Perfect competition
Perfect competition is the benchmark market structure. Though rare in pure form, it shows how competition drives prices down to costs.
Assumptions
Perfect competition assumes many buyers and sellers, identical (homogeneous) products, free entry and exit, and perfect information. No single firm can affect the market price; each is a price taker. Markets for wheat, some currencies, and certain agricultural goods come close.
The firm's demand curve
Because a competitive firm can sell any amount at the market price but nothing above it, it faces a perfectly elastic (horizontal) demand curve at that price. Price equals marginal revenue and average revenue.
Short-run outcomes
In the short run, a competitive firm produces where price equals marginal cost. It can make an economic profit (if price exceeds ATC), break even, or make a loss. If price falls below minimum AVC, it shuts down temporarily.
Long-run equilibrium
Profits attract entry, increasing market supply and lowering price; losses cause exit, raising price. In long-run equilibrium, price equals the minimum of average total cost, and firms earn zero economic profit (normal profit). No firm has an incentive to enter or leave.
Efficiency of competition
Perfect competition achieves allocative efficiency, because price equals marginal cost: goods are produced up to the point where their value to buyers equals their cost. It also achieves productive efficiency, because firms produce at minimum average cost. Total surplus is maximised.
Industry supply in the long run
In a constant-cost industry, entry does not raise input costs, so long-run supply is horizontal at minimum ATC. In an increasing-cost industry, expansion bids up input prices, so long-run supply slopes upward. Decreasing-cost industries are possible when growth lowers input costs.
Why it matters
Few markets are perfectly competitive, but the model is a benchmark: it shows what competition achieves and helps identify when markets fall short. Policies to reduce barriers to entry or improve information move markets closer to this ideal.
Worked example
Strawberry farms earn economic profits when price is 5 dollars a basket and minimum ATC is 3. New farms enter, supply increases, and price falls. Entry continues until price reaches 3, where farms just cover all costs, including the opportunity cost of their land and time.
Key takeaways
Perfect competition has many firms, identical products, free entry and exit, and perfect information. Firms are price takers facing horizontal demand. In the short run they produce where P = MC and may profit or lose. In the long run entry and exit drive price to minimum ATC and economic profit to zero. The outcome is allocatively and productively efficient.
Flashcard
Many firms, identical products, free entry
Check your understanding
In long-run equilibrium under perfect competition, firms earn: