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Perfect competition
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As we already know, social scientists, especially economists, are
model builders. We use models to try to explain how things work and
what might be the possible outcomes oI certain economic situations.
Perfect competition is a model used as the starting point to explain
how firms operate. It is a theoretical model, based upon some very
precise assumptions. However, although it is purely theoreticai, it is
very important because once we have built our model oI a perfectly
competitive market we can then begin to relax the theoretical
assumptions that we have made and move towards models of
markets that are much more realistic.
The assumptions of pedect competition
Perlect competition is based upon a number of assumptions.
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The industry is made up of a very large number of firms.
Each firm is so small, relative to the size of the industry that it is
not capable oI altering its own output to have a noticeable effect
upon the output of the industry as a whole. This means that a firm
cannot affect the supply curve of the industry and so cannot affect
the price of the product. Individual lirms have to sell at whatever
price is set by demand and supply in the industry as a whole. We
say that the individual firms are "price-takers".
The firms all produce exacdy identical products. Their goods are
"homogeneous". It is not possible to distinguish between a good
produced in one firm and a good produced in another. There are
no brand names and there is no marketing to attempt to make
goods different from each other.
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perfect
competit'on
IIIE
Firms are completely free to enter or leave the industry. This
means that the lirms already in the indusfy do not have the
ability to stop new firms frorn entering it and are also free to leave
the industry, if they so wish. We say that there are no barriers to
entry or barriers to exit.
All producers and consumers have a per{ect knowledge of the
market. The producers are fully aware oI market prices, costs in
the industry, and the workings of the market. The consumers are
fully aware of prices in the market, the quality of products, and
Lhe availability of the goods.
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Although we say that it is completely theoretical, there are some
industries in the world that get quite close to being perfectly
competitive markets. The industries most often used as examples by
economists are usually agricultural markets.
For example, let us consider the growing of wheat in the European
Union (EU). There are some large wheat farms in the EU, but they
are very small in relation to th€ whole wheat-growing industry. An
individual farm could increase its output many times over without
having a noticeable effect on the total supply of wheat in the EU.
Thus a single larm is not able to alfect the price of wheat in the EU,
since it cannot shift the industry supply cuwe. The farm has to sell at
whatever the existing industry price is. In addition, wheat is wheat,
and so there is no way to tell one farm's wheat from another.
So far so good for tJle assumptions of perfect competition. However,
although firrns are relatively free to enter or leave the wheat
industy, there are significant costs in doing either and these may
affect the decisions of firms. Also, although inlormation is fairly open
in the industry it is unlikely that producers and consumers will have
"perfect knowledge". We can say that the wheat industry in the EU
may be close to being a perfectly competitive market, but is not
precisely one.
The demand curves for the industry and the firm in
pedect competition
We have said that the individual firms in perfect competition will be
price-takers, since they cannot affect the price of the industry and so
must sell at whatever the market price is. This means that we can
make certain assumptions about the demand curves for both the firm
and the indusfiy.
The industy
The
Quantity
Quantity
fim
Quantity
103
Figure
71 The demand curves for the industry and the llrm in perfect comPetition
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7
.
perfect competitron
As we can see in Figure 7.1, the industry in perlect competition
will face normal demand and supply curves. We would expect
producers to wish to supply more at higher pdces and we would
expect consumers to demand less as price rises. we would expect
demand to be donnward sloping and supply to be upward sloping.
The industry price would therefore be p and the quantiry demanded
would be Q.
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For the individual firms we know that they will have to sell ar the
industry price, P, because they are pdce-takers. If they try to sell at
a higher price then consumers will simply buy the product from
another 1im, since the goods are homogeneous and so there is no
dilference in looks or qualiry. If they sell at the industry price the
firm can sell as much as it wants, because as it increases output it
does not affect the industry supply curve and so it does not alter
the industry pdce.
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If the firm can sell all that it wishes at the price P rhen it must face a
perfectly elastic demand at that price. In Figure 7.1 we can see that
the firm dedves its price of P from the equilibrium pdce in the
industry, where the industry supply equals the industry demand. This
is another explanation of the term "price-taker", because the firm has
to take the price set in the indusuy.
