Perfect Competition (Edexcel A Level Economics A)

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 and 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

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 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

• 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

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

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

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) and the firm is making supernormal profit

• Incentivised by profit, new entrants join the industry and 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

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) and the firm is making a loss

• Some firms leave the industry and 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