Perfect Competition

This section explains Perfect Competition, including the Characteristics of Perfect Competition and Profit Maximising Equilibrium in the Short Run and Long Run.

Perfect competition is a theoretical market structure that represents the benchmark of maximum efficiency in economics. Although rarely found in reality, it provides a useful standard against which other market forms can be compared.

Characteristics of Perfect Competition

Perfect competition is defined by a set of key assumptions:

• Many buyers and sellers: No single firm or consumer can influence market price.
• Homogeneous products: All firms sell identical goods or services.
• Perfect information: Consumers and producers have full knowledge of prices, products, and technology.
• Freedom of entry and exit: No barriers to firms entering or leaving the market.
• Firms are price takers: Each firm accepts the market price determined by supply and demand.
• Profit maximisation: Firms aim to maximise profit by producing where marginal cost (MC) = marginal revenue (MR)

Profit Maximising Equilibrium in the Short Run and Long Run

Short-Run Equilibrium

• In the short run, firms can make supernormal profits, normal profits, or losses.
• The firm maximises profit where MC = MR.
• If the price is above average total cost (ATC), supernormal profits are made.
• If the price is below ATC but above average variable cost (AVC), the firm may continue operating to cover some fixed costs.
• If price falls below AVC, the firm will shut down.

Long-Run Equilibrium

• Due to freedom of entry and exit, supernormal profits attract new firms.
• Increased supply causes market price to fall until only normal profit is earned (where AR = AC).
• In the long run, all firms produce at the point where MC = MR = AC = AR, ensuring both allocative and productive efficiency.

Diagrammatic Analysis

Short-Run Diagram:

• Downward-sloping demand (AR) curve and horizontal MR (since price is constant).
• U-shaped AC and MC curves.
• Profit maximisation occurs where MC = MR.
• Supernormal profit is shown as the area between AR and AC at the profit-maximising output.

Long-Run Diagram:

• New firms enter if supernormal profits exist, shifting supply and reducing price.
• In the long run, AR = AC at the equilibrium output.
• Only normal profit is made.
• Firm operates at the minimum efficient scale, achieving both productive and allocative efficiency.

Summary

Perfect competition serves as a model of ideal efficiency. Although real-world markets rarely meet all its assumptions, the model helps economists evaluate the performance and outcomes of less competitive market structures.