Perfect competition is a theoretical ideal where all firms are price-takers, earn normal profit and are allocatively and productively efficient in the long-run. Perfect competition is a purely theoretical model, it does not exist in reality. Perfect competition provides an economist with a benchmark to measure monopoly and oligopoly against. An economist may advise the government to make monopolies and oligopolies more like perfect competition to make those industries more efficient.
1) Many Buyers and Sellers.
Many sellers means that each firm has a small market share. Many buyers means no buyer has any monopsony power to affect prices.
2) Perfect Information.
All information is available at zero cost. All incumbent firms and potential firms know each other’s prices and products. All consumers know each firms’ prices and product.
3) Homogenous Output.
All firms produce identical goods. All goods are perfect substitutes.
4) Firms are Price-Takers.
A firm is a price-taker if it must accept the market price and cannot affect prices. Markets determine prices. Because of assumptions 1-3, perfectly competitive firms must charge the industry price P*. Any single firm cannot charge because consumers have perfect information so they will buy the homogenous good from cheaper firms. Any single firm cannot charge because they will make a loss in the long-run so must shut-down. So firms face a perfectly elastic demand curve .
5) Firms Maximize Profits at .
6) No Entry or Exit Barriers.
New firms can enter the industry at any time and incumbent firms can leave the industry at any time.
Long-Run Equilibrium Because perfectly competitive firms maximize profit they set and produce q* in the longrun. Because , and firms earn normal profit in the long-run.
A) Allocatively Efficient.
Allocative efficiency occurs when , firms produce what consumers want and in the quantities demanded. Perfectly competitive firms are always (long-run and short-run) allocatively efficient because they always set .
B) Productively Efficient.
Productive efficiency occurs when firms produce at the lowest point on their AC curve and minimize costs. Perfectly competitive firms are productively efficient in the long-run, but they may be productively inefficient in the short-run.
C) Pareto Efficient.
An allocation is Pareto efficient if there is no way to make someone better off without making someone else worse off. Perfectly competitive firms are always Pareto efficient since they always maximize profit and are always (long-run and short-run) allocatively efficient. Producer and consumer surplus are both maximized. The only way to make firms better off (increase producer surplus) is to make consumers worse off (decrease consumer surplus).
Short-Run Equilibrium Assume that firms in the industry are making super-normal profit at point A
Firms maximize profit at , so super-normal profit is made. Because of perfect information and no entry barriers, super-normal profit acts as a signal attracting new firms to enter the industry. So industry supply increases from S’ to S, P’ decreases back down to P*, falls down to , super-normal profit is competed away and normal profit is earned again.
Alternatively assume that firms in the industry are making a loss at point Z. Firms maximize profit at , so the firm makes a loss.
A firm cannot keep making losses in the long-run because losses are unsustainable, but the firm may stay in the industry in the short-run if it can minimize its losses. At point A (in the diagram below), the firm makes a loss but stays in the industry in the short-run because , variable costs are covered and some contribution can be made towards fixed cost (i.e. the firm can minimize/lower its losses if it stays in the short-run). The firm then leaves the industry in the long-run. At point B (in the diagram below), the firm leaves the industry straight away in the short-run according to the shut-down rule , it cannot even cover variable costs (i.e. the firm suffers higher losses if it stays).
After loss-making firms leave the industry, the industry supply curve shifts left, market price rises and firms are back making normal profit again in the long-run.
An Example of Perfect Competition: The Banana Market Agriculture is a good example of perfect competition. There will never be a pure case of perfect competition because it does not exist in reality but agriculture is a close approximation. Let’s look at one type of agricultural market, the banana market.