perfect-competition

Characteristics of Perfect Competition

• The characteristics of perfect competition are as follows

1. There are many buyers and sellers: due to the number of market participants sellers are price takers

2. There are no barriers to entry and exit from the industry: firms can start-up or leave the industry with relative ease which increases the level of competition

3. 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

4. The products are homogenous: this means firms are unable to build brand loyalty as perfect substitutes exist and any price changes will result in losing customers

Perfectly Competitive Firms are Price Takers

• Firms in perfect competition have low market power, low market share and a low industry concentration ratio

• There is little market failure in perfectly competitive industries

  • This is why governments try to encourage more competition in every sector in their economy 

 Diagram: Individual Firm and Market in Perfect Competition

Diagram analysis

• 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 and 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

Perfect Competition in the Short-run

• Firms in perfect competition are able to make abnormal profit in the short-run

  • A seller may gain a competitive advantage for a short period of time, which allows them to make abnormal profit

Diagram: A Firm in Perfect Competition Making Abnormal Profit

Diagram analysis

• The marginal cost curve (MC) is the supply curve of the firm

• The firms is producing at the profit maximisation level of output, where MC=MR (Q₁)

  • At this point, AR (P₁) > AC (C₁)

  • The firm is making abnormal profit

Abnormal Profit is Eliminated in the Long-run

• If firms in perfect competition make abnormal profit in the short-run, new firms are attracted to the industry

  • They are incentivised by the opportunity to make abnormal profit

  • There are no barriers to entry

    • It is easy to join the industry

Diagram: Abnormal Profits are Eliminated in Long-run