The Market and the Firm Under Perfect Competition

When economists talk about perfect competition they mean a market structure that leaves firms virtually powerless to compete as we normally use that term. In fact, the firm under perfect competition does not compete. Instead, it reacts to the market conditions, taking price and other market factors as beyond its control.
        A market is a perfect competition if it meets four basic criteria:
        1.      The product of all sellers is identical.
        2.      All participants in the market, buyers and sellers, must be small relative to the entire market. As a result, there should be many firms and buyers in the market.
        3.      Factors of production must be perfectly mobile in the long run.
        4.      Market participants have perfect knowledge of and access to technology and prices.
Finding perfect competitions is difficult. Some economists feel that agricultural markets come close to perfect competition, but they usually fail one or more of the tests. There may be a large buyer, information may not be perfect, and factors of production may not be mobile. Moreover, there is frequently government intervention in agriculture. But to a certain extent, agricultural markets offer an actual market structure that conforms most closely to perfect competition.

The Price Taking Firm
When a market meets these tests of perfect competition, there are two primary outcomes. First, firms are unconcerned about their competitors, because there is nothing they can do to affect their own behavior, that of their competitors, or the market outcome. Second, as shown in figure 10.1, the demand curve each firm sees is horizontal. At the market price, P_m, the firm can sell as much as it wants.

We call a firm in this situation a price taker. It has no incentive to lower its price - it can sell all it wants at the market price - and no ability to raise price - to do so would drive all customers away, for they could buy the same good elsewhere for less. The firm has no alternative but to sell at P_m, at which it faces an infinite price elasticity of demand.

Profit Maximization by the Perfectly Competitive Firm
We already know to maximize profit a firm sets production where marginal revenue equals marginal cost. By the relationship between marginal revenue and price, however, we can see that the perfectly competitive firm achieves this condition by setting output where marginal cost equals price. Since MR=P(1-1/e_p), and with a horizontal demand curve e_p equals infinity, the profit maximizing firm in perfect competition produces where P=MC.

A firm's production decision can be found by superimposing marginal cost, average cost, and average variable cost curves on the firm's demand curve, as shown in figure 10.2. The figure uses short run cost curves because production decisions occur in a short run environment.

The short run supply curve
For the firm in a perfect competition, the marginal cost curve determines its output for any given price. We see this in figure 10.5. At a price of P₁, nowhere is price above average variable cost. Thus, the firm shuts down in the short run. Output is zero, as indicated by Q₁ being located at the origin. If price equals P₂ or P₃, however, price exceeds average variable cost, and we can determine output by reading down from the marginal cost curve. This gives the following important conclusion: A firm's short run supply curve is that section of its short run marginal cost curve that is located above its average variable cost curve. Market supply is just the horizontal sum of individual supply curves. Thus, if we measure what the quantity supplied by each firm will be at each price, summing these quantities gives the market quantity supplied.

The competitive market in the long run
The role of profit and loss in perfect competition
The existence of profit in a perfect competition attracts entry - new firms entering the market - or expansion - existing firms expanding their scale of operation. Economic losses have the opposite effect. If economic losses occur, we expect that in the long run firms will leave the industry or adjust capital in some way to mitigate or eliminate the low return.

Short run and long run adjustments
We already know that positive profit will bring about entry or expansion or both, and loss brings about exit or contraction. For the existing firm, entry or exit means a change in its profit maximizing output.

Figure 10.14 tells the story. Suppose the initial price in the market is P₁, as determined by the market demand, D, and the short run market supply, SRS₁. At that price, our representative firm, with short run cost curves are as shown in the right panel, sets its output at q₁ and makes a positive profit. The profit brings about entry. New firms want their share, start producing in this market, and the market supply curve shifts out to SRS₂. The firm produces q₂ units, still makes a profit, but both its output and profit are smaller than before the entry occurred.
Entry continues until no incentive exists for more - that is until firms in the market are making only normal returns - when aggregate short run supply is SRS₃ and price has fallen to P₃. At that price, on these particular sets of short run curves, the firm is making only normal returns. It is producing at minimum short run average cost, and thus cannot change output to alter short run profits, given the price P₃. There is no incentive for entry or exit, because short run profits are zero, and it looks like a stable situation.

But is it? A long run equilibrium requires that firms have no reason to enter, exit, expand or contract. The long run cost curves show that firms in the market may well have a motivation to change the amount of capital in place, a long run adjustment of expansion or contraction.
In figure 10.15 the long run average cost curve and an additional set of short run cost curves are added to the firm's graph. When the firm is operating with the curves labeled with subscript 1, at a market price of P₃ its profit is zero. But, by investing in more capital, and expanding to the curves subscripted 2, the firm can again make a positive economic profit. The incentive to expand is there, and so output q₃ is not a long run equilibrium for the firm.

A similar analysis holds when market price is so low that firms suffer short run losses, as shown in figure 10.16. We show two possibilities for firms to be losing money at a market price of P*. A firm at the short run curves labeled with a subscript 1 could improve its situation, and even make a positive profit, by expanding to a capital level which would put it on the curves with subscript 3. But also possible is that the firm is too large - it is on the cost curves SMC₂ and SAC₂. By eliminating some capital investment, such firms can improve their profit picture.

Long run equilibrium
Long run equilibrium in a competitive market means existing firms have no ability to expand or contract to increase profits, no reason to exit the industry, and gives new investors no incentive to enter.

Assuming the representative firm has a u-shaped long run average cost curve, competitive market long run equilibrium is reached when price equals minimum long run average cost, an output of q_m in figure 10.17. Market short run supply (SRS) and demand (D) establish a market price of P_m. At that price the firm maximizes profit at q_m, where short run marginal cost, SMC, equals P_m and both short run average cost and long run average cost are at their minimum values.
Since price equals average cost, profit is zero. Thus, there is no incentive for entry or exit. Moreover, because the firm is at its minimum long run average cost, there is no change in investment that can increase profit. We find the interesting paradox that the drive to make above normal returns (profits) results in a zero profit equilibrium in the competitive market. Firms make a normal return, but no more.