Profit maximization for the firm in perfect
competition
Firms maximize profits when they produce at the level ol output
where MC = MR. For pedect competition, we now have to add the
marginal cost curve, shown in Figure 7.2.
The industry
Quantity
Figure
72
Quantity
The profit-maximizing level of output in perfect competition
We can see that the lirm takes the price P from the industry and,
because the demand is perfectly elastic, P:D =AR:MR. Profit is
maxirnised where MC:MR, which is at the level oI output q. We
must remember that although the scale of the price axes is the same
for the firm and the industry, this is not the case for output. The
quantity q is very small in relation to the total industry output, Q,
and it would not even register on the output axis for the industry. II
it could, then it would be large enough to shift the supply cuwe and
thus alter the industry price.
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in the inlustry,
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s. perfect
competit'on
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Possible short-run profit and loss situations in
perfect competition
In the short run in perfect competition, there are two possible profit/
loss situations:
1
Short-run abnormal profits : In this case, which is show{r in Figure 7.3,
the firms in the industry are making abnormal profits in the short
run. This means that they are more than covering their total costs,
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including the opportunity costs.
fhe ndustry
The
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]\,1C
:
l.
MR
detemines
the quant ty.
Quantity
Quantity
Figure 7.3 Short-run abnormal profits in perfect competition
As we can see in Figure 7.3, the firm is selling at the industry
price, P, and is maximizing profits by producing at the quantity q,
where MC:MR. At q, the cost per unit, average cost, is C, and the
revenue per unit, average revenue, is P, so average cost is less than
average revenue and rhe firm is making an abnormal profit of P-C
on each unit. The shaded area shows the total abnormal profit.
Short-run /osses: In this case, shown in Figure 7.4, the firms in the
industry are making losses in the short run. This means that they
are nol covering their total costs.
Ihe
The industry
Quantity
f/rm
AC determines
the cost per Lrnit
Quantity
Figure 7.4 Shortrun losses in perfect competition
In Figure 7.4 the firm is selling at the industry price, R and is
maximizing profits by producing at the quantity q, where
MC=MR. However at output q, the cost per unit is C, which is
greater than the price and so the firm is making a loss of C-P on
each unit. The shaded area shows the total loss. Although making
a loss, the firm is still producing at the "profit-maximizing" level
of output, because any other output would create a greater loss.
In effect, they are loss minimizing.
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peffect competition
The movement flom short run to long run in perfect
competition
If firms are making either sho -run abnormal profits or short-run
losses, other firms begin to react and the situation starts to change
until an equilibrium point is reached in the long run.
Short-run abnormal profits to long-run normal plofits
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Let us look first at the situation of short-run abnormal profits. The
process is shown in Figure 7.5. The firm is making abnormal profits
shown by the shaded area, but this situation will not continue for long.
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Since there is perfect knowledge and no barriers to entry, firms
outside oI the industry that could also produce the good will stan to
enter the industry, attracted by the chance to make abnormal profits.
At fi$t, this will have no real e{fect, because the firms are relatively
small. However, as more and more firms enter the industry, attracted
by the abnormal profits, the industry supply curve will start to shift
to the right.
As the industry supply curve starts to shift lrom S towards 51, the
industry price will begin to Iall from P towards pr. Because the firms
in the industry are price-takers, the price that they can charge will
start to fall and their demand curves will start to shift downwards.
This means that the abnormal profits that they had been making will
start to be "competed away".
P
c
0
Quantity
D:AR:A,ilR
q,q
Quantity
Figure 75 The movement from short-run abnormal profit to long-run normal profit
This process will continue as long as there are abnormal profits in
the industry. Eventually the industry supply curve reaches S,,
where the price is Pr. At this point, the firms are "taking" the
price of Pr and the demand curve is Dr=AR1:MR1. We now find
that the firms are making normal profits with the price per unit
equal to the cost per unit, i.e. P,:C1. The entrepreneurs of the
firms in the industry are satisfied, because they are exactly
covering their opportunity costs. However, there is now no
abnormal profit to attract more firms into the industry and so the
industry is in a long-run equilibrium situation. No one will now
enter and no one will now leave. The outcome is a much bigger
industry producing Qr units, with smaller firms each producing
qr units.
