Perfect competition is a theoretical market structure with a large number of buyers and sellers selling identical products.
Perfect competition does not commonly exist in its pure form.
Agricultural markets are often considered close examples.
Conditions for Perfect Competition
-
Many buyers and sellers
No individual buyer or seller can control the market. -
Identical products
Products from different sellers are the same. -
Informed buyers and sellers
Buyers and sellers have information about prices and product quality. -
Free entry and exit
Firms can enter when profits are available and leave when they experience losses.
Price Taker
A perfectly competitive firm is a price taker.
The market determines the equilibrium price, and an individual firm must accept that price.
Therefore, the demand curve facing an individual firm is horizontal.
Entry and Exit of Firms
Economic Profit
Economic profit attracts new firms into the market.
Entry continues until economic profit becomes zero.
Economic Loss
Economic loss causes some firms to leave the market.
Exit continues until firms return to normal profit.
Efficiency
Perfect competition can achieve:
Productive Efficiency
Firms produce goods at the lowest possible cost.
Allocative Efficiency
Resources are allocated toward the goods consumers want.
Dynamic Efficiency
Firms have incentives to innovate and adapt to changes in consumer preferences.
Long-Run Supply
The shape of the long-run industry supply curve depends on how input prices respond to industry expansion.
- Constant-cost industry
Input prices stay unchanged as the industry expands. The long-run supply curve is horizontal. - Increasing-cost industry
Expansion bids up the price of a scarce input, so higher prices are needed to bring forth more output. The long-run supply curve slopes upward.
Worked Examples
Economic Profit in Perfect Competition
A firm produces 1,000 units at an ATC of Rs. 20. The market price is Rs. 25. Find the economic profit.
Solution Reveal Hide
The economic profit is Rs. 5,000.
Positive profit attracts entry in the long run, which pushes the price down toward ATC.
Long-Run Supply with a Scarce Input
What is the shape of the long-run supply curve when a key input is scarce?
Solution Reveal Hide
The curve slopes upward. The industry is an increasing-cost industry.
A constant-cost industry would have a horizontal curve.
