Chapter 7 · Microeconomics
Perfect Competition
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Key Definitions
- Perfect competition
- A market with a large number of buyers and sellers, homogeneous products, no barriers to entry or exit, and perfect information.
- Price taker
- A firm that must accept the market price because its own output is too small to affect it.
- Allocative efficiency
- Output is where price equals marginal cost (P = MC), so resources meet consumer wants.
- Productive efficiency
- Production occurs at the minimum point of long-run average cost.
Core Concepts
Characteristics
- A large number of buyers and sellers.
- Homogeneous (identical) products, so demand is perfectly elastic.
- No barriers to entry or exit.
- Perfect information.
- Perfectly mobile resources.
- No branding or advertising.
Profit maximisation
- Produce where MR equals MC, with MC cutting MR from below.
- Short-run outcomes: supernormal profit when AR exceeds AC, normal profit when AR equals AC, subnormal profit when AR is below AC.
- Shut down in the short run when P is below AVC; shut down in the long run when P is below ATC.
Incentives in the long run
- No growth incentive beyond the minimum efficient scale.
- No price competition (each firm is a price taker).
- No R&D or marketing because profits are competed away and products are identical.
Efficiency outcomes
- Allocative efficiency at P = MC; underproduction creates deadweight loss.
- Productive efficiency at the minimum LRAC.
- No dynamic efficiency: only normal profit, and innovation is quickly copied.
Consumer welfare
- Low price and large consumer surplus.
- But low variety and limited quality differences.
Equity
- Perfect competition is unlikely to worsen income distribution.
Diagram Notes
The firm faces a perfectly elastic (horizontal) demand curve at the market price. It produces where MR equals MC. Short-run supernormal, normal and subnormal profit positions arise as AR stands above, on, or below AC at that output.
Entry and exit drive each firm to where AR equals AC and P equals MC at the minimum of LRAC, so the firm earns only normal profit while reaching allocative and productive efficiency.