Perfect Competition: Study Guide (Microeconomics 3.7)

What makes a market perfectly competitive

Perfect competition is a model of a market with the most competition possible. It is the benchmark that the other market structures in the course are compared with. A market is perfectly competitive when:

1. Many buyers and many sellers. Each one is tiny compared with the whole market.
2. An identical (standardised) product. Buyers do not care which firm they buy from.
3. No barriers to entry or exit. Firms can join or leave the market freely in the long run.
4. Good information. Buyers and sellers know the market price.

Together these features mean that no single firm has market power: no firm can change the market price by changing how much it sells. Each firm is a price taker. The price is set by market supply and market demand, and each firm simply accepts it.

Real markets only come close to this, for example some markets for standard farm goods. The model is still useful because it shows what an ideal competitive market achieves.

The price taker’s demand curve

Suppose a firm charges even a little more than the market price. Its product is identical to everyone else’s, so buyers switch and it sells nothing. It has no reason to charge less, because it can already sell all it can produce at the market price. So the demand curve facing one firm is horizontal (perfectly elastic) at the market price.

Each extra unit sells for the same price, so:

• marginal revenue (MR) = price (P);
• average revenue (AR) = total revenue ÷ quantity = P.

That is why the firm’s horizontal line is labelled P = MR = d (some books add AR). Total revenue is TR = P × q, a straight line through the origin.

Always draw the market and the firm side by side, with the same price on both vertical axes. Use capital Q for market quantity and lower-case q for one firm’s output.

Throughout this guide we use Velmora, a fictional country with a perfectly competitive market for basic solar lanterns. Fifty identical firms currently sell lanterns, and the market price is $18.

How a price taker chooses output

Every firm, in every market structure, maximises profit by producing where marginal revenue equals marginal cost (MR = MC). For a price taker, MR = P, so the rule becomes:

Produce the output where P = MR = MC, on the rising part of the MC curve.

If P is above MC, one more unit adds more to revenue than to cost, so produce it. If MC is above P, the last unit lost money, so cut back. With a table of whole units, keep producing while the MC of the next unit is no more than the price.

Once you know q, find profit:

• Total revenue: TR = P × q
• Total cost: TC = ATC × q
• Economic profit = TR − TC = (P − ATC) × q

On a graph, profit is a rectangle. Its height is the gap between P and ATC at the chosen output, and its width is q. If P is above ATC, it is an economic profit. If P is below ATC, it is an economic loss.

Remember Topic 3.6. A firm making a loss still produces in the short run if P is at least average variable cost (AVC). Revenue then covers all variable costs and some fixed costs. It shuts down (q = 0) if P falls below minimum AVC. The part of the MC curve above minimum AVC is the firm’s short-run supply curve.

From short run to long run: entry and exit

In the short run, the number of firms is fixed, so the price can be above or below minimum ATC:

Short-run situation	What firms earn	Long-run response	Effect on market supply and price
P > minimum ATC	economic profit	new firms enter	supply shifts right; price falls
P < minimum ATC	economic loss	some firms exit	supply shifts left; price rises
P = minimum ATC	zero economic profit (normal profit)	no entry or exit	no change: long-run equilibrium

Entry and exit are possible because there are no barriers. They carry on until the incentive disappears: until price equals minimum ATC and every firm earns zero economic profit.

Notice two results that students often mix up:

• Market quantity rises (from 80 thousand to 96 thousand), because there are more firms.
• Each firm’s output falls (from 1,600 to 800), because the price each firm takes is lower.

Long-run equilibrium and efficiency

In long-run equilibrium, three things are equal for every firm:

P = MR = MC = minimum ATC

Each part tells you something:

• P = MC: allocative efficiency. The price measures the marginal benefit of the last unit to buyers. MC measures the cost of the resources used to make it. When they are equal, the market produces exactly the quantity society values most. Making one more unit would cost more than it is worth to buyers; making one fewer would give up a unit worth more than it costs. Firms set MC = P in the short run too, so the market is allocatively efficient in both runs (when there are no external costs or benefits, which you meet in Unit 6).
• P = minimum ATC: productive efficiency. Each firm produces at its efficient scale, the lowest possible cost per unit. In the short run this need not happen: in Figure 1 the firm makes 1,600 lanterns at an ATC of $12, above the minimum of $10.
• Zero economic profit. Firms cover all their costs, including a normal return. No one wants to enter or leave.

Prices as signals. In a competitive market, the price carries information. To buyers, it shows the extra cost of producing one more unit. To sellers, it shows how much buyers value one more unit. It also gives everyone a reason to act on that information: a high price tells firms to produce more and buyers to use less; a low price does the reverse. No planner is needed. This is how prices steer resources to where they are valued most.

Long-run supply: constant, increasing and decreasing cost

When demand changes, entry or exit changes the size of the industry. What happens to each firm’s costs as the industry grows decides the shape of the long-run supply (LRS) curve.

Type of industry	What happens to firms’ costs as the industry expands	Long-run supply curve	Long-run price after a rise in demand
Constant cost	input prices do not change; ATC curves stay put	horizontal at minimum ATC	same as before
Increasing cost	more firms bid up input prices (for example, scarce skilled workers); ATC curves shift up	upward-sloping	higher than before
Decreasing cost	a bigger industry makes inputs cheaper (for example, specialised suppliers can produce at lower cost); ATC curves shift down	downward-sloping	lower than before

In every case, firms still end at zero economic profit. The long-run price is the minimum ATC of whichever cost curves firms face at the new industry size.

