Perfect Competition: Features and Price–Output Determination

Perfect competition is a market form in which there are a very large number of buyers and sellers dealing in a homogeneous product, with free entry and exit and perfect knowledge, so that a single uniform price prevails and every firm is a price taker.

Main features

• Large number of buyers and sellers — each is too small a part of the market to affect price by its own action.
• Homogeneous product — the goods of all sellers are identical, so buyers have no reason to prefer one seller.
• Free entry and exit — firms can enter when profits exist and leave when losses occur.
• Perfect knowledge — buyers and sellers know the ruling price everywhere.
• Perfect mobility of factors and goods, and no transport cost — assumptions that ensure one price.

Price determination in the industry. In a perfectly competitive industry, price is fixed by the free interaction of total (market) demand and total supply. The price at which the quantity demanded equals the quantity supplied is the equilibrium price, and the corresponding quantity is the equilibrium quantity.

The individual firm is a price taker. Because its output is a negligible fraction of the total, the firm can sell any quantity it likes at the ruling price but nothing above it. Hence the firm's demand (AR) curve is a horizontal straight line at the market price, and since price is constant, $AR = MR = P$ for the competitive firm.

Equilibrium of the firm. A competitive firm chooses the output at which profit is greatest. This is where

Since $AR = MR = P$, the condition becomes $P = MC$. Depending on where the AC curve lies at this output, in the short run the firm may earn:

• Supernormal (abnormal) profit when $P > AC$,
• Normal profit when $P = AC$, or
• Losses when $P < AC$ (it continues so long as price covers average variable cost). …