How Well Do You Understand Perfect Competition?

Perfect Competition: Characteristics, Conditions, and Government Intervention

• Perfect competition is a market structure in which firms are price takers for a homogeneous product.

• The theory of perfect competition has its roots in late-19th century economic thought, and was formalized in the 1950s by Kenneth Arrow and Gérard Debreu.

• Imperfect competition was created to explain the more realistic kind of market interaction that lies between perfect competition and a monopoly.

• Perfect competition provides both allocative efficiency and productive efficiency.

• Real markets are never perfect, but economists who believe in perfect competition as a useful approximation to real markets may classify those as ranging from close-to-perfect to very imperfect.

• In a perfect market, the sellers operate at zero economic surplus, making a level of return on investment known as normal profits.

• Economic profit does not occur in perfect competition in long run equilibrium; if it did, there would be an incentive for new firms to enter the industry.

• Economic profit is, however, much more prevalent in uncompetitive markets such as in a perfect monopoly or oligopoly situation.

• Governments will try to intervene in uncompetitive markets to make them more competitive, including the use of antitrust or competition laws, which were created to prevent powerful firms from using their economic power to artificially create barriers to entry.

• If a government feels it is impractical to have a competitive market, it will sometimes try to regulate the existing uncompetitive market by controlling the price firms charge for their product.

• In a perfectly competitive market, the demand curve facing a firm is perfectly elastic.

• In the absence of externalities and public goods, perfectly competitive equilibria are Pareto-efficient.Equilibrium in a Two-Good Economy

• In a two-good economy, the prices of the two goods must equal their respective marginal costs in equilibrium.

• Marginal cost equals factor price divided by factor marginal productivity.

• Optimal factor employment by a price-taking firm requires equality of factor rental and factor marginal revenue product.

• The marginal utility of money must be equal for both goods for a consumer purchasing both goods in equilibrium.

• The consumer surplus in equilibrium is the difference between the maximum amount the consumer is willing to pay and the amount they actually pay.

• The producer surplus in equilibrium is the difference between the price and the minimum amount the producer is willing to accept.

• Total surplus in the economy is the sum of consumer and producer surplus.

• If a tax is imposed on one of the goods, the price of that good will increase and the equilibrium quantity of that good will decrease.

• The tax incidence will be shared between consumers and producers depending on the relative elasticities of supply and demand for the taxed good.

• A subsidy on one of the goods will decrease the price of that good and increase the equilibrium quantity of that good.

• The subsidy incidence will be shared between consumers and producers depending on the relative elasticities of supply and demand for the subsidized good.

• The deadweight loss from a tax or subsidy is the loss of consumer and producer surplus due to the market distortion caused by the tax or subsidy.Overview of Perfect Competition in Economics

• Perfect competition is an ideal market structure where there are many small firms selling identical goods or services, and no single firm has market power to influence price.

• In perfect competition, firms are price takers and must accept the market price for their output.

• The optimal allocation of resources in a competitive market occurs when the marginal rate of substitution between goods for consumers is equal to the marginal rate of transformation for producers.

• Monopoly violates this optimal allocation condition by underutilizing factors in the monopolized industry, leading to higher indirect marginal utility than in their uses in competitive industries.

• In contrast to a monopoly or oligopoly, in perfect competition, it is impossible for a firm to earn economic profit in the long run, which is to say that a firm cannot make any more money than is necessary to cover its economic costs.

• The zero-long-run-profit thesis means that profits in the classical meaning do not necessarily disappear in the long period but tend to normal profit.

• In perfect competition, abnormal profit in the short term acts as a trigger for other firms to enter the market, causing prices to fall until all firms are earning normal profit only.

• In the short run, a firm operating at a loss must decide whether to continue to operate or temporarily shut down based on whether it earns sufficient revenue to cover its variable costs.

• The shutdown rule states that for a firm to continue producing in the short run it must earn sufficient revenue to cover its variable costs.

• The firm should compare total revenue to total variable costs rather than total costs when determining whether to shut down.

• If the revenue the firm is receiving is greater than its total variable cost, then the firm is covering all variable costs and there is additional revenue ("contribution"), which can be applied to fixed costs.

• If the firm is not covering its production costs, then it should immediately shut down.Perfect Competition Model and Short-Run Supply Curve

• The perfect competition model is a theoretical concept in economics that assumes all firms in a market are price-takers and produce homogeneous products.

• The short-run supply curve for a perfectly competitive firm is the marginal cost curve at and above the shutdown point.

• The shutdown point is the price at which a firm's revenue no longer covers its variable costs.

• A firm should continue to operate if its revenue is equal to or greater than its variable costs.

• A firm should shut down if its revenue is less than its variable costs.

• Shutting down is a short-run decision, while exiting the industry is a long-term decision.

• In the long run, a firm operates where marginal revenue equals long-run marginal costs.

• The perfect competition model is criticized for not being realistic due to the assumption of product homogeneity and passivity of agents.

• Some economists criticize the model for raising the question of who sets the prices.

• The rejection of perfect competition does not generally entail the rejection of free competition in most product markets.

• The absence of marketing expenses and innovation as causes of costs is found to be fundamentally lacking in the perfect competition model.

• The acceptance or denial of perfect competition in labor markets makes a big difference to the view of the working of market economies.