Perfect competition is a theoretical market structure characterized by a large number of buyers and sellers, homogeneous products, free entry and exit, and perfect information. In reality, very few markets perfectly meet all these conditions, but it serves as a useful benchmark for analyzing other market structures.
Key Characteristics
Large Number of Buyers and Sellers: No single buyer or seller has enough market power to influence the market price.
Homogeneous Products: The products offered by all sellers are identical. This means consumers have no preference for one seller's product over another.
Free Entry and Exit: There are no significant barriers to new firms entering the market or existing firms leaving the market.
Perfect Information: All buyers and sellers have complete and accurate information about prices, quality, and other relevant market conditions.
Price Takers: Individual firms are price takers, meaning they must accept the prevailing market price. If a firm tries to charge a higher price, it will sell nothing.
Market Equilibrium
In a perfectly competitive market, the market equilibrium is determined by the interaction of supply and demand. The equilibrium price is the price at which quantity supplied equals quantity demanded.
Graphical Representation
Suggested diagram: A graph showing the supply and demand curves in a perfectly competitive market, with the equilibrium price and quantity clearly labeled. The firm's demand curve is perfectly elastic (horizontal) at the equilibrium price.
Profit Maximization
Firms in perfect competition maximize profit by producing the quantity where marginal cost (MC) equals marginal revenue (MR). Since the firm is a price taker, marginal revenue is equal to the market price (P). Therefore, profit maximization occurs when MC = P.
Short-Run Equilibrium
In the short run, a firm in perfect competition will earn economic profit if P > Average Total Cost (ATC). If P < ATC, the firm will incur an economic loss. If P = ATC, the firm will earn zero economic profit.
Long-Run Equilibrium
The key characteristic of the long run in perfect competition is free entry and exit. This means that:
If firms are earning economic profits, new firms will enter the market, increasing supply and driving down the market price until economic profits are eliminated.
If firms are incurring economic losses, some firms will exit the market, decreasing supply and driving up the market price until economic losses are eliminated.
In the long run, firms in perfect competition earn zero economic profit. The market price equals the minimum Average Total Cost (ATC) of production.