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7 o perfect competition
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Short-run losses to long-run normal profits
Now take the situation of short-run losses. The process is shown in
Figure 7.6. As we can see, the firm is making losses shown by the
shaded area, but this situation will not remain the same.
Some firms in the industry will, after a time, start to leave the
industry. At first this will have no real effect, because the firms are
relatively small. However, as more and more firms leave the industry,
unable to achieve norrnal profit, the industry supply curve will start
to shift to the left.
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As the industry supply curve starts to shift from S towards S,, the
industry price will begin to rise from P towards Pr. As the firms in
the industry are pdce-takers, the price that they can charge will stafi
to rise and their demand curves will start to shift upwards. This
means that the losses that they had been making begin to get
smaller.
-
The industry
a
Sr
g
t-),:AR':MR,
"1
P
qi-o
qq,
Quantity
Quantity
Figure 76 The movement from short-run losses to long+un normal profit
will continue as long as there are losses being made in the
industry. Eventually the industry supply curve reaches Sy, where the
price is Pr. At this point, the firms are "taking" the price of P1 and
the demand curve is Dr=ARr=MRr. We now find that the firms are
making normal profits, with the price per unit equal to the cost per
unit, i.e. Pr=Cr. Now the entrepreneurs of the firms in the industry
are satisfied, because they are exactly covering all of their costs,
including their opportunity costs. There would be no reason to leave
the industry as the firm could not do better elsewhere. However.
there is now no abnormal prolit to attract more firms into the
industry and so the industry is in a long-run equilibrium situation.
No one will now enter and no one will now leave. The outcome will
be a smaller industry producing only Q1 units, with slightly larger
firms, each producing qr units.
This process
Long-run equilibrium in perfect competition
We can conclude that, in the long run, firms in perfect competition
will make normal profits. This is because, even if they are making
short-run abnormal prolits or short-run losses, the industry will
adjust with firms entering or leaving the industry until a nomal
profit situation is reached.
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7
.
Perfect competition
Ihe industry
Student workpoint 7.1
Be a thinker-explain and
illustrate
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Quantity
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Quantity
Figure 77 Long-run equilibrium in perfect competition
Why is a firm in perfect
competition a "price-taker"?
Draw the following
diagrams. Be sure to use a
ruler and include accurate
labels. Also be sure that
your MC curves cross at
the minimum of AC.
In Figure 7.7, the firms are making normal profits in the long run.
They are selling at the price P, which rhey are taking ftom the
industry. MC is equal to MR so they are maximizing profits by
producing q, and at that output P is equal to AC so they are making
normal profits.
In this situation there is no incentive for firms to enter or leave the
industry and so the equilibrium will persist until there is a change in
either the industry demand curve or in the costs that the firms face. If
this does happen, then firms will be making either short-run abnormal
profits or short-run losses and the industry will once again adjust,
with firms €ntering or leaving until long-run equilibrium is restored.
a
A firm in perfect
competition earning
abnormal profits
b
A firm in per{ect
competition making
economic losses
c
A firm in perfect
competition in its longrun equilibrium earning
normal profits
Productive and allocative efficiency in
perfect competition
Productive efficiency
One of the efficienry measures used by economists is that o{ productive
efficiency. A firm is said to be productively efficient if it produces its
product at the Iowest possible unit cost (average cost). This is shown
in Figure 7.8.
At the output q, the firm in Figure 7.8 is able to produce at the most
efficient level of output, i.e. the lowest average cost of production.
This is the cost c. So q is known as the productively efficient level of
output.
We know fuom chapter 6 that MC always cuts AC at its lowest point,
and so we can say that the productively efficient level is where:
MC:AC
Productive efficiency is important in economics, because if a firm is
producing at the productively efficient level of output then they are
combining their resources as efficiently as possible and resources are
not being wasted by inefficient use.
Allocative efficiency
This measure o{ efficiency is sometimes also called the socially
optimum level of output.
IOA
Allocative efliciency occurs where suppliers are producing the
optimal mix of goods and services required by consumers.
