At one end of the spectrum of market structures is perfect competition. This model has a special place is economic analysis, because if all of its assumptions were fulfilled, and if all markets operated according to its precepts, the best allocation of resources would be ensured for society as a whole. Although, it may be argued that this ideal is not often achieved, competition nevertheless provides a yardstick by which all other forms of market structure can be evaluated.
There are six assumptions of the model of perfect competition:
- Firms aim to maximise profits
- There are many participants (both buyers and sellers)
- The product is homogeneous
- There are no barriers to entry or exit from the market
- There is perfect knowledge of market conditions
- There are no externalities
Perfect competition in the short run
With the above assumptions, it is possible to analyse how a form will operate in the market. An important implication of these assumptions is that no individual trader can influence the price of the product. In particular, this means that the firm is a price taker, and has to accept whatever price is set in the market as a whole.
This means that the firm faces a perfectly elastic demand curve for its product, as is shown below.
In this diagram, the price set by the demand curve is the price the firm must sell at within the market. If it tries to set a price above this, it will no sell anything, as buyers are fully aware of the market price and will not buy at a higher price, especially as they know there is no quality difference between the products sold by firms in the market. What this also implies is that the firm can sell as much output as it likes at that price – which means there is no incentive for a firm to set a price below the market price. Thus, all firms charge the same price.
The firm’s short run supply decision
If the firm can sell as much as it likes at the market price, how does it decide how much to produce?
As explained previously, to maximise profits a firm needs to set output at such a level that marginal revenue is equal to marginal cost. MC = MR.
This diagram illustrates this by adding short run costs to the demand curve. Remember that MC cuts ATC at its minimum point, the same is also true for AVC.
As the demand curve is horizontal, the firm faces constant average and marginal revenue and will choose output q*, where MC = MR.
If the market price were to change, the firm would react by changing output, but always choosing to supply output at the level at which MC = MR. This suggest that the short-run, marginal cost curve represents the forms short run supply curve; in other words, it shows the quantity of output that the form would supply at any given price.
However, there is one proviso to this statement. If price falls below the short run variable cost, the firms best decision would be to exit from the market, as it will be better off just incurring its fixed costs. So the firm’s short run supply curve is the MC curve above the point where it cuts AVC (at its minimum point).
Industry equilibrium in the short run
One crucial question not yet examined is how the market price is determined. To answer this, it is necessary to consider the industry as a whole. In this case there is a conventional downward sloping demand curve, of the sort met in AS. This is formed according to the preferences of customers in the market.
On the supply side, it has been shown that the the individual firm’s supply curve is its marginal cost curve above AVC. If you add up all the supply curves of each firm operating in the market, the result is the industry supply curve. The price, as usual in AS, in the intersection of supply and demand. The firms in the industry will supply the quantity and charge the price suggested by this intersection, and the market will be in equilibrium.
The firm in the short run – revisited
As this seems to be a well-balanced situation, with price adjusting to equate with demand and supply, the only question is why it is described as just a short run equilibrium. This clue to this can be found back with the individual firm.
This diagram returns to the position facing an individual firm in the market. As before, the firm maximises profits by accepting the price P as set in the market, and producing up to the point where MC=MR, which is at Q1. However, now the firm’s average revenue, which is equal to price, is greater than its average cost (C). Thus, the firm is making supernormal profits at this price (remember that normal profits are included in total cost. Indeed, the amount of total profits being made is shown as the shaded area on the graph. Notice that average revenue minus average cost equals profit per unit, so multiplying this by the quantity sold determines profit.
This is where the assumption about freedom of entry becomes important. If firms in this market are making profits above opportunity cost, the market is generating more profits than other markets in the economy. This will prove attractive to the other firms, which will seek to enter the market – and the assumption is there are no barriers to entry to stop them from doing so.
This process of entry will continue for as long as firms are making supernormal profits. However, as more firms join the market, the position of the industry supply curve, which is the sum of the supply curves of an ever growing number of individual firms, will be affected. As the industrial supply curve shifts to the right, as there is more output for any given price, the market price will fall. At some point the price will have fallen to such an extent that firms are not making supernormal profits, and the market will then stabilise.
If the price were to fall even further, some firms would choose to exit the market, as MR falls below their AVC, and the process will go in reverse. Therefore, price can be expected to stabilise such that the typical firm in the industry is just making normal profits.
Perfect competition in long run equilibrium
The graph shows the situation for the industry as a whole once long run equilibrium is achieved and firms no longer have any incentive to enter or exit the market. The market is in equilibrium, with demand equal to supply at the going price. The typical firm sets marginal revenue equal to marginal cost to maximise profits, and just makes normal profits.
