Perfect competition is a market structure with:

  • Freedom of entry and exit
  • Perfect information/knowledge
  • Many firms
  • The price is set by the industry supply and demand.
  • Firms are price takers; this means their demand curve is perfectly elastic. If they set a higher price, nobody would buy because of perfect knowledge. Therefore firms have an elastic demand curve.
  • In the long-run firms in perfect competition will make normal profits.

Diagram of Perfect Competition

  • The market price is set by the supply and demand of the industry (diagram on right)
  • This sets the market equilibrium price of P1.
  • Individual firms (on the left) are price takers. Their demand curve is perfectly elastic.
  • A firm maximises profit at Q1 where MC = MR
  • At this price firms make normal profits – because average revenue (AR) = average cost (AC)

Changes in Perfect Competition equilibrium

  1. Market demand rises from D1 to D2 causing the price to rise from P1 to P2.
  2. Due to the rise in price to P2, profits are now maximised at Q2.
  3. A firms marginal cost (MC) curve is effectively its supply curve
  4. At Q2, (P, AR is greater than ATC) and therefore the firm now makes supernormal profit.

Perfect competition in the long run

  • However, the supernormal profit encourages more firms to enter the market.
  • New firms enter (supply increases from S1 to S2) until the price falls to P1.
  • With price at P1, profits are maximised at Q1 and normal profits are made once again (AR=AC).

Effect of a fall in demand

  • If there was a fall in market demand, the price would fall.
  • Now firms would make a loss, and some will go out of business causing the supply curve to shift to the left.
  • The supply curve will fall until price rises back to a level which gives normal profit.

Perfect competition in the real world?

Some markets are close to perfect competition, for example

  • Foreign exchange markets
  • Farmers market with many farmers and buying selling vegetables.

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