PERFECT COMPETITION (A COMPLETE EXPLANATION)

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Perfect competition is a market structure where many buyers and sellers of homogenous goods have perfect knowledge of market conditions and the price charged.

A perfect competition is also known as pure competition.

The following are some characteristics of perfect competition.

1. a Large number of buyers and sellers:
In perfect competition, many sellers and buyers have perfect knowledge of the market conditions, the means of the product and the price charged.

In short, buyers and sellers know everything that pertains to buying, producing, and selling.

2. Perfectly competitive firms are price takers: There are a large number of suppliers in a perfect competition that none can dominate price and output.

This is because an individual firm sells an insignificant amount of the market output. That is, the individual firm's output level does not necessarily affect the output, let alone price.

Perfectly competitive firms are price takers. A price taker is a firm that does not have the power to raise the price of the products it sells. 

If a perfectly competitive firm decides to raise its price above the market prices, it will lose almost or all of its sales to competitors.

3. Homogenous goods: Goods sold in a perfectly competitive firm are considered homogenous because they are identical– at least in the eyes of the buyer.

Hence, goods sold in perfectly competitive firms are considered perfect substitutes.

4. Complete freedom of entry and exit: In this market structure, there is no barrier to entry, and exit as firms can enter and exit easily.

Barriers of entry,  as explained in this post,  are technological and legal obstacles and restrictions that deter another firm from entering a market.

In perfect competition, such barriers do not exist as a firm can easily enter and even exist the markets 

It is important to note that perfect competition is more of a theoretical extreme than real-life. 

Cases of perfect competition are very rare. The only industry that comes close to perfect competition is the agricultural industry

DEMAND CURVE OF PERFECT COMPETITION
In perfect competition, there are many buyers and sellers. Altogether, the buyers make up the market demand. Likewise, all sellers make up the market supply.

An equilibrium price will be determined by the intersection of market demand and supply. 

Once the equilibrium price has been set by the intersection of demand and supply in the market, the individual firm has no choice but to sell all its output at the equilibrium price. The accompanying figure illustrates this.

Hence, the demand curve faced by the firm will be a horizontal straight line, which indicates a perfectly elastic demand.

But, why does a perfectly competitive firm sell at the equilibrium price?
If a perfectly competitive firm decides to raise its price above the market prices, it will lose all of its sales to competitors. This is because the goods in a perfectly competitive are perfect substitutes.

Thus, perfectly competitive firms can not raise prices above the market-established equilibrium price and are, therefore, price takers.

PRODUCTION DECISION IN PERFECT COMPETITIVE MARKET 
A Perfectly competitive firm has only one decision to make: which is, to determine output to produce. 

This would be done by considering the relevant cost of production and the profit-maximization point.

Like every other firm, the total revenue for a perfectly competitive firm is price multiplied by the quantity sold. 

So if the equilibrium price is €4 and the output sold by the firm is 3. It follows that the total revenue will be €12.

Supposed the firm sells an additional unit of output, making the total output 4, the revenue would be €16.

As you would observe, the firm gains an additional revenue of €4(€16–€12) from selling an additional unit. This is called marginal revenue.

Marginal revenue is defined as the change in total revenue resulting from a unit change in output.

Since perfectly competitive firms will always receive the equilibrium price for every quantity sold, both its marginal revenue and average revenue will equal its price. This is illustrated below

And because price equals marginal revenue, the marginal revenue curve for a perfectly competitive firm will be the same as its demand curve.

Remember that the demand curve relates price to quantity while the marginal revenue relates to marginal revenue to quantity.

Marginal cost is the additional cost resulting from a unit change in output. It is calculated as:

$MC=\frac{∆TC}{∆Q}$

What level of output should a perfectly competitive firm produce?
A perfectly competitive firm determines the output to product is by using the profit-maximization rule.

Profit maximization is the process by which a firm determines the price and output level that will result in the largest profit.

The profit-maximization point, as represented below, is the point where marginal revenue equals marginal cost.


The firm will produce 125 units. This is because the firm will be maximizing profit($MR=MC$) at that point.

The intuition for this is simple. Profit-maximizing firms will keep expanding production as long as marginal revenue is greater than marginal cost. 

Profit-seeking firms would stop expanding production if marginal revenue equals marginal cost. This is because the firm is making the highest profit possible at the profit-maximizing point. 

If the firm decides to further expand production beyond the profit-maximizing point(to 140 in the above graph), then it would successfully produce where marginal cost is greater than marginal revenue.

Sometimes, the output where marginal revenue equals marginal cost may not be profit-maximizing, rather, it might be the loss-minimizing output. This is due to the relationship between price and average cost. 

To better understand this, we may identify three possible cases for a perfect competitor.

