Perfect competition is a market structure where many firms sell identical products. Buyers and sellers have perfect information, and no single participant can influence prices. This creates a level playing field where firms are price takers.

In the short run, firms maximize profits by producing where price equals marginal cost. In the long run, firms enter or exit the market freely, leading to zero economic profit. This results in allocative and productive efficiency, benefiting consumers.

Characteristics and Dynamics of Perfect Competition

Key Characteristics

• Large number of buyers and sellers prevents any single participant from influencing market price, making all participants price takers
• Homogeneous products sold by different firms are identical or nearly identical with no product differentiation (wheat, oil)
• Free entry and exit allows firms to easily enter or leave the market without significant legal, technological, or economic barriers
• Perfect information ensures all market participants have complete knowledge about prices, product quality, and production techniques
• Profit maximization drives firms to maximize profits given the market conditions

Short-Run Output Decisions

• Firms are price takers facing a perfectly elastic demand curve determined by the interaction of market supply and demand, requiring acceptance of the market price (P)
• Profit maximization occurs when marginal revenue (MR) equals marginal cost (MC), with MR = P in perfect competition as each additional unit is sold at the market price
• Firms should produce the quantity where P = MC to maximize profits or minimize losses
• Economic profit is earned if P > average total cost (ATC) at the profit-maximizing quantity
• Economic loss is incurred if P < ATC at the profit-maximizing quantity, but firms may continue operating in the short run as long as P ≥ average variable cost (AVC)
• Firms should shut down to minimize losses if P < AVC

Long-Run Adjustments

• In the long run, firms freely enter or exit the market in response to economic profits or losses
• New firms enter the market if existing firms are earning economic profits in the short run, increasing market supply and putting downward pressure on the market price until economic profits reach zero (normal profit)
• Some firms exit the market if incurring economic losses in the short run, decreasing market supply and putting upward pressure on the market price until economic losses reach zero (normal profit)
• Long-run equilibrium in a perfectly competitive market is characterized by:
  1. All firms earning zero economic profit (normal profit)
  2. P = MC = minimum ATC for each firm
  3. No incentive for firms to enter or exit the market
• Perfectly competitive markets are allocatively efficient (P = MC) and productively efficient (firms produce at minimum average total cost) in the long run