Perfect Competition

5. Perfect mobility of the factors of production. Labour and capital can move freely between firms and between uses, so that resources flow to wherever the return is highest.

6. No transport cost. Included so that a single price can rule throughout the market. If transport costs differ, prices differ, and the market has broken into several.

7. No government interference. No price control, no quota, no tax that falls unevenly on some sellers.

8. Absence of selling costs. No advertising, because there is nothing to advertise: the product is identical and everybody already knows the price. This is a striking feature and an examiner likes it. Advertising exists only where products differ or knowledge is imperfect.

Pure competition against perfect competition. Some writers reserve the term pure competition for the first three features alone, a large number of sellers, a homogeneous product and free entry, and require the remaining conditions for perfect competition. Mentioning the distinction and attributing it to Chamberlin is worth a line.

The consequences that follow from the features

These are what the features are for, and a good answer derives them rather than listing them separately.

A single ruling price. Follows from homogeneity plus perfect knowledge. There cannot be two prices for the same thing in a market where everybody knows both.

The firm is a price taker. It can sell any quantity it likes at the ruling price and nothing at all above it.

The firm's demand curve is horizontal, that is perfectly elastic, at the ruling price. This is the single most examined proposition in the topic. Note the contrast: the industry's demand curve slopes downward in the ordinary way, because the industry as a whole faces all the buyers. Only the individual firm faces a horizontal line, because it is too small to matter.

Average revenue equals marginal revenue equals price. Average revenue is total revenue divided by output, which for a firm selling every unit at the same price is that price. Marginal revenue is the addition to total revenue from selling one more unit, which is again that price because the price does not have to be cut to sell more. So AR = MR = P, and the firm's demand curve, its average revenue curve and its marginal revenue curve are one and the same horizontal line. Under every other market form MR lies below AR, and that single difference generates most of what distinguishes monopoly.

How price and output are determined

The industry fixes the price. Total market demand and total market supply meet at the equilibrium price, exactly as in [How Demand and Supply Together Set a Price]. That price is then a datum for every firm.

The firm fixes only its output. It expands output so long as the revenue from one more unit exceeds the cost of one more unit. So it produces where marginal cost equals marginal revenue, which here means where marginal cost equals price.

A numerical illustration. Suppose the ruling price is 50 rupees and a firm's marginal cost is 30 rupees at 100 units, 50 rupees at 140 units and 70 rupees at 160 units. At 100 units another unit adds 50 in revenue and 30 in cost, so it should be made. At 160 units another unit adds 50 and costs 70, so it should not. The profit maximising output is 140 units, where marginal cost has risen to equal the price.

Short run and long run equilibrium

In the short run the number of firms is fixed and plant cannot be changed. A firm produces where price equals marginal cost, and at that output it may earn:

• supernormal profit, if price is above average total cost;
• normal profit, if price equals average total cost. Normal profit is the minimum return needed to keep the entrepreneur in this line of business, and in economics it is counted as a cost, not as profit;
• a loss, if price is below average total cost. A firm continues to produce at a loss in the short run so long as price covers average variable cost, because it is then contributing something towards its fixed costs. Below average variable cost it shuts down. That price is called the shutdown point.

In the long run, entry and exit do their work. If firms are earning supernormal profit, new firms enter, industry supply rises, price falls, and profits are competed away. If firms are making losses, some leave, supply falls, price rises. The process stops only when price equals average cost and every firm earns exactly normal profit.

So in long run equilibrium under perfect competition, price equals marginal cost equals the minimum of average cost, and only normal profit is earned. That single line is the most quoted conclusion in the whole of microeconomics, and its three parts each carry a meaning:

• Price equals marginal cost means the value buyers put on the last unit equals what it cost society to make it, so no reallocation could improve matters. This is allocative efficiency.
• Production at the minimum of average cost means each firm is producing at the lowest cost per unit it is capable of. This is productive efficiency.
• Only normal profit means no producer is extracting a surplus from buyers.

A worked example: the mandi at Lasalgaon

The market. Several thousand onion growers bring produce to the same regulated market on the same morning. The onions of any one grower are indistinguishable from any other's of the same grade.

Feature by feature. Very many sellers: yes. Homogeneous product within a grade: nearly. Free entry: largely, though land is a constraint. Knowledge: much better than it was, because arrivals and rates are published and reach growers by phone. No selling costs: correct, because a grower does not advertise onions. Transport costs: not zero, which is the first real departure.

The consequence. Sanjay, who brings forty quintals, cannot ask more than the ruling rate: the trader will simply buy from the next heap. Nor need he accept less. He is a price taker with a horizontal demand curve, and his only decision is how much to bring and when.

Where the model breaks, honestly stated. The buyers are not numerous. A limited number of licensed traders buy from many growers, which is the oligopsony noted in [Market Structure: The Four Forms]. The market is therefore competitive on the selling side and concentrated on the buying side, which is exactly why agricultural market reform in India has been about widening the set of permitted buyers rather than about the number of farmers.

What beginners get wrong

"The firm's demand curve is horizontal, so demand is unlimited." No. It means the firm can sell as much as it can produce at the going price, which is a statement about the firm's insignificance, not about the market's appetite.