Worked example 1: profit and loss from a cost table

Question. Pinecrest Farm, a fictional grower, sells crates of tomatoes in a perfectly competitive market. Its fixed cost is $60 per day.

q (crates per day)	0	1	2	3	4	5	6	7	8
Total cost, TC ($)	60	90	110	126	146	176	216	270	340

(a) The market price is $45 per crate. Find Pinecrest’s profit-maximising output and its economic profit. (b) The price falls to $25. Find the new output and profit. Should Pinecrest keep producing in the short run? (c) At what price would Pinecrest earn zero economic profit? If all firms are identical and the industry has constant costs, what is the long-run price?

Step 1: build MC, AVC and ATC. MC is the change in TC. Variable cost is TC − 60.

q	1	2	3	4	5	6	7	8
MC ($)	30	20	16	20	30	40	54	70
AVC ($)	30.00	25.00	22.00	21.50	23.20	26.00	30.00	35.00
ATC ($)	90.00	55.00	42.00	36.50	35.20	36.00	38.57	42.50

(a) P = MR = $45. On the rising part of MC, the 6th crate costs $40 (less than $45, so produce it) and the 7th costs $54 (more than $45, so do not).

1. Output: q = 6 crates per day.
2. TR = 45 × 6 = $270. TC = $216.
3. Economic profit = 270 − 216 = $54 per day. Check: (P − ATC) × q = (45 − 36) × 6 = $54.

(b) P = MR = $25. The 4th crate costs $20 (produce it); the 5th costs $30 (do not).

1. Output: q = 4 crates per day.
2. TR = 25 × 4 = $100. TC = $146.
3. Profit = 100 − 146 = −$46: a loss of $46 per day. Check: (25 − 36.50) × 4 = −$46.

Should it keep producing? P = $25 is above AVC at q = 4 ($21.50), so revenue covers all variable costs plus $14 of the fixed cost. If it shut down, it would still pay the $60 fixed cost. A $46 loss is smaller than a $60 loss, so it keeps producing in the short run. It would shut down only if the price fell below minimum AVC, $21.50.

(c) Zero profit needs P = ATC at the chosen output. The lowest ATC is $35.20 at q = 5. At P = $35.20, the 5th crate (MC $30) is worth producing and the 6th (MC $40) is not, so q = 5, TR = 35.20 × 5 = $176 = TC, and profit is zero. In a constant-cost industry, entry or exit pushes the price to minimum ATC, so the long-run price is $35.20.

Interpretation. At $45, profits would attract new farms and the price would fall. At $25, losses would make some farms leave and the price would rise. Both paths end at $35.20.

Worked example 2: entry and the number of firms

Question. Use the Velmora lantern market (Figures 1 and 2). Each of the 50 identical firms has a minimum ATC of $10 at 800 lanterns per week. At the current price of $18, each firm produces 1,600 lanterns, where its ATC is $12. Market demand is Q = 116,000 − 2,000P. The industry has constant costs.

(a) Calculate each firm’s economic profit now. What will happen next? (b) Find the long-run price, each firm’s output and the market quantity. (c) How many firms will there be in long-run equilibrium? (d) Show that the long-run outcome is efficient.

(a)

1. TR = 18 × 1,600 = $28,800.
2. TC = 12 × 1,600 = $19,200.
3. Economic profit = 28,800 − 19,200 = $9,600 per firm per week, or (18 − 12) × 1,600.

Positive economic profit and no barriers mean new firms enter. Market supply shifts right and the price falls.

(b) Constant costs mean the long-run price equals the unchanged minimum ATC: P = $10. Each firm produces at its efficient scale, q = 800 lanterns. Market quantity demanded at $10 is Q = 116,000 − 2,000 × 10 = 96,000 lanterns per week.

(c) Number of firms = market quantity ÷ output per firm = 96,000 ÷ 800 = 120 firms. So 120 − 50 = 70 firms enter.

Check the short run as well: 50 firms × 1,600 = 80,000 lanterns, and demand at $18 is 116,000 − 36,000 = 80,000. The data are consistent.

(d) At q = 800, P = MC = $10, so the value of the last lantern to buyers equals the cost of making it: allocative efficiency. P also equals minimum ATC = $10, so each lantern is made at the lowest possible average cost: productive efficiency. Profit = (10 − 10) × 800 = zero economic profit, so entry stops.

Interpretation. Buyers gain the most: they get 16,000 more lanterns per week at a price $8 lower. Each firm sells fewer lanterns, but the market sells more.

Common misconceptions

• “The firm’s demand curve slopes down because market demand does.” Market demand slopes down; the demand facing one price-taking firm is horizontal at the market price.
• “Firms maximise profit where profit per unit (P − ATC) is largest.” They maximise total profit, at MC = MR. In Figure 1, P − ATC is largest at 800 lanterns ($8 per lantern, $6,400 in total), but total profit is larger at 1,600 ($9,600).
• “Zero economic profit means the firm earns nothing.” It earns a normal profit: enough to cover all opportunity costs.
• “Measure the profit rectangle at the lowest point of ATC.” Its height is P − ATC at the output the firm actually chooses.
• “Entry raises each firm’s output.” Entry lowers the price, so each firm produces less; market output rises because there are more firms.
• “A firm making a loss must shut down at once.” In the short run it keeps operating as long as P ≥ AVC. Losses lead to exit only in the long run.
• “Long-run price always returns to its old level.” That is true only in a constant-cost industry.
• “Perfect competition is productively efficient in the short run as well.” Only in the long run, when P = minimum ATC.

Where this leads

Perfect competition is the benchmark for the rest of the course. In Unit 4 you compare it with markets where firms have market power, starting with the introduction to imperfectly competitive markets. Test yourself with the practice questions, then use the revision notes and the checklist to consolidate.