Characteristics of perfect competition
All goods/services are the same and therefore firms within in perfectly competitive markets cannot gain price making powers through unique goods/services. This also means that consumers do not have any preference over which firm they buy the good/service from. All of this contributes to firms being price takers.
Many buyers and sellers
There are many buyers within the market and many small firms selling the good/service. Therefore, consumers have lots of choice, meaning that if one firm increases their prices, the consumer will simply shop at another firm. This is one of the reasons why firms in perfectly competitive markets have no price making ability.
No barriers to entry or exit
Firms can easily enter and exit the market whenever they want. This means that any supernormal profit that can be gained from the market will attract new entrants, thus increasing supply, leading to a decrease in price and therefore the removal of the supernormal profits.
Buyers and sellers have perfect levels of information. This means that buyers and sellers know when another firm has changed their price level. For example, if a firm increases their price level, consumers will know about this and therefore buy from one of the many other firms selling the good/service. Furthermore, if a firm decides to lower their prices, all of the sellers within the market will know about this and therefore will lower their prices also. This is one of the main reasons why all firms within a perfectly competitive market are price takers, as they only decrease their own total revenue and profit levels when trying to gain competitive advantages through decreasing their price level.
Firms profit maximise
Firms operate at the profit maximising point where marginal cost is equal to marginal revenue.
Profit maximising equilibrium in the short run and long run
Perfectly competitive markets can be shown on both a long run and short run diagram. One of the main aspects of the perfect competition diagram is that the AR=MR=D line is completely elastic. This is due to the characteristics in perfectly competitive markets that cause firms to be price takers. For example, firms produce homogenous goods which means that no firms can have a competitive advantage over one another. Furthermore, there is perfect information and therefore a rise in the price will lead to a loss of customers and a decrease in the price will lead to a loss of revenue (as mentioned earlier). Therefore firms have no benefit in changing their price levels, thus causing them to become price takers as shown by firms taking the market price (P1).
As firms within perfectly competitive markets are profit-maximisers, they produce at the point where MC=MR. This gives a price level of P1 and a quantity of Q2. The price point that they’re operating at is above their average costs and therefore some supernormal profit is made. However, due to the perfectly competitive characteristics… Read more