Perfect Competition

What is perfect competition? 

A market structure characterized by the interaction of large numbers and sellers. In which sellers produce standardized or homogeneous products. These sellers are price takers, can sell as much output as they choose to produce at the price market, and can easily enter or exit an industry. 

Price takers are firms that take or accept the market price and have no ability to influence that price. 

Perfect competition is a theoretical market structure in economics. While it rarely occurs in real-world markets, it serves as a useful model for understanding how supply and demand impact prices and behavior in a market economy. Here are the key characteristics of perfect competition:

Many Buyers and Sellers: In a perfectly competitive market, there are numerous buyers and sellers, all competing with one another. No single entity has significant market power.

Homogeneous Product: All firms in perfect competition sell an identical product. This product is often referred to as a commodity because it lacks differentiation.

Price Takers: Firms in perfect competition are price takers. They cannot influence the market price of their products. Instead, they accept the prevailing market price.

Perfect Information: Buyers have complete information about the product being sold and the prices charged by each firm. This information extends to the past, present, and future.

Mobile Resources: Capital resources and labor are perfectly mobile. Firms can easily enter or exit the market without incurring costs.

No Monopolies: Unlike a monopoly, where a single firm dominates the market, perfect competition has no monopolies. Instead, there are many small firms.

Normal Profits: Companies in perfect competition earn just enough profit to stay in business and no more. If they were to earn excess profits, other firms would enter the market and drive profits down.

Remember that perfect competition is an idealized model, and most real-world markets deviate from this structure. However, understanding perfect competition helps economists analyze market dynamics and make comparisons with more realistic market scenarios. 

Firm Demand and Market Equilibrium

Firm Demand:

• In a perfectly competitive market, firms are price takers. This means that their demand curve is perfectly elastic. Essentially, they have no control over the market price.
• If a perfectly competitive firm raises its price, buyers will simply shift to other identical products available at the prevailing market price.
• Therefore, in the long run, firms in perfect competition tend to make normal profits.

Market Equilibrium:

• Equilibrium occurs when the quantity demanded equals the quantity supplied for a particular good or service.
• In a competitive market, the equilibrium price is determined by the intersection of the supply curve (representing the quantity firms are willing to produce) and the demand curve (representing the quantity buyers are willing to purchase).
• Graphically, we find the equilibrium point where these curves intersect.
• For instance, imagine a market for squirrel repellent. If sellers are willing to sell 500 units at a price of $5 per can, and buyers are willing to buy 500 units at that price, the market is in equilibrium at $5 per can and a quantity of 500 cans.
• Whenever markets experience imbalances (such as surpluses or shortages), market forces drive prices toward equilibrium:
• Surplus: When the price is above equilibrium, sellers lower their prices to eliminate the surplus
• Shortage: When the price is below equilibrium, the price of the good increases.
• Changes in the determinants of supply or demand lead to a new equilibrium price and quantity. For example, if there’s an increase in demand (say, due to an invasion of aggressive unicorns), the price will adjust until supply and demand are once again equal

Market Equilibrium

The demand curve, D, and the supply curve, S, intersect at the equilibrium point E, with an equilibrium price of 1.4 dollars and an equilibrium quantity of 600. The equilibrium is the only price where the quantity demanded is equal to the quantity supplied. At a price above equilibrium, like 1.8 dollars, the quantity supplied exceeds the quantity demanded, so there is excess supply. At a price below equilibrium, such as 1.2 dollars, the quantity demanded exceeds the quantity supplied, so there is excess demand.

Market Equilibrium Price in a Perfect Competition

In this graph, the marginal revenue faced by the firm is constant and equal to the market price. Average revenue is also constant and equal to price. 

Price (P) = Marginal Revenue (MR = Average Price (AR)

Marginal Revenue  

Marginal revenue represents the incremental change in earnings resulting from the production and sale of an additional unit of a product or service.

Formula:

Marginal Revenue = Changes in Total Revenue     

                            Changes in Quantity

Graphical Representation: It is often depicted as a downward-sloping line on a graph, illustrating how a company typically needs to lower prices to drive additional sales. However, in perfect competition, it remains constant and equal to price and average revenue

Average Revenue

Average Revenue is revenue per unit sold, equal to total revenue divided by quantity of output produced and sold. 

Formula:

Average Revenue (AR) = Total Revenue      or    AR =   TR

                                             Quantity                                Q

Total Revenue = Price X Quantity 

Example

Use the table to answer the following question. Which of the following is true about the market for Lettuce if we assume the market is perfectly competitive?

Lettuce (pounds)	Total Revenue (TR) (dollars)	Marginal Revenue  (MR) (dollars)	Average Revenue  (AR) (dollars)
2	$4
4	$8
6	$12
8	$16

A. Firm Demand = TR

B. TR = MR

C. MR =AR=Firm Demand

D. MR is $4

Answer: C.

Reason: In a perfectly competitive market, MR = AR = Firm Demand. You can also calculate MR by dividing the change in total revenue by the change in quantity. You can calculate AR by dividing TR by the quantity. In both cases, this will equal $2.