Perfect Competition - Interpretation of the Long-Run Supply Curve (Perfect Competiton)
Section 2, Topic 32b, Oct. 24, 2007
by Steve Jackson

Perfect Competition

Perfect competition is defined as an ideal market condition characterized by a large number of small firms, identical products sold by all firms, freedom of entry and exit out of the industry, and perfect knowledge of prices and technology (AmosWEB, 2007). There are four strict conditions of perfect competion (Chartrand, 2007):
  • Anonymity - Consumers are indistinguishable to producers. Firms have no reason to favor one customer over another. Products among firms are homogenous and consumers have no reason to prefer the product of one firm over that of another.
  • No Market Power - Large number of both producers and consumers. Sales or purchases by any buyer or seller are small relative to the total volume of exchange in the market. No one has market power.
  • Perfect Knowledge - Both consumers and producers have perfect knowledge about price and quality. Market equilibrium price is set.
  • Free Entry & Exit - Unimpeded flow of resources which are mobile and move to the use with greatest advantage in terms of opportunity costs. Firms exit if they experience economic loss. Firms enter the market if they expect to earn economic short-run and/or long run profits.

Perfect competition is graphically shown below (AmosWeb, 2007). The market supply and demand is depicted in the left graph. The firm's demand is depicted in the right graph. In a perfectly competitive market, the demand curve for an individual firm's product is simply the market price. The market price is determined by the interaction of supply and demand in the market. If the firm tried to change the price, they would sell nothing. Firms have to charge the market price because consumers view all products from all firms as perfect substitutes. If one firm would increase the price, then consumers would just go to another firm. Firms have an incentive not to change the price from the market price.

Market
Market
Firm
Firm















Long-Run Supply Curve

Before discussing the long-run, it is best to understand what happens in the short-run. In the short-run, firms earn profits (or losses) as shown in the left graph. The price P1 is determined at the intersection of the Market Supply (MS) and Market Demand (MD) curves. At P1, moving over to the firm's graph, you can see the firm will make a profit since MC is greater than AC.

Over the long-run, firms enter the market and move the Market Supply (MS2) to the right and lower the price to P2. At P2, the firm is at equibrium point where MC is equal to MR2. At this equilibrium point, the firm earns zero economic profits (Baye, 2006). In the long run, all factors are variable and long-run optimal output exists where P = LRMC. The long-run supply curve is the portion of the long-run marginal cost curve above the long-run average cost (tutor2u, 2007).

The adjustment to the long-run equilibrium
The adjustment to the long-run equilibrium


Application of Perfect Competition and Long-Run Supply Curve

The best and closest example of a perfectly competive market exists in agricultural markets where there are large number of suppliers and almost perfectly substitutable products (corn, wheat, soybeans, etc.). The following example shows how the agricultural market for corn is considered a perfectly competitive market.

  • There are many Indiana farms producing corn along with many buyers (individuals and firms)
  • All the Indiana farmers are producing the same kind of corn with no differentiation
  • The farmers and consumers know everything about the corn (type, market price, etc.)
  • There are no transaction costs when purchasing the corn
  • Anyone with land can start to farm and farmers can stop growing corn anytime

Another recent example of a perfectly competitve market is eBay auctions. At eBay, there are many sellers of products with no barriers to entry or exit (anyone can sell on eBay).
  • There are many sellers and buyers on eBay (millions).
  • Identical products are available from multiple sellers.
  • Buyers and sellers have the right information avaiable to them
  • Transactions costs area minimal (<$2)
  • Anyone can enter or exit the eBay market when they want


Example Multiple Choice Questions

1. Which of the following is not a characteristic of perfect competition:
a. small number of large firms
b. no barriers to market entry or exit
c. perfect knowledge of products and technology
d. none of the above

2. The computer industry is an example of a perfect competition market.
True
False

3. The long-run supply curve is equal to the long-run marginal cost curve above the long-run average cost curve
True
False

4. In the long-run perfect competition market equilibrium, the price is equal to which of the following:
a. long-run marginal cost
b. average total cost
c. long-run actual cost
d. all of the above

5. As a perfectly competitve market adjusts over the long-run, the number of suppliers increase and the price
a. increases
b. decreases
c. stays the same
d. increases then decreases

Answers

1. a, should be large number of small firms
2. false, computers are not a homogeneous product (different types and prices)
3. true, refer to graph
4. d, at equilibrium, price is equal to all of these
5. b, decreases, refer to graph

References

Baye, Michael R., Managerial Economics and Business Strategy, 5th Edition, McGraw-Hill Irwin, 2006

PERFECT COMPETITION, LONG-RUN EQUILIBRIUM CONDITIONS, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2007. [Accessed: October 17, 2007]

PERFECT COMPETITION, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2007. [Accessed: October 17, 2007]

Chartrand, Harry Hillman, 4.2 PERFECT COMPETITON, Elemental Economics, http://members.shaw.ca/h-chartand/4.3.htm, Compiler Press, 2007. [Accessed: October 17, 2007]

PERFECT COMPETITION, tutor2u, http://www.tutor2u.net/economics/revision-notes/a2-micro-perfect-competition.html [Accessed: October 24, 2007]

PERFECT COMPETITION, wikipedia, http://en.wikipedia.org/wiki/Perfect_competition [Accessed: October 24, 2007]