Output
Figure 7.8 Productive efficiency
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:r,
Perfect
competition
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Price reflects the value that consumers place on a good and is shown
on the demand curve (average revenue). Marginal cost rellects the
cost to society of all the resources used in producing an extra unit of
a good, including the normal profit required for the lirm to stay in
business. If price were to be greater than marginal cost, then the
consumers would value the good more than it cost to make it. If both
sets of stakeholders are to meet at the optimal mix, then output
would expand to the point where price equals marginal cost.
Similarly, if the marginal cost were to be greater than the price, then
society would be using more resources to produce the good than the
value it gives to consumers and output would fall.
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Allocative efficiency occurs where marginal cost (rhe cost of producing
one more unit) is equal to average revenue (the pdce received for a
unit). Thus the allocatively efficient level of output is where:
tt
cost
The
to producers
_ The
-
Output
valLre
to consurners
Output
Figure 7.9 Allocative efficiency
In Figure 7.9, we can see the allocatlvely efficient level of output for
a firm with a normal demand curve and for a firm with a perfectly
elastic demand curve. In both cases we are looking for the output
where MC:AR -q, for the firm with a normal demand curve and
q2 when the demand is perfectly elastic.
Allocative efficiency is important in economics, because if a firm is
producing at the allocatively efficient l€vel of output there is a
situation of "Pareto optimality" where it is impossible to make one
person better off without making someone else worse off. We will
look at this in more detail when we consider market failure in
Chapter 12.
Productive and allocative efficiency in the short run in perfect
comPetition
If a lirm is making abnormal profits in the short run in perfect
competition, we can see from Figure 7.10 that although they are
producing at the profit-maximizing level of output, q (where
MC:MR), and the allocatively ellicient level of output, q, (where
MC:AR), the firm is not producing at the most efficient level of
output, qr (where MC:AC).
t09
t . Perfect competition
!!!!
The industry
tE
D=AR=l\ilR
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o
Quantity
Quantity
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Figure
710 Productive and allocative e{ficiency with short-run Profits in perfect comPetition
In the same way, if a firm is making losses in the short run in perfect
competition, we can see from Figure 7.1 1 that although they are
producing at the profit-maximising level of output, q (where
MC=MR), and the allocatively efficient level of output, q, (where
MC:AR), once again the firm is not producing at the most efficient
level of output, qr (where MC=AC).
The firm
The industry
Quantity
Figure
7ll
Quantity
Productive and allocatjve efficiency with short-run losses in perfect competition
Productive and allocative efficiency in the long run in Perfect
competition
As we can see in Figure 7.12, profit-maximizing firms in the long
run in perfect competition all produce at the lowest point of their
long-run average cost curves. Because we assume that there is pedect
knowledge in the industry, all of the firms will lace the same cost
curves, and so they are all selling at the same price and minimizing
their average costs by producing where MC=AC.
The
indunry
ll=AR:MR
Quantity
I
l0
Quantlty
Quantity
Figure 712 Productive and allocative efficiency in the long run in perfect competition
7,
Perfect
competit'on
!l!E
.12 is the fact that all oI the profit-rnaximizing
firms in the long run in perfect competition are also producing at the
allocatively efficient level of output, because they produce where
Also shown in Figrre
7
MC=AR.
Student workpoint 7.2
=
6
Fill in the spaces in the table below with either a yes or a no.
@ffi@ryry
3.
Short run
LonS run
EXAMINATION QUESTIONS
Paper l, part (a) questions
t
With the help of a diagram, explain how it is possible for
a firm in perfect competition to earn abnormal profits in
the short
run.
2
With the help of a diagram, explain how it is impossible
for a firm in perfect competition to earn abnormal profits
in the long
5
[10 morks]
run.
[to morks]
Explain whether or not a firm in perfect competition earning
abnormal profits is productively and allocatively
efficient.
Paper
I a
l,
morks]
essay question
Explain the characteristics of a perfectly comPetitive
[10 morks]
market structure.
b
[lo
Evaluate the extent to which it is possible for a firm in
perfect competition to earn abnormal
profits.
fi5 morksl
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