- Identify the three features of a perfectly competitive market and explain why each firm is a price taker.
- Use revenue and cost information to determine a competitive firm's profit-maximizing output.
- Explain when a loss-making firm should keep producing or temporarily shut down.
- Describe how entry and exit produce long-run competitive equilibrium.
- Distinguish productive efficiency from allocative efficiency in perfect competition.
- Understand market demand, market supply, and equilibrium price.
- Recognize the basic meanings of revenue, cost, and profit.
The Foundations of Perfect Competition
Perfect competition combines many market participants, identical products, and open entry and exit, leaving individual firms unable to choose the market price.
Picture a farmers' market with numerous growers offering similar produce. Sellers watch one another's prices because a buyer can easily move to another stall. The setting illustrates how strong competition limits the influence of each participant.
A market is perfectly competitive when all three of the following conditions hold:
- Many buyers and sellers participate, so none is large enough to change the market price alone.
- Every firm offers the same product, such as a bushel of wheat that buyers regard as equivalent across sellers.
- Firms face no barriers that prevent them from entering or leaving the market.
Competitive firms take the price established where market demand meets market supply. Because each seller is small and offers the same good as many rivals, charging even one cent more would drive its sales to zero. At the market price, however, the firm can sell all the output it chooses to offer.
Demand Seen by One Firm
The individual firm's demand curve is horizontal at the market price because it may sell any quantity at that price but nothing at a higher one. This differs from the downward-sloping demand curve for the market as a whole.
Scale explains the difference. The wheat market may trade 2.25 billion bushels at $7 each, while Farmer Parker supplies only 15,000 bushels. Whether that farmer produces 6,000 or 15,000 bushels does not alter the market price.
Why are farmers' markets likely to contain many vendors offering similar kinds of produce instead of only one or two dominant sellers?
Produce can be supplied by many relatively small growers, and buyers can compare similar goods and move among sellers. Those conditions limit any one vendor's control over price.
Choosing the Profit-Maximizing Output
A price-taking firm selects output by comparing the added revenue from another unit with that unit's added cost.
Because a competitive producer cannot change price, it seeks higher profit through lower costs and an appropriate production quantity. Profit is greatest where the gap between total revenue and total cost reaches its maximum.
Three Revenue Measures
- Total revenue (TR) equals price multiplied by the quantity sold.
- Average revenue (AR) equals total revenue divided by quantity; for a competitive firm, it equals the market price.
- Marginal revenue (MR) is the change in total revenue caused by selling one additional unit. Since every unit sells for the same price, MR also equals price.
This equality depends on the firm's inability to affect price. Its marginal-revenue curve is therefore the same horizontal line as its demand curve.
Marginal Cost and the Output Rule
Marginal cost can decline at lower output levels and then rise as production expands. For example, if total cost increases from 21.00 at four units, the fourth unit has a marginal cost of $2.50.
When MR exceeds MC, another unit adds more revenue than cost, so expanding output raises profit. Once MC exceeds MR, an extra unit lowers profit. Since price equals MR in perfect competition, the maximizing condition can also be written as P = MC.
Worked Example: Farmer Arnzen's Wheat
Farmer Arnzen receives the market price of 7. The production schedule is:
| Quantity (bushels) | Total Cost | Marginal Cost | Total Revenue | Profit |
|---|---|---|---|---|
| 0 | $10.00 | — | $0 | -$10.00 |
| 1 | $14.00 | $4.00 | $7 | -$7.00 |
| 2 | $16.50 | $2.50 | $14 | -$2.50 |
| 3 | $18.50 | $2.00 | $21 | $2.50 |
| 4 | $21.00 | $2.50 | $28 | $7.00 |
| 5 | $24.00 | $3.00 | $35 | $11.00 |
| 6 | $28.50 | $4.50 | $42 | $13.50 |
| 7 | $34.50 | $6.00 | $49 | $14.50 |
| 8 | $42.00 | $7.50 | $56 | $14.00 |
| 9 | $51.00 | $9.00 | $63 | $12.00 |
| 10 | $62.00 | $11.00 | $70 | $8.00 |
A graph gives the same result: at seven bushels, the vertical separation between the total-revenue line and total-cost curve is largest.
Showing Profit with Average Total Cost
On a cost-curve graph, total profit forms a rectangle whose height is P − ATC and whose width is Q. A green rectangle represents profit when P is above ATC. When P is below ATC, a red rectangle with height ATC − P represents the loss. If P equals ATC, the firm breaks even and earns zero economic profit.
- P > ATC: the firm earns a profit.
- P = ATC: the firm breaks even.
- P < ATC: the firm incurs a loss.
Why does a profitable farmer stop expanding output instead of producing without limit?
Marginal cost rises as output expands. Production should stop increasing when the next unit's marginal cost would exceed its marginal revenue, because that unit would reduce profit.
