Perfect Competition

Perfect Competition
KEY CHARACTERISTICS
Market participants (consumers and producers) are price-takers → they
are not significant enough to affect the market price of a good.
The market is made up of many firms and buyers.
No barriers to entry/exit → firms can easily enter
or leave the industry.
In the long run, all firms will make a normal profit and achieve
allocative efficiency and productive efficiency.
Market participants have perfect information → they know all prices,
utility, and costs involved.
Firms sell a standardized product (aka a commodity) → consumers can’t
differentiate one firm’s product from another’s.
Demand in perfect competition

P Market S P Firm
MC ATC
Pe =
Pf
-
MR=D=AR=P
D
& =
Qe Q Qf Q
The market determines equilibrium price and quantity.

Firms accept this price and can assume that they can sell any
quantity of output at this price (many buyers).
Long Run Adjustment
In the long run, all firms will earn zero economic profit (normal profit)
in a perfectly competitive market.
Firms will have time to make adjustments.
If some firms are making a lot of
money(positive economic profit), P S
its rings a bell for other S’
*
businesses. As more firms enter
the market to get a share of their Pm2
profits, the competition Pm
increases. With more options for
consumers to choose from, D’
individual firms start loosing D
some of their customers. Which
leads to a decrease in demand Qm Qm2 Qm3 Q
for each firm’s product.
In the long run, firms have their flexibility to adjust everything—input

levels, production techniques, and so on. As more firms enter and their
profits decrease, some firms might decide to leave the market. On top of
that, since firms are suffering losses, some might exit, reducing the
competition.
This process continues until economic profit is 0. In other words, firms

will make normal profit, which is enough for them to cover all their
costs, but they do not make any extra cash.
Conclusion: in the long run, firms adjust and compete until

economic profit levels off at 0, and everyone is making normal
profit. It’s a balancing act.
Supply in Perfect Competition
P MC above the AVC
MC is the Short Run
ATC
AVC & Supply Curve
P1 MR Side note: supply curve
- represents the quantity

producers are willing to
supply at each price level.
Q1 Q
If MR=P and producers are willing to produce where MR=P=MC

(which they are because this will maximize their profits,) then the MC
curve represents their supply curve. However, a firm will not produce in
the short run if MR=P=MC goes below AVC. So, the short run supply
curve is the MC curve but only above the AVC.
The long run supply curve will depend on if it’s a constant return
industry, increasing cost industry, or decreasing cost industry.
In a constant cost industry, the entry/exit of new firms will not change
overall costs of production (input costs don’t change at all).
Firm Industry
P MC P d’ s
AC d s’ The long run
supply curve in a
p’ P’ B constant cost
A
p . ↓
A . C
Pu &
industry is
perfectly elastic.
q q’ Q Q
Q Q’
Cost
Industry
A
P
p’
p
Increasing
Firm
MC
AC
P
p’
p”
d
Industry
d’
A -
B
s
. C
s’
SL
The long run
supply curve in
an increasing
cost industry
is upward
sloping.
-
q q’ Q Q Q’ Q
It is also possible that firms enter an industry that the cost of production
for individual firms increases. This means that if the price goes up and
firms start making profits (thus attracting new firms), that each
individual firm’s total cost curve will shift up.
Allocative Efficiency Allocative efficiency

Price/ Price
Cost/ >
Revenue MC
AC S
P1 &
P2 &
D=AR
D
-
Q1 Q2 Quantity
About the graph from earlier:
Each perfectly competitive firm achieves allocative and productive
efficiency.
Allocative efficiency means the firm is producing where P=MC / the
market is producing where Supply (Marginal Cost) equals Demand
(Marginal Utility).
Resources are being allocated efficiently up to the last unit of output
where the price consumers are willing to pay (equal to their marginal
utility) is equal to the marginal cost to the firm.
Productive
Efficiency Good X PPC
Price/ Production Efficiency
Cost/ MC
Revenue C
-
A &
AC &
D
C1 &
& B
Q1 Quantity Good Y
Productivity efficiency means the firm is producing where P=minimum

ATC. If a firm is producing at its lowest average cost, it is making use of
its scarce resources.
Note:
Remembering back to the PPC model → economies/firms
producing along their curve are productively efficient.

Perfect Competition

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Perfect Competition

Demand in perfect competition

The market determines equilibrium price and quantity.

In the long run, firms have their flexibility to adjust everything—input

This process continues until economic profit is 0. In other words, firms

Conclusion: in the long run, firms adjust and compete until

P1 MR Side note: supply curve

- represents the quantity

If MR=P and producers are willing to produce where MR=P=MC

Allocative Efficiency Allocative eﬃciency

Productivity eﬃciency means the firm is producing where P=minimum

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