Perfect Competition

Perfect competition is the market form economists use as a theoretical benchmark — a market with the maximum possible degree of competition — even though few real markets meet every one of its conditions exactly. A market is perfectly competitive when it satisfies five conditions together: a very large number of buyers and sellers, none big enough individually to influence the market price by changing its own output or purchase; a homogeneous (identical) product, so that no buyer prefers one seller's unit over another's; free entry and exit of firms, with no legal, financial, or technical barrier stopping a new firm from starting production or an existing one from leaving; perfect knowledge, meaning every buyer and seller knows the price and terms prevailing everywhere in the market; and no transport cost or other friction that would let one seller's product sell at a different delivered price than another's.

The single most important consequence of these conditions is that an individual firm under perfect competition is a price taker rather than a price maker. Because the firm is only one of a very large number of identical sellers, the quantity it alone decides to produce is too small a fraction of total market supply to move the price at all — the firm must simply accept whatever price the market, through the intersection of total demand and total supply, has already settled on. This is why the demand curve facing an individual perfectly competitive firm is drawn as a horizontal straight line at the going market price: the firm can sell any quantity it wishes at that price, but nothing at all above it, and has no reason to sell below it. Since every extra unit sold by the firm adds exactly the market price to revenue, average revenue (price received per unit) and marginal revenue (the addition to total revenue from selling one more unit) are equal to each other and to price at every level of output:

This single equality is what distinguishes the firm's revenue behaviour under perfect competition from every other market form covered later in this chapter, where AR and MR pull apart. …