industry.
The Demand Curve in Perfect Competition
- A perfectly competitive firm faces a demand curve is a horizontal line equal to the equilibrium price of the entire market.
- In a perfectly competitive market the market demand curve is a downward sloping line, reflecting the fact that as the price of ordinary good increases, the quantity demanded of those good decreases.
- Price is determined by the intersection of market demand and market supply; individual firms do not have any influence on the market price in perfect competition. Once the market price has been determined by market supply and demand forces, individual firms become price takers. Individual firms are forced to charge the equilibrium price of the market or consumers will purchase the product from the numerous other firms in the market charging a lower price (keep in mind the key conditions of perfect competition). The demand curve for an individual firm is thus equal to the equilibrium price of the market.
- The demand curve for a firm in a perfectly competitive market varies significantly from that of the entire market. The market demand curve slopes downward, while the perfectly competitive firm’s demand curve is a horizontal line equal to the equilibrium price of the entire market. The horizontal demand curve indicates that the elasticity of demand for the good is perfectly elastic. This means that if any individual firm charged a price slightly above market price, it would not sell any products.
- A strategy often used to increase market share is to offer a firm’s product at a lower price than the competitors. In a perfectly competitive market, firms cannot decrease their product price without making a negative profit.
- Instead, assuming that the firm is a profit-maximizer, it will sell its goods at the market price. The Average Revenue (AR) Curve is the demand curve of the firm as it can sell any quantity it wants at the market price.
Short-run Equilibrium of a Competitive Firm
- The price of the product is given and the firm can sell any quantity at that price
- The size of the plant of the firm is constant
- The firm faces given short-run cost curves
Conditions for the equilibrium of a firm are
- MC = MR
- MC curve cuts the MR curve from below
In other words, the MC curve must intersect the MR curve from below and after the intersection lie above the MR curve. In simpler terms, the firm must keep adding to its output as long as MR>MC.
This is because additional output adds more revenue than costs and increases its profits. Further, if MC=MR, but the firm finds that by adding to its output, MC becomes smaller than MR, then it must keep increasing its output.
Since it is a perfectly competitive market, the demand for the product of the firm is perfectly elastic. Further, it can sell all its output at the market price. Therefore, its demand curve runs parallel to the X-axis throughout its length and its MR curve coincides with the AR curve.
On the supply side, recall the four cost curves – AFC, AVC, MC, and ATC. Of these, the supply curve is that portion of the MC curve which lies above the AVC curve and is upward sloping.
In the short-run, the firm cannot avoid fixed costs. Even if the production is zero, the firm must incur these costs. Therefore, the firm cannot avoid losses by not producing and continues producing as long as its losses do not exceed its fixed costs. In other words, a firm produces as long as its average price equals or exceeds its AVC.
Three Possibilities in Short-run
In a perfectly competitive market, a firm can earn a normal profit, super-normal profit, or it can bear a loss. At the equilibrium quantity, if the average cost is equal to the average revenue, then the firm is earning a normal profit.
On the other hand, if the average cost is greater than the average revenue, then the firm is bearing a loss. However, if the average cost is less than average revenue, then the firm is earning super-normal profits.
In the above figure 4, you can see that the costs and revenue are on the Y-axis and the Quantity is on the X-axis. Further, marginal costs cut the marginal revenue curve from below at point A. At point ‘A’, P is the equilibrium price and ‘Q’ is the equilibrium quantity.
Note that corresponding to the equilibrium quantity, the average cost is equal to the average revenue. It also means that the firm is earning a normal profit.
In the figure 5 above, the cost and revenue curves are on the Y-axis and the quantity demanded is on the X-axis. Further, the marginal cost curve cuts the marginal revenue curve from below at point ‘A’, the equilibrium point.
Corresponding to point ‘A’, P* and Q* are the equilibrium price and quantity respectively. Also, corresponding to Q*, the average cost is more than the average revenue.
In this case, the per unit cost of OQ* (average cost) is more than the per unit revenue of OQ* (average revenue). As per the figure, the per unit revenue is OP and the per unit cost is OP’. This means that the per unit loss is PP’. Also, the total loss on quantity OQ* is P*P’BA.
In the figure 6 above, the per unit revenue or average revenue is OP* while the per unit cost or average cost is OP’. Therefore, the per unit receipts are high in comparison with the per unit cost.
That’s why the average revenue curve lies above the average cost curve corresponding to Q*. The firm is earning super-normal profits. The per unit profit is P’P* and the total profit is for quantity OQ* is P’P*BA.
Long-run Equilibrium of a Competitive Firm
- Over the long-run, if firms in a perfectly competitive market are earning positive economic profits, more firms will enter the market, which will shift the supply curve to the right. As the supply curve shifts to the right, the equilibrium price will go down. As the price goes down, economic profits will decrease until they become zero.
- When price is less than average total cost, firms are making a loss. Over the long-run, if firms in a perfectly competitive market are earning negative economic profits, more firms will leave the market, which will shift the supply curve left. As the supply curve shifts left, the price will go up. As the price goes up, economic profits will increase until they become zero.
- In sum, in the long-run, companies that are engaged in a perfectly competitive market earn zero economic profits. The long-run equilibrium point for a perfectly competitive market occur where the demand curve (price) intersects the marginal cost (MC) curve and the minimum point of the average cost (AC) curve.
- In the long run, economic profit cannot be sustained. The arrival of new firms in the market causes the demand curve of each individual firm to shift downward, bringing down the price, the average revenue and marginal revenue curve.
- In the long-run, the firm will make zero economic profit. Its horizontal demand curve will touch its average total cost curve at its lowest point.