Losses, Temporary Shutdown, and Short-Run Supply
A loss does not automatically justify closing. The short-run choice depends on whether price covers average variable cost.
A firm may experience losses when market conditions push price below average total cost. In the short run, it must decide whether to continue at the loss-minimizing output or temporarily produce nothing.
The Temporary Shutdown Choice
Temporary shutdown does not eliminate fixed costs. Because these costs must be paid either way, the firm treats them as sunk and bases its current decision on variable costs.
If price is at least as high as average variable cost (AVC), operating covers variable expenses and contributes something toward fixed costs. The firm therefore loses less by producing. If price drops below AVC, revenue cannot cover variable cost, so production would add to the loss and the firm should shut down temporarily.
From Marginal Cost to Supply
For any price at or above the shutdown point, a competitive firm chooses the quantity where . Consequently, the portion of its marginal-cost curve above minimum AVC is its short-run supply curve. Below that price, it supplies zero output, represented along the price axis.
Market supply is constructed by adding every firm's supplied quantity at each price. If 150,000 wheat farmers each offer 15,000 bushels at $7, their combined supply at that price is 2.25 billion bushels.
Entry, Exit, and Long-Run Equilibrium
Profit attracts entrants and losses cause exits, moving price toward the minimum average total cost of the typical firm.
Competitive firms may earn economic profit or bear economic losses for a time. Over the long run, open entry and exit change market supply and remove those conditions for the typical firm.
How Profit Encourages Entry
Suppose carrot sellers initially receive
- At that price, the typical grower covers every explicit and implicit cost, so economic profit is zero.
How Loss Leads to Exit
If carrot demand falls and the price declines from 7 per box, growers experience economic losses. Some leave the industry, shifting market supply left. Exit continues until price returns to $10 and the remaining firms again break even.
The Long-Run Competitive Position
In this equilibrium, price equals the minimum point of the typical firm's average-total-cost curve. A demand change may move price temporarily, but the resulting entry or exit pushes it back toward that long-run level.
Shapes of Long-Run Supply
- In a constant-cost industry, expansion does not alter the typical firm's average costs. Long-run supply is horizontal, or perfectly elastic, at minimum ATC.
- In an increasing-cost industry, expansion raises input prices and average total cost, giving long-run supply an upward slope. Producing more of a wine variety, for example, may raise the price of its grapes.
- In the less common decreasing-cost industry, average costs fall during expansion, so long-run supply slopes downward.
Early iPhone app developers could earn high profits. What would happen next, and how does it demonstrate long-run competitive adjustment?
The profits would attract more developers because entry was accessible to people with programming skill, creativity, and a computer. Their entry would expand supply and reduce the exceptional profits as the market became more competitive.
Efficiency and the Usefulness of the Model
Long-run perfect competition provides benchmarks for producing at minimum cost and matching marginal benefit with marginal cost.
Perfect competition is associated with two forms of efficiency that help evaluate market performance.
Producing at the Lowest Cost
At long-run equilibrium, firms operate at minimum average total cost. A producer may lower costs to gain profit, but rivals rapidly copy successful methods. Competition then passes the lasting benefit of lower costs to consumers through lower prices.
Producing What Consumers Value
Price reflects the marginal benefit received by consumers. Since a competitive firm selects output where .
A Benchmark Rather Than a Perfect Description
Markets vary in how closely they match the model. Wheat farming is among the closest examples because wheat has little differentiation across producers. Apples are less exact because varieties and growing regions differentiate the product. Farmers' market vendors may also distinguish their offerings through unusual varieties or added service.
The model remains useful as a baseline for studying price, output, and efficiency under the strongest competition. Other market structures can then be compared with it when products are differentiated, firms possess market power, or entry is restricted.
Common misconceptions
Watch out: The firm should choose output where marginal cost equals average total cost.
Instead: The output rule is MR = MC. If MC is still below MR at the point where MC equals ATC, stopping there leaves profitable units unproduced.
Watch out: Any firm reporting a loss should immediately stop production.
Instead: In the short run, a firm continues producing when price covers average variable cost because doing so reduces its loss. It shuts down only when price falls below AVC.
Lesson recap
- Perfect competition requires many buyers and sellers, identical goods, and unrestricted entry and exit.
- Each firm accepts the market price, faces horizontal demand, and has P = AR = MR.
- Profit is maximized where MR and MC meet, or at the nearest feasible output before MC exceeds MR.
- Price relative to ATC determines profit, break-even, or loss; price relative to AVC determines short-run shutdown.
- The firm's short-run supply is its MC curve above minimum AVC, while market supply adds the quantities of all firms.
- Entry after profit and exit after loss move the typical firm toward zero economic profit at minimum ATC.
- Long-run perfect competition provides benchmarks for both lowest-cost production and the equality of marginal benefit and marginal cost.