Topic 3.7 Notes – Perfect Competition

1. What a Perfectly Competitive Market Is

Perfect competition has a very specific structure. That structure forces firms to be price takers and leads to efficiency.

Core characteristics

• Many small firms
  Each firm produces a tiny share of total output. No single firm can affect market price.
• Identical products
  Goods are perfectly standardized. Classic example is agriculture like wheat or corn. One farmer’s wheat is indistinguishable from another’s.
• No barriers to entry or exit
  Firms can enter when profits exist and leave when losses occur. No patents, high startup costs, or legal restrictions keeping others out.
• Perfect information
  Buyers and sellers know the market price.
• No market power
  Because products are identical and there are many firms, no firm can charge above the market price.

This structure creates price takers.

• The market (industry supply and demand) determines price.
• Each firm faces a perfectly elastic (horizontal) demand curve at that price.
• For the firm:
  $$P = MR = D$$

Here’s the classic side-by-side setup. Focus on how the left panel determines the market price, and how that same price appears as a horizontal line for the individual firm on the right.

On the left, the intersection of industry supply and demand sets the market price. On the right, the firm takes that price as given, which is why its demand and marginal revenue curves are horizontal.

2. How a Perfectly Competitive Firm Maximizes Profit

Firms maximize economic profit, which equals:

$$\text{Economic Profit} = (P - ATC) \times Q$$

The decision rule is always:

• Produce where MR = MC
• In perfect competition, MR = P
• So produce where P = MC

After finding that quantity, compare P to ATC to see profit or loss.

Short-Run Outcomes

The shutdown rule is huge on tests:
Produce only if $P \ge AVC$.

Why? Because variable costs must be covered in the short run. Fixed costs are sunk.

On FRQs, if they give you numbers, plug them in. For example:
If $P = 12$, $ATC = 9$, and $Q = 100$:

$$(12 - 9) \times 100 = 300 \text{ dollars of economic profit}$$

Draw the rectangle between P and ATC at the profit-maximizing quantity.

3. From Short Run to Long Run Equilibrium

The adjustment mechanism is entry and exit.

If firms earn short-run profits

1. New firms enter (no barriers).
2. Market supply shifts right.
3. Market price falls.
4. Each firm’s horizontal price line drops.
5. Profits shrink to zero.

If firms earn short-run losses

1. Firms exit.
2. Market supply shifts left.
3. Market price rises.
4. Remaining firms’ price line rises.
5. Losses disappear.

In long-run equilibrium:

• $P = MR = MC$
• $P = \text{minimum ATC}$
• Economic profit = 0 (normal profit only)
• Firms produce at efficient scale

This is the break-even outcome caused by free entry and exit.

4. Why Perfect Competition Is Efficient

Perfect competition achieves both types of efficiency.

Allocative efficiency

• Occurs where $P = MC$.
• Price reflects:
  • Marginal benefit (what consumers are willing to pay)
  • Marginal cost (cost of the last unit produced)

Resources go to their highest-valued use. No deadweight loss.

Productive efficiency

• Occurs where firms produce at minimum ATC.
• Firms use the least-cost combination of inputs.

In long-run equilibrium:

$$P = MC = \text{minimum ATC}$$

That’s why this model is the efficiency benchmark when comparing to monopoly or oligopoly.

5. Constant, Increasing, and Decreasing Cost Industries

Long-run price depends on how input costs change as firms enter.

1. Constant Cost Industry

• Entry does not change input prices.
• Long-run price stays the same.
• Long-run supply is perfectly elastic (horizontal).

2. Increasing Cost Industry

• Entry increases input prices (scarce resources).
• Long-run price rises.
• Long-run supply is upward sloping.

3. Decreasing Cost Industry

• Entry lowers input costs (economies of scale, better infrastructure).
• Long-run price falls.
• Long-run supply is downward sloping.

On exams, constant cost is most common. Show the sequence clearly: demand shift → short-run profit/loss → entry/exit → new long-run equilibrium.