Perfect Competition

Definition

Perfect competition is a market structure characterized by a large number of small firms selling homogeneous products, with no barriers to entry or exit, and where firms are price takers rather than price makers. This market structure is a benchmark for analyzing the efficiency of other market structures in microeconomics and macroeconomics.

5 Must Know Facts For Your Next Test

1. In a perfectly competitive market, firms are price takers because they have no ability to influence the market price of the product.
2. Perfectly competitive firms maximize profit by producing the quantity where marginal revenue (which equals the market price) is equal to marginal cost.
3. In the long run, perfectly competitive firms will earn only normal profits, as new firms will enter the market until economic profits are driven to zero.
4. The long-run equilibrium in a perfectly competitive market is characterized by firms producing at the minimum point of their long-run average cost curve.
5. Perfect competition is considered the most efficient market structure because it leads to the socially optimal allocation of resources and the lowest possible prices for consumers.

Review Questions

• Explain how the concept of perfect competition relates to the principles of microeconomics and macroeconomics.
  • Perfect competition is a fundamental concept in microeconomics, as it serves as a benchmark for analyzing the efficiency of other market structures. It is used to understand how prices, output, and resource allocation are determined in a market setting. In macroeconomics, perfect competition is often assumed in models of aggregate supply and demand, as it helps to explain how the overall economy reaches equilibrium and how changes in factors like government policies or technological advancements can affect economic outcomes.
• Describe how perfectly competitive firms make output decisions and the factors that influence these decisions.
  • Perfectly competitive firms make output decisions by producing the quantity where their marginal revenue (which equals the market price) is equal to their marginal cost. This allows them to maximize their profits. In the short run, firms will continue to produce as long as the market price is above their minimum point on the average cost curve. In the long run, the entry and exit of firms will drive economic profits to zero, and firms will produce at the minimum point of their long-run average cost curve.
• Analyze the role of entry and exit decisions in the long-run equilibrium of a perfectly competitive market.
  • In a perfectly competitive market, the long-run equilibrium is characterized by firms earning only normal profits. If firms in the market are earning economic profits, new firms will enter the market, increasing the total supply and driving down the market price until economic profits are eliminated. Conversely, if firms are earning losses, some will exit the market, reducing the total supply and causing the market price to rise until only normal profits are earned. This process of entry and exit continues until the market reaches a long-run equilibrium where all firms are producing at the minimum point of their long-run average cost curve.

Related terms

Homogeneous Products: Products that are identical or virtually indistinguishable from one another, making them perfect substitutes.

Price Takers: Firms that have no influence over the market price and must accept the prevailing price set by the market.

Barriers to Entry/Exit: Factors that prevent or discourage new firms from entering a market or existing firms from leaving the market.