The long run supply curve
Comparative static analysis can be used to explore this equilibrium a little more deeply. Suppose there is an increase in the demand for this product. Perhaps, for some reason, everyone becomes convinced that the product is excellent at lowering cholesterol, so demand increases for any given price. This disturbs the market equilibrium, and the question then is whether, and if so how, equilibrium can be restored.
Demand in the industry as a whole shifts to the right. The industry supply curve stays the same, so price is pushed up in the short run. Firms push their production up to the new profit maximising level, where MC = MR. They are now making supernormal profit, as average revenue is above average cost. This entices new firms in, and in the long run equilibrium is gained again, with supply shifting to the right, giving a price exactly the same as before – the minimum point of AC, the lowest price point to keep the typical firm in business. However, because of these shifts, there is a lot more output overall in the industry to supply demand.
The adjustment to this new demand in the short run is borne by the firms, who produce more and make supernormal profit. In the long run it is reached by the entry of new firms.
This suggests that the industry long-run supply curve (LRS) is horizontal at price P*, which is the minimum point of the long-run average cost curve for the typical firm in the industry.
Strictly speaking, the LRS is perfectly flat only if all firms face equal cost conditions, and if factor prices remain constant as the industry expands. For example, if there is a labour shortage, then industrial expansion may drive up costs, causing firms to face higher costs at any output level. In these sort of circumstances the LRS is slightly upward sloping.
Efficiency under perfect competition
Having reviewed the characteristics of the long-run equilibrium of a perfectly competitive market, you may wonder what is so good about such a market in terms of allocative and productive efficiency.
For an individual market, productive efficiency is reached when a firm operates at the minimum point of its average cost curve. Under perfect competition, this is indeed a feature of the long run equilibrium position. So productive efficiency is achieved in the long run – but not in the short run, when a firm need not be operating at minimum average cost.
For an individual market, allocative efficiency is when price is set equal to marginal cost. Due to the fact that all firms are price takers, marginal revenue is equal to price in perfect competition. And as we assume that all firms aim to maximise profit, MC = MR and therefore MC = P. This occurs in both the short run and the long run.
Evaluation of perfect competition
A criticism sometimes levelled at the model of perfect competition is that it is a merely a theoretical idea, based on a sequence of assumption that rarely holds in the real world. Perhaps you have some sympathy with that view.
It could be argued that the model does hold for some agricultural markets. One study in the USA estimated that the elasticity of demand for sweetcorn was -31,353, which is pretty close to perfect elasticity.
However, to argue that the model is useless because it is unrealistic is to miss a very important point. By allowing a glimpse of what the idea market would look like, at least in terms of resource allocation, the model provides a measure against which alternative market structures can be compared. Furthermore, economic analysis can be used to to investigate the effects of relaxing the assumptions of the model, which can be another valuable exercise. For example, it is possible to examine how the market is affected if firms can differentiate their products, or if the traders in the market are acting with incomplete information .
So, although there may be relatively few markets that display all of the characteristics of perfect competition, that does not destroy the usefulness of the model in economic theory. It will continue to be a reference point when comparing market structures.
Questioning the perfection of perfect competition
Some writers, e.g. Nobel prize winner Friedrich von Hayek, have disputed the idea that perfect competition is the best form of market structure. Hayek argued that supernormal profits can be seen as the basiss for investment by firms into new technology, reasearch and development and innovation. If supernormal profits are always competed away, as happens under perfect competition, such activity will not take place. Similarly, Joseph Schumpter argued that only in monopoly and oligopoly markets can firms afford to undertake R&D. Under this sort of argument, it is not quite so clear that perfect competition is the perfect market structure.
- The model of perfect competition describes an extreme form of market structure. It rests on a sequence of assumptions
- Its key characteristics are hat no individual trader can influence the market price of a good or service being traded, and there is freedom of entry and exit.
- In such circumstances each firm faces a completely elastic demand curve for its product, and can sell as much as it likes at the going market price.
- A profit-maximising firm chooses to produce the level of output at which marginal revenue is equal to marginal cost. MC = MR
- The firm’s short run marginal cost curve, above its short run average variable cost curve, represents its short run supply curve.
- The industry’s short run supply curve is the horizontal summation of the supply curves of all the firms in the market.
- Firms may make supernormal profits in the short run, but because there is freedom of entry these profits will be competed away in the long run by new firms joining the market
- The long-run industry supply curve is horizontal, with price adjusting to the minimum level the typical firms long run average cost curve.
- Under perfect competition in long-run equilibrium, both productive efficiency and allocative efficiency are achieved.