2 Perfect Competition

The competitive market model

Perfect competition is a market model with many firms selling identical products. Each firm is too small to affect the market price, and firms can enter or leave the industry. These conditions make firms price takers: the market determines the price, and each firm chooses its output at that price.

Price and output decisions

An individual competitive firm faces a horizontal demand curve at the market price. It can sell its output at that price, but cannot raise the price without losing customers to other sellers. Since every additional unit sells for the same price, price equals both average revenue and marginal revenue:

To maximize profit, a firm chooses output where marginal revenue equals marginal cost. For a price taker, the rule is $P = MC$, provided the firm produces on the rising portion of its marginal-cost curve.

Economic profit is total revenue minus total economic cost:

where $q$ is the firm's output and $ATC$ is average total cost. If price exceeds average total cost, the firm earns an economic profit; if price is below average total cost, it incurs an economic loss.

For example, if the market price of a crop is 10 dollars per bushel, a small grower takes that price as given. The grower expands output while the marginal cost of another bushel is below the price and stops where marginal cost reaches it, unless producing would make the grower's loss greater than shutting down.

Short-run production and shutdown

In the short run, at least one input is fixed, and the number of firms in the industry cannot fully adjust. A firm that operates supplies the quantity where $P = MC$, as long as price covers average variable cost. Therefore, the firm's short-run supply curve is the portion of its marginal-cost curve at or above the minimum of its average-variable-cost curve.

If price falls below minimum average variable cost, the firm shuts down temporarily and produces zero because its revenue would not cover even its variable costs. If price is between average variable cost and average total cost, the firm continues producing in the short run, though it incurs an economic loss. It can cover variable costs and contribute something toward fixed costs.

Shutting down is a short-run choice; exit means leaving the industry in the long run. The distinction is that a temporary shutdown does not itself mean the firm has left the industry.

Market supply in the short run

The market short-run supply curve is the horizontal sum of the supply curves of all firms. At each possible price, add the quantities each firm is willing to supply. Market demand and market supply determine the equilibrium price and total quantity; each firm then treats that price as given and chooses its own output.

Entry, exit, and long-run equilibrium

In the long run, firms can change all inputs, and firms can enter or exit the industry. When firms earn positive economic profit, entry increases market supply, tending to lower the market price and firms' profits. When firms incur persistent economic losses, some firms exit; market supply falls, tending to raise the price and reduce losses.

This adjustment leads toward long-run equilibrium: firms have no incentive to enter or exit and earn zero economic profit. Zero economic profit does not mean owners receive no return. It means revenue covers explicit costs as well as the opportunity cost of resources supplied by the owners.

For a representative firm in the standard model, long-run equilibrium has price equal to marginal cost and minimum long-run average cost:

With identical firms and constant input costs, adjustment leaves the industry's long-run supply curve horizontal. If expanding the industry changes input prices or firms' costs, long-run supply may instead slope upward or downward. Zero economic profit is the general result; a horizontal long-run supply curve requires the constant-cost assumption.

Efficiency and the model's limits

Under the model's assumptions, competitive equilibrium has two important efficiency properties.

• Allocative efficiency: Price equals marginal cost, $P = MC$. If price reflects consumers' marginal benefit and marginal cost reflects the social cost of production, the value consumers place on the last unit equals the cost of producing it.

• Productive efficiency: In long-run equilibrium, firms produce at minimum average total cost, so output is produced at the lowest feasible average cost.

These are model results, not a guarantee that every real market is socially desirable. They rely on assumptions such as adequate information and the absence of unpriced external costs or benefits. Perfect competition is therefore a useful benchmark for assessing how real markets allocate resources.