Perfect competition is a market structure where many firms sell identical products, with no individual influence on prices. Firms are price takers, maximizing profits by producing where marginal revenue equals marginal cost. This model illustrates key economic principles of supply and demand.

In the short run, firms may earn profits or losses, but long-term equilibrium results in zero economic profit. This concept ties into broader themes of market efficiency, resource allocation, and the relationship between costs and production decisions explored in this chapter.

Characteristics of perfect competition

Market structure and participants

• Large number of buyers and sellers in the market too small to influence prices individually
• Homogeneous products identical or nearly identical across all firms (laundry detergent)
• No barriers to entry or exit allowing firms to freely enter or leave the industry
• Perfect information assumed with all participants having complete knowledge about prices, quality, and other factors

Firm behavior and demand

• Firms are price takers accepting the market price as given unable to influence it
• Demand curve for individual firms perfectly elastic represented as a horizontal line at market price
• Marginal revenue equals market price due to perfectly elastic demand

Profit Maximization in perfect competition

Profit-maximizing production decisions

• Firms maximize profits by producing where marginal revenue (MR) equals marginal cost (MC)
• Profit-maximizing rule expressed as $P = MR = MC$ where P is market price
• Continue production as long as market price exceeds average variable cost (AVC) in short run
• Shutdown point occurs when market price falls below minimum of AVC curve
• Exit market in long run if price falls below minimum of long-run average cost (LRAC) curve

Profit calculation and analysis

• Economic profit calculated as difference between total revenue and total cost
• Include both explicit costs (wages, rent) and implicit costs (opportunity cost of resources)
• Firms may earn economic profits, break even, or incur losses in short run
• Zero economic profit in long-run equilibrium indicates normal returns on investment

Equilibrium in perfect competition

Short-run equilibrium

• Firms can adjust output levels but not scale of operations or enter/exit market
• Equilibrium occurs when market price equals short-run marginal cost (P = MC)
• Firms produce where P = MC to maximize profits
• Economic profits, breakeven, or losses possible depending on price and average total cost

Long-run equilibrium

• All inputs variable allowing firms to adjust scale and enter/exit market freely
• Achieved when firms earn zero economic profit
• Market price equals minimum of long-run average cost curve
• Entry and exit in response to profits or losses drives market toward equilibrium
• All firms produce at most efficient scale operating at minimum point of average cost curves

Efficiency and welfare of perfect competition

Economic efficiency

• Allocative efficiency achieved with price equal to marginal cost of production (P = MC)
• Productive efficiency reached as firms produce at lowest possible average cost in long run
• Pareto efficiency attained with resources allocated so no one can be better off without making others worse off

Market outcomes and social welfare

• Market equilibrium maximizes total economic surplus (consumer surplus + producer surplus)
• Invisible hand concept explains how self-interest leads to socially optimal outcomes (Adam Smith)
• Eliminates deadweight loss ensuring all mutually beneficial transactions occur
• Real-world markets often deviate from perfect competition due to imperfections (monopolies, externalities)