Perfect+Competition

The concept of perfect competition applies to widely available commodity products where there are many companies and no single company can influence pricing. In the long run, companies that are engaged in a perfectly competitive market earn zero economic profits. Perfect competition is based on 5 assumptions as follows (1): 1) There are many buyers and sellers in a market with no single dominant buyer or seller. 2) Each company makes a substantially equivalent product. 3) Buyers and sellers have access to perfect information about price. 4) There are no transaction costs. 5) There are no barriers to entry into or exit from the market.

All goods in a perfectly competitive market are considered perfect substitutes, and the demand curve is perfectly elastic for each of the small, individual firms that participate in the market. These firms are price takers - if one firm tries to raise its price, there would be no demand for that firm's product - consumers would buy from another firm at a lower price instead.

In order to maximize profits in a perfectly competitive market, firms set marginal revenue (MR) = marginal cost (MC). MR is the slope of the revenue curve (P x Q), which is also equal to the demand curve (D) and price (P). It is possible in the short-term for economic profits to be positive, 0, or negative. If a firm's economic profit is negative, it should continue operating if the price exceeds its average variable cost (AVC) curve because the firm will recognize revenue on each product sold that will reduce its loss compared to the loss it would incur if it shutdown completely. If the firm's price is less than its AVC, it would be better of shutting down because it would lose even more money with each product sold than it would if it shutdown and only had a loss equal to its fixed costs. (1)

Interpretation of Long-Run Supply Curve: If firms in a perfectly competitive market are earning positive economic profits, the following sequence of events will occur: 1) More firms will enter the market, which will shift the supply curve to the right. 2) As the supply curve shifts to the right, the demand curve (price) will go down. 3) As the price goes down, economic profit will decrease until it becomes zero.

If firms in a perfectly competitive market are earning negative economic profits, the following sequence of events will occur: 1) More firms will leave the market, which will shift the supply curve to the left. 2) As the supply curve shifts to the left, the demand curve (price) will go up. 3) As the price goes up, economic profit will increase until it becomes zero.

In the long-run perfectly competitive market, the equilibrium point occurs where the demand curve (price) intersects the marginal cost (MC) curve and the minimum point of the average cost (AC) curve. (1)

Examples of Perfectly Competitive Markets: 1. Agriculture

(1) Baye, M.R. __Managerial Economics and Business Strategy__. 5th Edition. McGraw-Hill/Irwin: Madison, WI, 2006.