"Perfect competition means there is a lot of competition." In a sense the opposite: no firm competes with any other by price, quality or advertising, because none of those is available. Rivalry in the ordinary sense is a feature of monopolistic competition and oligopoly.

"Normal profit means zero profit." Normal profit is a real return to the entrepreneur, counted as a cost of production. Zero economic profit and zero accounting profit are different things.

"A firm making a loss must shut down at once." In the short run it should continue if price covers average variable cost.

Limits and criticism

No market meets all eight conditions. Products are differentiated, knowledge is imperfect and entry is rarely free.

Homogeneity and product variety are in conflict. A world of perfect competition would offer consumers no choice of style, brand or quality at all, and consumers plainly value that choice.

It cannot accommodate economies of scale. Where average cost falls continuously with size, as in electricity transmission or railways, a large number of small firms is the most expensive way to produce, and competition destroys itself. That is the case of natural monopoly in [Monopoly].

It has no place for innovation. With perfect knowledge and homogeneous products, nobody can profit from being first. Schumpeter's criticism, taken further in [Why Trade Cycles Happen, and What Governments Do About Them], is that the temporary monopoly profit that perfect competition abolishes is precisely what pays for innovation.

It is static. It describes an equilibrium and not the process by which markets actually move.

Quick revision

1. Eight features: very many buyers and sellers; homogeneous product; free entry and exit; perfect knowledge; perfect factor mobility; no transport cost; no government interference; no selling costs.
2. Consequences: one ruling price; the firm is a price taker; the firm's demand curve is horizontal while the industry's slopes downward; and AR equals MR equals price.
3. Equilibrium of the firm: produce where marginal cost equals marginal revenue, which here means marginal cost equals price.
4. Short run: supernormal profit, normal profit or loss are all possible. Continue producing while price covers average variable cost; below that, shut down.
5. Long run: entry and exit remove supernormal profit and losses, so price equals marginal cost equals minimum average cost and only normal profit is earned.
6. Normal profit is a cost, being the minimum return that keeps the entrepreneur in the business.
7. Efficiency: price equals marginal cost gives allocative efficiency; production at minimum average cost gives productive efficiency. This is why the model is the benchmark.
8. Pure competition requires only many sellers, a homogeneous product and free entry; perfect competition adds the rest.

Test yourself

1. State the features of perfect competition. A very large number of buyers and sellers, each too small to influence price; a homogeneous product, so that buyers are indifferent between sellers; complete freedom of entry into and exit from the industry; perfect knowledge of prices and qualities on the part of all participants; perfect mobility of the factors of production; absence of transport costs, so that one price rules throughout; absence of government interference; and absence of selling costs, since there is nothing to advertise.

2. Why is the demand curve of a firm under perfect competition horizontal, while the industry's slopes downward? The individual firm is so small a part of the market that it can sell its entire output at the ruling price without depressing it, and it can sell nothing at all above that price because buyers know that identical goods are available elsewhere at the ruling rate. Its demand curve is therefore perfectly elastic at that price. The industry, by contrast, faces the whole body of buyers, and the market can absorb a larger total quantity only at a lower price, so the industry's demand curve obeys the ordinary law of demand.

3. Show why average revenue equals marginal revenue equals price under perfect competition. Average revenue is total revenue divided by the quantity sold, and since every unit is sold at the same ruling price, average revenue is that price. Marginal revenue is the addition to total revenue from selling one further unit; because the firm need not lower its price to sell more, that addition is again the full price. Hence average revenue, marginal revenue and price coincide, and the firm's demand, average revenue and marginal revenue curves are the same horizontal line. Under all other market forms marginal revenue lies below average revenue, because more can be sold only at a lower price on every unit.

4. Describe the long run equilibrium of a firm under perfect competition. Free entry and exit remove both supernormal profits and losses. If profits are being earned, new firms enter, industry supply rises and price falls; if losses are being made, firms leave, supply contracts and price rises. Equilibrium is reached only when price equals average cost, so that every firm earns exactly normal profit, and since the firm also produces where price equals marginal cost, the outcome is that price equals marginal cost equals the minimum point of average cost.

5. What is normal profit, and why is it treated as a cost? Normal profit is the minimum return that must be earned by the entrepreneur to keep them in that line of production rather than moving their capital and effort elsewhere. Because it is the payment necessary to retain a factor of production in its present use, it is counted as part of the cost of production. A firm earning only normal profit is therefore said to earn zero economic profit while remaining perfectly viable, which is why zero economic profit does not mean a business is failing.

6. Why is perfect competition regarded as efficient, and what does the model leave out? Because in long run equilibrium price equals marginal cost, so the value buyers place on the last unit equals its cost to society, which is allocative efficiency; and because each firm produces at the minimum of its average cost curve, which is productive efficiency. The model leaves out product variety, since homogeneity means no choice at all; economies of scale, since it cannot accommodate industries in which average cost falls continuously with size; and innovation, since perfect knowledge and free entry remove the temporary profit that rewards being first.

7. When should a perfectly competitive firm continue to produce at a loss? When price covers its average variable cost, even though it is below average total cost. In that situation the revenue pays all the variable costs and contributes something towards the fixed costs, which must be borne whether or not the firm produces, so producing reduces the loss. If price falls below average variable cost the firm loses more by producing than by stopping, and it should shut down. The price at which price just equals minimum average variable cost is called the shutdown point.