Economics (9640) | Perfect competition

Welcome to Perfect Competition! Your Economic Yardstick

Hi there! This chapter introduces you to the simplest and most theoretical type of market structure: Perfect Competition (PC). While you might not find a truly "perfect" competitive market in the real world, understanding this model is absolutely crucial.
Why? Because it serves as the ultimate benchmark or yardstick against which we compare all other market structures (like monopoly or oligopoly) to see how efficient they are.

Ready to discover a world where no single firm has any power? Let's dive in!

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1. Defining Market Structure (Context)

Before focusing on Perfect Competition, remember that market structures exist along a spectrum of competition. This spectrum ranges from maximum competition (Perfect Competition) to zero competition (Pure Monopoly).

Factors used to distinguish market structures:

• Number of firms: How many competitors are there? (Ranging from very many to just one).
• Degree of product differentiation: Are the goods identical (homogeneous) or slightly different (heterogeneous)?
• Ease of entry/exit (Barriers to Entry): How difficult is it for new firms to start up or existing firms to leave?

Key Takeaway: Perfect Competition sits at the extreme end of the spectrum where competition is highest, meaning entry barriers are non-existent and the number of firms is massive.

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2. The Main Characteristics of Perfect Competition (3.3.3.2)

Perfect competition is built upon four foundational assumptions. If any one of these fails, the market is no longer perfectly competitive.

1. Large Number of Buyers and Sellers

In a perfectly competitive market, there are so many firms and so many customers that the actions of a single firm or individual buyer have no noticeable impact on the overall market price or quantity.
Analogy: Think of a single wheat farmer in the global wheat market. If one farmer doubles their production, the world price of wheat won't change. Similarly, if one person stops buying wheat, demand is unaffected.

2. Homogeneous (Identical) Products

The products sold by all firms are perfect substitutes. Buyers cannot tell the difference between the output of one firm and the output of another.
Example: Commodities like raw fish, milk, or basic stocks/shares are often considered homogeneous.

3. Perfect Information

Both buyers and sellers have full and costless knowledge of all relevant economic information, including prices, production methods, and profit levels across the market.
Did you know? If buyers had imperfect information, a firm could potentially charge a higher price because the consumer wouldn't know a cheaper alternative exists!

4. Freedom of Entry and Exit

There are no barriers to entry (no costs, no legal restrictions, no technical difficulties) preventing new firms from starting up, and no barriers to exit (firms can close down instantly). This is crucial for the long-run adjustment process (Section 5).

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3. The Perfect Competition Firm as a Price Taker

Due to the vast number of firms and the identical nature of the product, an individual firm in perfect competition must accept the market price. It is a Price Taker.

If the firm tries to charge even a tiny amount above the market price, all its customers will instantly switch to a competitor selling the identical product. If it charges below the market price, it won't maximise profit, as it can sell all it wants at the higher market price.

Demand Curve of the Firm

Because the firm is a price taker, the market demand and supply interaction determines the price (P*). At this fixed price, the firm faces a perfectly elastic demand curve.

• The price (P) is fixed.
• The firm's Average Revenue (AR) is simply the price of the good.
• The firm's Marginal Revenue (MR) (the extra revenue from selling one more unit) is also equal to the price, because the price doesn't drop when more units are sold.

Therefore, for a perfectly competitive firm, the demand curve (D), Average Revenue (AR), and Marginal Revenue (MR) are all the same horizontal line at the market price (P):
$$ P = D = AR = MR $$

Don't worry if this seems tricky at first! The key takeaway is simple: Price is constant for the firm, so selling an extra unit always brings in exactly the price amount. This is very different from a monopoly, where MR is always below AR.

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4. Equilibrium and Profit in the Short Run

All firms, regardless of market structure, aim to maximise profit. This occurs at the output level where Marginal Cost (MC) equals Marginal Revenue (MR).

$$ \text{Profit Maximisation Rule: } MC = MR $$

In the short run, a perfectly competitive firm can earn supernormal profit (abnormal profit), normal profit, or make a loss.

Short-Run Profit Scenarios:

We determine profit by comparing the price (P) with the Average Total Cost (ATC) at the profit-maximising output (\(Q^*\)).

