Boundless EconomicsCompetitive Markets
Perfect Competition
Definition of Perfect CompetitionPerfect competition is a market structure that leads to the Pareto-efficientallocation of economic resources.
Learning ObjectivesDescribe degrees of competition in different market structures
Key TakeawaysKey PointsThe major types of market structure include monopoly, monopolisticcompetition, oligopoly, and perfect competition.Perfect competition is an industry structure in which there are many firmsproducing homogeneous products. None of the firms are large enough toinfluence the industry.The characteristics of a perfectly competitive market include insignificantcontributions from the producers, homogenous products, perfect informationabout products, no transaction costs, and no long-term economic profits.In practice, very few industries can be described as perfectly competitive,though agriculture comes close.
Key Termsmonopoly: A situation, by legal privilege or other agreement, in which solelyone party (company, cartel etc. ) exclusively provides a particular product orservice, dominating that market and generally exerting powerful control over it.
Monopolistic competition: A market structure in which there is a large numberof firms, each having a small proportion of the market share and slightlydifferentiated products.oligopoly: An economic condition in which a small number of sellers exertcontrol over the market of a commodity.
Market structure is determined by the number and size distribution of firms in amarket, entry conditions, and the extent of product differentiation. The majortypes of market structure include the following:
Monopoly: An industry structure where a single firm produces a product forwhich there are no close substitutes. Monopolists are price makers. Barriers toentry and exit exist, and, in order to ensure profits, a monopoly will attempt tomaintain them.Monopolistic competition: A market structure in which there is a large numberof firms, each having a small portion of the market share and slightlydifferentiated products. There are close substitutes for the product of any givenfirm, so competitors have slight control over price. There are relativelyinsignificant barriers to entry or exit, and success invites new competitors intothe industry.Oligopoly: An industry structure in which there are a few firms producingproducts that range from slightly differentiated to highly differentiated. Eachfirm is large enough to influence the industry. Barriers to entry exist.Perfect competition: An industry structure in which there are many firms, nonelarge enough to influence the industry, producing homogeneous products.Firms are price takers. There are no barriers to entry. Agriculture comes close tobeing perfectly competitive.
Perfect competition leads to the Pareto-efficient allocation of economicresources. Because of this it serves as a natural benchmark against which to
contrast other market structures. However, in practice, very few industries canbe described as perfectly competitive. Nevertheless, it is used because itprovides important insights.
A perfectly competitive market has several important characteristics:
All producers contribute insignificantly to the market. Their own productionlevels do not change the supply curve.All producers are price takers. They cannot influence the market. If a firm tries toraise its price consumers would buy from a competitor with a lower priceinstead.Products are homogeneous. The characteristics of a good or service do not varybetween suppliers.Producers enter and exit the market freely.Both buyers and sellers have perfect information about the price, utility, quality,and production methods of products.There are no transaction costs. Buyers and sellers do not incur costs in makingan exchange of goods in a perfectly competitive market.Producers earn zero economic profits in the long run.
Conditions of Perfect CompetitionA firm in a perfectly competitive market may generate a profit in the short-run,but in the long-run it will have economic profits of zero.
Learning ObjectivesCalculate total revenue, average revenue, and marginal revenue for a firm in aperfectly competitive market
Key TakeawaysKey Points
A perfectly competitive market is characterized by many buyers and sellers,undifferentiated products, no transaction costs, no barriers to entry and exit,and perfect information about the price of a good.The total revenue for a firm in a perfectly competitive market is the product ofprice and quantity (TR = P * Q). The average revenue is calculated by dividingtotal revenue by quantity. Marginal revenue is calculated by dividing the changein total revenue by change in quantity.A firm in a competitive market tries to maximize profits. In the short-run, it ispossible for a firm's economic profits to be positive, negative, or zero. Economicprofits will be zero in the long-run.In the short-run, if a firm has a negative economic profit, it should continue tooperate if its price exceeds its average variable cost. It should shut down if itsprice is below its average variable cost.
Key Termseconomic profit: The difference between the total revenue received by the firmfrom its sales and the total opportunity costs of all the resources used by thefirm.
The concept of perfect competition applies when there are many producers andconsumers in the market and no single company can influence the pricing. Aperfectly competitive market has the following characteristics:
There are many buyers and sellers in the market.Each company makes a similar product.Buyers and sellers have access to perfect information about price.There are no transaction costs.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 firmsthat participate in the market. These firms are price takers--if one firm tries toraise its price, there would be no demand for that firm's product. Consumerswould buy from another firm at a lower price instead.
