Perfect Competition

1. There are very many buyers and sellers, each so small that its own output is a tiny share of the market.
2. The product is homogeneous, and there is free entry and exit with perfect knowledge shared by all participants.
   1. Together these assumptions force each firm to be a price taker, because none can move the price and none can charge more for an identical good.

The firm as a price taker

$$P=AR=MR$$

1. Because each firm is tiny, changing its own output cannot shift market supply enough to move the price.
2. Because the product is identical and buyers have perfect knowledge, raising price by even a penny would send every customer to a rival, so the firm cannot charge above the market price.
3. The firm's demand curve is therefore horizontal at the market price, so each extra unit sells for that same price and P = AR = MR.

Profit maximisation

$$MC=MR$$

1. Below this output an extra unit adds more to revenue than to cost, and beyond it each extra unit costs more than it earns, so profit peaks where the two are equal.
2. Since MR = price for the price taker, the firm effectively produces where MC = P.

Short-run equilibrium

$$AR=AC$$

1. In the short run the firm can earn supernormal profit (AR > AC), break even (AR = AC) or make a loss (AR < AC), depending on where the market price sits relative to its costs.
   1. On the diagram, output is on the horizontal axis and price and cost on the vertical axis, with the horizontal demand curve labelled AR = MR = D at the market price.
   2. The MC curve cuts the U-shaped AC curve at its lowest point; the firm produces where MC meets AR = MR, and profit or loss is the rectangle between AR and AC across that output.

Long-run equilibrium

1. Free entry and exit competes away any short-run profit or loss, leaving only normal profit in the long run.
   1. Supernormal profit attracts new firms, raising market supply and lowering price until the extra profit disappears; losses drive firms out, cutting supply and raising price until survivors just break even.
2. On the diagram, entry shifts the price down until the horizontal demand curve is tangent to the lowest point of the AC curve, where AR = AC and MC = MR at the same output.

Efficiency in perfect competition

1. In long-run equilibrium price = MC, so the value consumers place on the last unit equals the cost of making it and the market is allocatively efficient.
2. Output sits at the lowest point of the AC curve, so the firm is also productively efficient.
3. But with only normal profit there is little surplus to fund research, so dynamic efficiency may be weak.

Is perfect competition really efficient?

1. It holds on static grounds: in long-run equilibrium P = MC and output is at minimum AC, so the model is the benchmark for allocative and productive efficiency.
2. But it is dynamically weak, because firms earning only normal profit have little spare to invest, and a homogeneous product leaves no scope for product innovation.
3. And the model is unrealistic: perfect knowledge, identical products and costless entry rarely hold, so real markets (farming is only a rough proxy) seldom match it.
4. On balance it is best used as a yardstick for judging other structures rather than a description of reality, so whether it is truly efficient depends on how much weight is placed on dynamic rather than static efficiency.