1. Supernormal Profit (Abnormal Profit):
   Occurs when the price (AR) is greater than the average total cost (ATC).
   Condition: \(P > ATC\) at \(MC = MR\) output.
2. Normal Profit:
   Occurs when the price (AR) is exactly equal to the average total cost (ATC). This is the minimum profit needed to keep the firm in the market in the long run (covering opportunity cost).
   Condition: \(P = ATC\) at \(MC = MR\) output.
3. Loss (Subnormal Profit):
   Occurs when the price (AR) is less than the average total cost (ATC).
   Condition: \(P < ATC\) at \(MC = MR\) output.

The Short-Run Shut-Down Condition

Even if a firm is making a loss, it should continue operating in the short run as long as it covers its Average Variable Costs (AVC). Why? Because if P is greater than AVC, the firm is still contributing some revenue toward covering its Fixed Costs (rent, machinery leases), which it would have to pay anyway even if it shut down.

• Operate if: \(P \ge AVC\) (The firm covers variable costs and contributes to fixed costs).
• Shut down if: \(P < AVC\) (The firm cannot even cover the day-to-day costs of production).

Key Takeaway: In the short run, the PC firm aims for \(MC = MR\). It will stay open even with a loss, as long as it covers its AVC.

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5. Long-Run Equilibrium: The Zero Economic Profit Rule

The characteristic of free entry and exit means that the short-run profit situation cannot last in the long run.

The Entry/Exit Adjustment Process (Why P = ATC)

1. Start with Supernormal Profit (\(P > ATC\)):
   The high profit attracts new firms to enter the market (since entry is free).
2. Market Supply Increases:
   As new firms enter, the market supply curve shifts to the right.
3. Market Price Falls:
   The increased supply causes the equilibrium market price (P) to fall.
4. Adjustment Stops at Normal Profit:
   This process continues until the price falls to the level where firms are only making Normal Profit (\(P = ATC\)). At this point, there is no longer an incentive for new firms to enter, and the market stabilises.

Conversely, if firms were making a loss in the short run, firms would exit the market (due to free exit). Supply shifts left, price rises, and the loss disappears, returning the firm to normal profit.

The Final Long-Run Equilibrium Position

In the long run, the perfectly competitive market is in equilibrium when:

$$ P = MR = MC = AC $$

This means the firm is:

• Achieving profit maximisation (\(MR = MC\)).
• Earning only Normal Profit (\(P = AC\)).

Analogy: Think of a newly discovered gold mine (supernormal profit). Everyone rushes in (entry). As more people mine, the market is flooded with gold, the price drops, and soon only the most efficient miners can cover their costs (normal profit).

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6. Efficiency and Critical Assessment

Perfect competition is often used to demonstrate efficiency in resource allocation. The syllabus requires you to understand why, given certain assumptions (like the absence of externalities), perfect competition results in an efficient allocation of resources.

Static Efficiency

Static efficiency concerns efficiency at a particular point in time. PC achieves both main forms of static efficiency in the long run:

1. Productive Efficiency

A firm is productively efficient if it produces output at the lowest possible cost.
Condition: Production occurs at the minimum point of the Average Cost curve. In the long run PC equilibrium, \(P = \text{Minimum } ATC\).
Conclusion: Perfect competition achieves productive efficiency.

2. Allocative Efficiency

Allocative efficiency occurs when resources are allocated to produce the combination of goods and services most desired by consumers. This happens when the price consumers are willing to pay (P, which represents marginal benefit) equals the cost of the last unit produced (MC, which represents marginal cost).
Condition: \(P = MC\).
In PC equilibrium, since \(P = MR\) and \(MR = MC\), we have \(P = MC\).
Conclusion: Perfect competition achieves allocative efficiency.

Critical Assessment: Limitations of Perfect Competition

While PC achieves high levels of static efficiency, it has limitations, especially when we look at the long term or real-world factors:

• No Dynamic Efficiency: Dynamic efficiency involves innovation and technological change over time. Since firms only earn Normal Profit in the long run, they have no spare funds (retained profit) for Research and Development (R&D). This can lead to technological stagnation.
• Lack of Consumer Choice: Since products are homogeneous (identical), consumers have no variety. In the real world, consumers often value choice (e.g., choosing different brands of coffee).
• Economies of Scale: PC firms are typically small. They may be too small to exploit Economies of Scale (cost advantages of producing at a large scale). A larger firm (like a monopolist) might produce cheaper in the long run, even if it is technically less "efficient" by the PC definition.

Key Takeaway: Perfect Competition is the most efficient market structure statically (\(P=MC\) and minimum \(AC\)) but fails dynamically due to the absence of supernormal profits.

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