3.8 Perfect Competition

Characteristics of Perfect Competition

A perfectly competitive market has many small firms selling an identical (homogeneous) product, free entry and exit, and perfect information. Because no single firm can affect price, each firm is a price taker facing a horizontal (perfectly elastic) demand curve equal to market price = marginal revenue (MR) = average revenue (AR).

Short-Run Profit Maximization

A firm maximizes profit where MR = MC. If price (P) exceeds average total cost (ATC) at that quantity, the firm earns economic profit; if P is between AVC and ATC, it minimizes losses but stays open (covering variable costs); if P < AVC, it should shut down since it can't cover variable costs.

Long-Run Equilibrium

Economic profits attract new entrants, increasing supply and lowering price, while losses drive firms out, raising price. In the long run, firms earn zero economic profit where P = MR = MC = minimum ATC. This is allocative efficiency (P = MC) and productive efficiency (P = min ATC).

Key terms

Price taker

A firm that must accept the market price because it has no power to influence it.

Profit-maximizing rule

Produce where MR = MC.

Shutdown rule (short run)

Shut down if P < AVC; the firm can't cover variable costs.

Long-run equilibrium condition

P = MR = MC = minimum ATC; zero economic profit.

Allocative vs. productive efficiency

Allocative efficiency: P = MC. Productive efficiency: P = minimum ATC.

Try an AP-style question

A perfectly competitive firm faces a demand curve that is…

1. perfectly elastic at the market price
2. upward sloping like a supply curve
3. downward sloping like a monopolist's
4. perfectly inelastic at any quantity