Perfect Competition

Features of Perfect Competition

1. Many firms.

2. Freedom of Entry and Exit; this will require low sunk costs.

3. All firms produce an identical or homogenous product.

4. All firms are price takers, Therefore firm’s demand curve is perfectly elastic

5. There is perfect information and knowledge.

Diagram for Perfect Competition

 

These factors are unrealistic in the real world. However Perfect Competition is as important economic model to compare other models. It is often argued that competitive markets have many benefits which stem from this theoretical model.

· In the Industry price is determined by the interaction of Supply and Demand

· The firm will maximise output where MR = MC at Q1

· In the Long Run Firms will make Normal profits.

If Supernormal profits are made new firms will be attracted into the industry causing prices to fall. If firms are making a loss then firms will leave the industry causing price to rise

Changes in Long Run Equilibrium

1. The Effect of an Increase in Demand for the Industry.

If there is an increase in demand there will be an increase in price Therefore the Demand curve and hence AR will shift upwards. This will cause firms to make supernormal profits.

This will attract new firms into the market causing price to fall back to the equilibrium of Pe

2. An increase in firms costs

The AC curve will increase therefore AR< AC
Firms will now start making a loss and therefore firms will go out of business. This will cause supply to fall causing prices to increase.

Efficiency of Perfect Competition

• Firms will be allocatively efficient P=MC
• Firms will be productively efficient. Lowest point on AC curve
• Firms have to remain efficient otherwise they will go out of business.
• Firms are unlikely to be dynamically efficient because they have no profits to invest in research and development.
• If there are high fixed costs, firms will not benefit from efficiencies of scale
• see more: efficiency of perfect competition

Examples of Perfect Competition

In the real world it is hard to find examples of industries which fit all the criteria of ‘perfect knowledge’ and ‘perfect information’. However, some industries are close.

Foreign Exchange Markets. Here currency is all homogenous. Also traders will have access to many different buyers and sellers. There will be good information about relative prices.

Agricultural markets. In some cases, there are several farmers selling identical products to the market. Therefore, agricultural markets often get close to perfect competition.