1.5.3a The perfectly competitive model and its assumptions

Perfect Competition Rests on Four Key Assumptions

1. Perfect competition assumes a very large number of buyers and sellers.
2. It assumes a homogeneous product, free entry and exit, and perfect knowledge.
3. These assumptions make each firm a price taker.

Each Firm Is Too Small and Undifferentiated to Set Its Own Price

1. Each firm is tiny relative to the whole market.
2. Its product is identical to every rival's, so it cannot charge more.
3. Buyers have perfect knowledge and would switch instantly.

The Market Sets the Price and the Firm Takes It as Given

1. The market demand and supply set the price.
2. The individual firm then takes that price as given.
3. Its own demand curve is horizontal at that price.

Short-Run Profit or Loss Is Competed Away to Normal Profit in the Long Run

1. In the short run the firm maximises profit where $MC=MR$, and as a price taker this is where $MC=MR=AR=price$; here it can make supernormal profit when $AR>AC$, normal profit when $AR=AC$, or a loss when $AR<AC$.
2. Because entry and exit are free, supernormal profit attracts new firms into the industry, while losses cause some existing firms to leave.
3. Entry raises market supply and pushes the price down, while exit lowers supply and pushes the price up, so the price moves until it reaches the level where $AR=AC$.
4. So in long-run equilibrium every firm makes only normal profit, producing where $MC=MR=AR=AC$.

Is Perfect Competition Really the Ideal?

1. Perfect competition delivers low prices, productive and allocative efficiency and large consumer surplus, which is why it is used as the benchmark for judging other markets.
2. But the assumptions of identical products, perfect knowledge and costless entry almost never hold, so the model is an idealisation rather than a description of most real markets.
3. More competition is not always better, since firms earning only normal profit have little spare to fund research, so a monopoly or oligopoly may be more dynamically efficient over time.
4. Where large economies of scale exist, many tiny price-taking firms would each produce at higher average cost than one large firm, so fragmentation can raise costs rather than lower them.
5. So whether the competitive ideal is best depends on the industry, and in particular on how large economies of scale are and how far the product relies on ongoing innovation.

1.5.3b Price takers and efficient resource allocation

Competitive Firms Are Price Takers Who Accept the Market Price

1. In highly competitive markets there are many buyers and sellers.
2. Firms are price takers, accepting the price the market sets.
3. Easy entry and exit stops firms earning high profits for long.

Many Rivals and Free Entry Keep Prices Close to Costs

1. With many rivals, no firm can raise price above the market level.
2. New entrants arrive whenever profits look attractive.
3. This keeps prices close to costs and pushes firms to be efficient.

In Long-Run Equilibrium the Market Is Allocatively and Productively Efficient

1. In long-run equilibrium price equals marginal cost, giving allocative efficiency.
2. Output sits at the bottom of the average cost curve, giving productive efficiency.
3. Firms earn only normal profit, so there is no supernormal profit.

The Last Unit Is Worth Its Cost and No Resources Are Wasted

1. Price equal to marginal cost means the last unit is worth what it costs.
2. Production at minimum average cost wastes no resources.
3. Free entry competes any supernormal profit away.

Only Normal Profit May Leave Little to Fund Innovation

1. With only normal profit, firms have little spare to invest.
2. Critics argue this limits research and development.
3. So the model doubles as a benchmark for judging other structures.

Give Both Static Efficiency Conditions Together