4.1 Perfect competition

• Characteristics of perfect competition

  • Many buyers and sellers
  • Sellers are price takers
  • Free entry to and exit from the market
  • Perfect knowledge
  • Homogeneous goods
  • Firms are short run profit maximisers
  • Factors of production are perfectly mobile
• In a perfectly competitive market, price is determined by the interaction of demand and supply
• Firms make supernormal profits in the short run

  New firms enter the market due to low barriers to entry
• New firms entering the market

  Increases supply, lowering the average price and competing away existing firms' profits
• Profit maximising equilibrium in the short run

  1. Firm accepts industry price

  2. Firm produces output Q1

  3. Firm earns supernormal profits
• Profit maximising equilibrium in the long run

  1. New firms enter the industry

  2. Supply increases from S to S1

  3. Price falls

  4. Firms produce at new output Q2

  5. Firms only make normal profits
• Advantages of perfect competition

  • Lower price in the long run
  • Allocative efficiency in the long run
  • Productive efficiency
  • Supernormal profits in the short run may increase dynamic efficiency
• Disadvantages of perfect competition

  • Limited dynamic efficiency in the long run
  • No economies of scale
  • Assumptions rarely apply in real life