1. Price is greater than the average cost: The firm is making an economic profit. 

So, a perfectly competitive firm will be maximizing profit if the price is greater than the average cost. This is illustrated below.
2. Price equals average cost: The firm is making zero economic profit. The firm will be break-even when price equals average cost. 

3. Price is lesser than average cost but greater than average variable cost: The firm will be sustaining an economic loss. A perfectly competitive firm will be minimizing loss when the price is greater than the average cost.
SHORT-RUN AND LONG-RUN OUTCOME OF PERFECT COMPETITION
A perfectly competitive firm can earn a profit, loss, or even make zero profit in the short run. The accompanying diagram illustrates.
Various profit and loss region for perfect competitor
Figure(a)

From figure(a), if the firm decides to produce above the point where the marginal cost curve intersects the average cost curve, it will be making an abnormal profit in the short run. 

The firm will be making zero profit if it decides to produce at the point where the marginal cost curve intersects the average cost curve.

Another case would be when the marginal cost curve is below the average cost but above the average variable cost. The firm will be making losses at this point. 

But the firm will continue and not shut down the production. This is because the price received is still covering its variable cost.

So, when will the firm shut down?
Perfectly competitive firms will only shut down when the market-established price is below the variable cost.

This can be visualized in figure (a) as the marginal cost curve below the average variable cost. 

The short-run supply curve for a perfectly competitive firm can be derived from this.

No firm will produce below the shutdown point, hence, the short-run supply curve of a perfectly competitive is the marginal cost above the shutdown point.

As earlier noted, it is possible for a perfectly competitive to earn abnormal profit in the short run.

Abnormal profit, however, is not a feature of the long-run in perfect competition, in the long run, because of entry and exit, perfectly competitive firms can not earn abnormal profit in the long run. The best they can do is to break even.

How does freedom of entry and exit lead to zero abnormal profit in the long run?

In the short run, if firms in perfect competition are making abnormal profits(price greater than average cost). 

More firms will enter the market, thereby, shifting the market supply outward(indicating an increase in market supply)

As the market supply increases, the market price will start decreasing(excess supply). Decreasing the market price means economic profit will decrease. This continues until economic profit is zero(that is, Price equals average cost)

Now, Think of what would happen if firms in perfect competition are sustaining an economic loss in the short run? Since there is freedom of exit, some firms would leave the market.

As more firms leave the market, the market supply will decrease. As a result of this, the market price will rise(excess demand). 

This market price will keep rising until the economic loss fade away entirely so that there is zero-economic profit( that is, price equal average cost)

Therefore, we can say entry in the short-run forces economic profit to fall until it reaches zero profit while exit causes economic loss to reduce until it is completely erased and converted to zero-profit. 

With this idea, we can now describe long-run equilibrium for perfect competition.

The long-run competitive equilibrium can be defined as a situation in which the firms left in the market are the most allocative and productive efficient, thereby earning zero economic profit.

Definitions are of critical importance to economics, therefore, let's quickly identify three important point

1. Firms can not make an economic profit: in the long run, a perfectly competitive firm can not earn an economic profit, the best they could do is break even so that their revenue is equal to cost.

2. The remaining firms are productively efficient: Productive efficiency means producing at the lowest possible cost so that there is no waste. It is illustrated as the alternatives on the production possibility curve

When Perfectly competitive firms achieve long-run equilibrium, there will be productively efficiency. 

This is because they will produce at the point where the marginal cost curve intersects the average cost curve. And this occurs at the lowest point of the average cost curve.

3. Firms are allocatively efficient: Allocative efficiency means producing the goods most preferred by the consumer. 

Looking at it from a specific perspective, we can say that a firm will be allocative efficient if it is producing at the point where price equals marginal cost. 

This, of course, is consistent with a perfectly competitive firm. Remember that the price received by a profit-maximizing perfectly competitive firm is equal to its marginal revenue which equals its marginal cost.

Related posts
We have come to the end of this blog post. For a recap, here are ten things you should note about perfect competition.

1. All firms in perfect competition are price takers.

2. Goods sold in perfect competition are considered perfect substitutes.

3. Abnormal profit(or economic profit) is only a feature of the short-run in perfect competition, not the long-run.

4. The demand curve, average revenue curve, and marginal curve of a perfectly competitive firm are the same.

5. In the short run, a perfect competitor shut-down where the price received is lesser than the average variable cost.

6. The demand curve of a perfect competitor is perfectly elastic.

7. Perfectly competitive firm will be making a profit when the price is greater than the average cost at the profit-maximization point.

8. Perfectly competitive firm will be sustaining economic loss when the average cost is greater than the price at the profit-maximization point.

9. In the long-run, Perfectly competitive firm are both allocatively and productively efficient.

10. In perfect competition, firms can freely enter and exit the market.

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