Perfect competition is a market structure, with these properties:
- Many, small firms;
- Firms are price takers;
- No barriers to entry or exit;
- Perfect information;
- Homogeneous products – the products are all the same and there is no product differentiation.
As a result of no barriers to entry or exit and perfect information, firms will make zero supernormal profits in the long run.
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Examples
This market structure is theoretical. No true “perfectly competitive” market exists. In terms of market structures that are close to perfect competition though, here are a few examples:
- Online sellers on platforms like eBay and Amazon.
- Currency exchange (foreign exchange) markets.
- International markets for farming produce like wheat.
Diagrams
Short run perfect competition
Firms are price takers in perfect competition. In other words, they take the price as given (single firms cannot influence the price directly).
So the price, which is their revenue per unit sold (average revenue, AR), is also the marginal revenue (MR, the extra revenue from selling one more unit).
So MR and AR are both equal to the price. A horizontal line represents MR and AR.
The firm has the usual cost curves, as shown by marginal (MC) and average total cost (ATC).
Below, the diagram shows a perfectly competitive firm’s costs and revenue.
The firm maximises profit by setting MR=MC. So the firm produces output level q and makes supernormal profit equal to (p-c)q – the shaded area.
In perfect competition, firms can make supernormal profit or supernormal losses in the short run. But not in the long run…
Short run to long run: perfect competition diagram
Firms have perfect information. So firms outside the market observe the supernormal profits being made in the industry. There are also no barriers to entry. So in the long run, firms enter the market.
At the industry level, this shifts industry supply to the right from S to S1. This reduces the price from p to p1.
This affects an individual firm. The price a firm takes as “given” is lower, at p1 instead of p. So AR and MR fall too, to AR1 and MR1.
Note the firm still maximises profit by producing where marginal revenue equals marginal cost. But marginal revenue has now fallen. So the output produced falls from q to q1.
This reduces supernormal profits to zero.
Productive efficiency and X efficiency
Productive efficiency means producing at the minimum point of the ATC curve. This occurs in the long run in perfect competition.
If a firm was not productively efficient in the long run, other firms would undercut on cost. This would force the productively inefficient firm out of the market. So all firms left are productively efficient.
A similar argument occurs with X-efficiency. X-inefficiency occurs when firms do not have incentives to control costs. Perfectly competitive firms are X-efficient, meaning they produce on their lowest ATC curve. Again, if a firm were X-inefficient, other X-efficient firms would force that firm to shut down (or force it to be X-efficient) by undercutting on prices. Firms thus have an incentive to control costs in perfect competition.
Allocative efficiency
Allocative efficiency occurs when the output level maximises social welfare.
On the diagram, this means price equals marginal cost (p=MC).
This occurs in perfect competition in the short run and the long run.
We know that firms are price takers. So p=MR=AR. But we also assume firms maximise profits. So MR=MC. It follows that p=MC, in other words there is always allocative efficiency.
Dynamic inefficiency
In the long run, firms make zero supernormal profits in perfect competition.
So firms are dynamically inefficient. They have no supernormal profit to reinvest in reducing costs or improving product quality.
Note you can argue perfectly competitive firms can be dynamically efficient in the short run. In the short run, firms can make supernormal profits for reinvestment.
Other properties of firms in perfect competition
- Homogeneous products means a lack of variety. This reduces consumer welfare.
- Perfect information may reduce incentive to innovate and cut costs. Suppose one firm pays a cost to innovate to improve production processes. Then another firm can just copy the final production process, without paying the innovation cost. So, perfect information allows copying by firms. While this may be good for consumers in the immediate term, it may reduce the incentive to innovate in the first place.
- As firms are small, they may not be able to access economies of scale. So long-run average total costs remain high. So consumers may face higher prices compared with a natural monopoly operating in the market.
Other evaluation points
Some possible evaluation points for perfect competition include:
- In response to productive efficiency / dynamic inefficiency: This depends on the time frame. In the short run firms can make supernormal profits and so may not be productively efficient …. (or so they may be dynamically efficient in the short run.
- In response to allocative efficiency / consumer surplus point: This depends on the preferences of consumers. Consumers may desire variety and perfect competition has homogenous goods, thus consumers get less variety and less in the way of consumer welfare as a result.
- In response to productive efficiency: This depends on the extent of information. Under perfect competition there is perfect information. So suppliers can copy each other’s production process. If one firm wants to invest in new equipment to reduce its costs, its resulting production process could be copied by other firms without the initial investment. This makes the original firm worse off relative to competitor firms and reduces incentives to invest in cost reduction, keeping costs and prices high for consumers.
- In response to productive efficiency: This depends on the extent of economies of scale or the size of the firm. If there are significant economies of scale, then many small firms will not be able to achieve economies of scale. This results in higher average costs and hence prices for consumers in a perfectly competitive market …
- In response to allocative efficiency: This depends on whether market failures exist. E.g. a negative externality may not be accounted for in perfect competition, leading to allocative inefficiency / market failure.
Essay plan
Here is a quick essay plan for the following question:
Evaluate the view that perfectly competitive markets are efficient (25 marks)
Intro – define perfect competition and give key properties.
Point 1 – productively efficient in the long run via diagram
Evaluation 1 – short run vs long run
Point 2 – cannot achieve economies of scale as firms are small. Show economies of scale diagram. Can be seen as productive inefficiency.
Evaluation 2 – depends on the size of the firm or the extent of economies of scale.
Optional point 3 – allocative efficiency in short run and long run
Evaluation 3- assumes no market failure. If there is an externality, there may be overprovision.
Conclusion – I’ll leave this to you! What do you think? Are perfectly competitive markets efficient and why / why not? What does your conclusion depend on?
Related posts
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