Characteristics of Perfect Competition
- The characteristics of perfect competition are as follows
- There are many buyers and sellers: due to the number of market participants sellers are price takers
- There are no barriers to entry & exit from the industry: firms can start-up or leave the industry with relative ease which increases the level of competition
- Buyers & sellers possess perfect knowledge of prices: this assumption presupposes perfect information e.g if one seller lowers their price then all buyers will know about it
- The products are homogenous: this means firms are unable to build brand loyalty as perfect substitutes exist & any price changes will result in losing customers
Profit Maximising Equilibrium in the Short & Long-run
- In order to maximise profit, firms in perfect competition produce up to the level of output where marginal cost = marginal revenue (MC=MR)
- The firm does not have any market power so it is unable to influence the price & quantity
- The firm is a price taker due to the large number of sellers
- The firm's selling price is the same as the market price, P1 = MR = AR = Demand
A diagram that illustrates how an individual firm in perfect competition has to accept the market/industry price (P1)
- In the short-run, firms can make supernormal profit or losses in perfect competition
- However, they will always return to the long-run equilibrium where they make normal profit
Perfect Competition Diagrams
Short-run Profit Maximisation
- Firms in perfect competition are able to make supernormal profit in the short-run
- The MC curve is the supply curve of the firm
A diagram illustrating a perfectly competitive firm making supernormal profit in the short-run as the AR > AC at the profit maximisation level of output (Q1)
Diagram Analysis
- The firms is producing at the profit maximisation level of output where MC=MR (Q1)
- At this point the AR (P1) > AC (C1)
- The firm is making supernormal profit
Short-run Losses
- Firms in perfect competition are able to make losses in the short-run
A diagram illustrating a perfectly competitive firm making losses in the short-run as the AR < AC at the profit maximisation level of output (Q1)
Diagram Analysis
- The firms are producing at the profit maximisation level of output where MC=MR (Q1)
- At this level of output, the AR (P1) < AC (C1)
- The firm's loss is equivalent to
Moving From Short-run Profits to the Long-run Equilibrium
- If firms in perfect competition make supernormal profit in the short-run, new entrants are attracted to the industry
- They are incentivised by the opportunity to make supernormal profit
- There are no barriers to entry
- It is easy to join the industry
A diagram illustrating how new entrants shift the industry supply curve to the right (S1→S2 ) which changes the industry price from P1→P2. The firm can now only sell its products at P2 and supernormal profits are eliminated
Diagram Analysis
- The firm is initially producing at the profit maximisation level of output where MC=MR (Q1)
- At this level of output, the AR (P1) > AC (P2) & the firm is making supernormal profit
- Incentivised by profit, new entrants join the industry & supply increases from S1→S2
- Overall quantity in the industry increases from Q1→Q2
- The industry price falls from P1→P2
- The firm now has to sell its products at the industry price of P2
- The output of the firm falls from Q1→Q2 as it now has a smaller market share of the larger industry
- At the profit maximisation level of output (MC=MR) the firm is now producing at the point where AR= AC
- The firm is making normal profit
- In the long-run, firms in perfect competition always make normal profit
- Firms making a loss leave the industry
- Firms making supernormal profit see them slowly eradicated as new firms join the industry
Moving From Short-run Losses to Long-run Equilibrium
- If firms in perfect competition make losses in the short-run, some will shut down
- The shut down rule will determine which firms shut down
- There are no barriers to exit, so it is easy to leave the industry
A diagram illustrating how firms leaving the industry shifts the industry supply curve to the left (S1→S2 ) which changes the industry price from P1→P2. The firm can now only sell its products at P2 which returns it to a position of normal profit
Diagram Analysis
- The firm is initially producing at the profit maximisation level of output where MC=MR (Q1)
- At this level of output, the AR (P1) < AC (C1) & the firm is making a loss
- Some firms leave the industry & supply decreases from S1→S2
- Overall quantity in the industry falls from Q1→Q2
- The industry price increases from P1→P2
- The firm now has to sell its products at the industry price of P2
- The output of the firm increases from Q1→Q2 as it now has a larger market share of the smaller industry
- At the profit maximisation level of output (MC=MR) the firm is now producing at the point where AR= AC
- The firm is making normal profit
- In the long-run, firms in perfect competition always make normal profit
- Firms making a loss leave the industry
- Firms making supernormal profit see them slowly eradicated as new firms join the industry
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