Perfect Competition: Features and Price Determination

Perfect competition is a theoretical market form used as a benchmark against which every other market form is compared. Its defining features are: (i) a very large number of buyers and sellers, none big enough to influence price individually; (ii) a homogeneous product, so buyers are indifferent between sellers; (iii) free entry and exit of firms in the long run; (iv) perfect knowledge of prices and market conditions among buyers and sellers; and (v) perfect mobility of factors of production.

Because no single seller can influence the price, every firm is a price taker — it accepts the price fixed by the industry (the intersection of market demand and market supply) and decides only how much to produce at that price. This gives perfect competition its most important property: for an individual firm, price equals average revenue equals marginal revenue at every level of output,

so the firm's demand curve is a horizontal straight line at the ruling market price.

Short-run equilibrium. A firm maximises profit where marginal cost equals marginal revenue, i.e. $MC = MR = P$. Because price is fixed by the market, the firm only has to find the output level at which its own rising marginal-cost curve cuts this horizontal price line. Depending on where the average-cost curve sits at that output, the firm may earn a super-normal profit, a normal profit, or even a loss in the short run — but it will continue to produce as long as price at least covers average variable cost. …