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
- Market demand rises from D1 to D2 causing the price to rise from P1 to P2.
- Due to the rise in price to P2, profits are now maximised at Q2.
- A firms marginal cost (MC) curve is effectively its supply curve
- 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.