Firm RevenuesA firm in a competitive market wants to maximize profits just like any other firm.The profit is the difference between a firm's total revenue and its total cost. Fora firm operating in a perfectly competitive market, the revenue is calculated asfollows:
Total Revenue = Price * QuantityAR (Average Revenue) = Total Revenue / QuantityMR (Marginal Revenue) = Change in Total Revenue / Change in Quantity
The average revenue (AR) is the amount of revenue a firm receives for each unitof output. The marginal revenue (MR) is the change in total revenue from anadditional unit of output sold. For all firms in a competitive market, both AR andMR will be equal to the price.
Profit MaximizationIn order to maximize profits in a perfectly competitive market, firms set marginalrevenue equal to marginal cost (MR=MC). MR is the slope of the revenue curve,which is also equal to the demand curve (D) and price (P). In the short-term, it ispossible for economic profits to be positive, zero, or negative. When price isgreater than average total cost, the firm is making a profit. When price is lessthan average total cost, the firm is making a loss in the market.
MCPrice
Quantity
D=AR=P
ATCP
QMR
Economicprofit
Perfect Competition in the Short Run: In the short run, it ispossible for an individual firm to make an economic profit. Thisscenario is shown in this diagram, as the price or average revenue,denoted by P, is above the average cost denoted by C.
Over the long-run, if firms in a perfectly competitive market are earning positiveeconomic profits, more firms will enter the market, which will shift the supplycurve to the right. As the supply curve shifts to the right, the equilibrium pricewill go down. As the price goes down, economic profits will decrease until theybecome zero.
When price is less than average total cost, firms are making a loss. Over thelong-run, if firms in a perfectly competitive market are earning negativeeconomic profits, more firms will leave the market, which will shift the supplycurve left. As the supply curve shifts left, the price will go up. As the price goesup, economic profits will increase until they become zero.
In sum, in the long-run, companies that are engaged in a perfectly competitive
market earn zero economic profits. The long-run equilibrium point for aperfectly competitive market occurs where the demand curve (price) intersectsthe marginal cost (MC) curve and the minimum point of the average cost (AC)curve.
MCPrice
Quantity
D=AR=MR
ATC
P
Q
Perfect Competition in the Long Run: In the long-run,economic profit cannot be sustained. The arrival of new firms inthe market causes the demand curve of each individual firm toshift downward, bringing down the price, the average revenueand marginal revenue curve. In the long-run, the firm will makezero economic profit. Its horizontal demand curve will touch itsaverage total cost curve at its lowest point.The Demand Curve in Perfect CompetitionA perfectly competitive firm faces a demand curve is a horizontal line equal tothe equilibrium price of the entire market.
Learning Objectives
Describe the demand for goods in perfectly competitive markets
Key TakeawaysKey PointsIn a perfectly competitive market individual firms are price takers. The price isdetermined by the intersection of the market supply and demand curves.The demand curve for an individual firm is different from a market demandcurve. The market demand curve slopes downward, while the firm's demandcurve is a horizontal line.The firm's horizontal demand curve indicates a price elasticity of demand that isperfectly elastic.
Key TermsPerfectly elastic: Describes a situation when any increase in the price, nomatter how small, will cause demand for a good to drop to zero.
In a perfectly competitive market the market demand curve is a downwardsloping line, reflecting the fact that as the price of an ordinary good increases,the quantity demanded of that good decreases. Price is determined by theintersection of market demand and market supply; individual firms do not haveany influence on the market price in perfect competition. Once the market pricehas been determined by market supply and demand forces, individual firmsbecome price takers. Individual firms are forced to charge the equilibrium priceof the market or consumers will purchase the product from the numerous otherfirms in the market charging a lower price (keep in mind the key conditions ofperfect competition). The demand curve for an individual firm is thus equal tothe equilibrium price of the market.
Demand Curve for a Firm in a Perfectly Competitive Market: The demandcurve for an individual firm is equal to the equilibrium price of the market. Themarket demand curve is downward-sloping.
The demand curve for a firm in a perfectly competitive market variessignificantly from that of the entire market.The market demand curve slopesdownward, while the perfectly competitive firm's demand curve is a horizontalline equal to the equilibrium price of the entire market. The horizontal demandcurve indicates that the elasticity of demand for the good is perfectly elastic.This means that if any individual firm charged a price slightly above marketprice, it would not sell any products.
A strategy often used to increase market share is to offer a firm's product at alower price than the competitors. In a perfectly competitive market, firms cannotdecrease their product price without making a negative profit. Instead,assuming that the firm is a profit-maximizer, it will sell its goods at the marketprice.
Licenses and Attributions
Previous Next
SUBJECTS
Accounting
Business
Communications
Economics
Finance
Law
Management
Marketing
Mathematics
Sociology
Statistics
LEGAL
Copyright Policy
Honor Code
Terms
Academic Integrity
Cookie Policy
Privacy Policy
COMPANY
Documents Sitemap
Study Guides
CONNECT WITH US
YouTube
© Learneo, Inc. 2023Course Sidekick is not sponsored or endorsed by any college or university.