Study Notes

3.4.2 Perfect Competition (Edexcel)


Last updated 20 Sept 2023

This Edexcel study note looks at perfect competition

a) Characteristics of Perfect Competition:

  1. Large Number of Sellers: In a perfectly competitive market, there are many sellers, each of whom is too small to influence the market price through their individual actions.
  2. Homogeneous or Identical Products: Firms in perfect competition produce identical or homogeneous products that are perfect substitutes for each other. Consumers perceive no difference between the products of different sellers.
  3. Perfect Information: Both buyers and sellers have access to perfect and complete information about the market, including prices, product quality, and production techniques. This ensures transparency and prevents information asymmetry.
  4. Free Entry and Exit: Firms can enter or exit the market without any barriers. There are no significant obstacles such as high entry costs or government regulations that prevent firms from entering or leaving the industry.
  5. Price Takers: Individual firms in perfect competition are price takers, meaning they cannot influence the market price. They must accept the prevailing market price as given and adjust their production accordingly.
  6. Zero Long-Run Economic Profit: In the long run, firms in perfect competition earn zero economic profit. Economic profit is just enough to cover all costs, including opportunity costs of capital.
  7. Perfect Mobility of Resources: Resources, including labor and capital, can easily move in and out of different firms or industries without restrictions, ensuring efficient allocation.
  8. Non-Collusive Behavior: Firms do not engage in collusion or cooperative behavior. They compete vigorously against each other.

b) Profit Maximizing Equilibrium in the Short Run and Long Run:

Short Run: In the short run, a firm in perfect competition seeks to maximize its profit or minimize its loss. To determine the profit-maximizing output and price in the short run, a firm compares its marginal cost (MC) with the market price (P). The short-run profit maximization rule is as follows:

  1. If MC < P, the firm should increase its output because producing one more unit adds more to revenue than to cost.
  2. If MC > P, the firm should decrease its output because producing one more unit adds more to cost than to revenue.
  3. If MC = P, the firm is maximizing its profit at the current output level.

The firm will produce as long as P covers the average variable cost (AVC). If P is greater than or equal to AVC but less than average total cost (ATC), the firm will continue to produce in the short run, even if it incurs a loss.

Long Run: In the long run, firms in perfect competition adjust to reach a state of zero economic profit. This involves:

  1. If firms are making economic profit in the short run, new firms will enter the market due to the absence of entry barriers. This increases supply, lowers prices, and reduces the profits of existing firms.
  2. If firms are incurring economic losses in the short run, some firms will exit the market, reducing supply, raising prices, and allowing remaining firms to potentially cover their costs.

This process continues until all firms in the industry earn only normal profit, where P = ATC. In the long run equilibrium, no firm is making economic profit or incurring economic losses, and resources are efficiently allocated.

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