Characteristics of Perfect Competition - Online Tutor, Practice Problems & Exam Prep

In a perfectly competitive market, goods are identical, and firms are price takers, meaning they accept the market price without influence. The demand curve for an individual firm is perfectly elastic, represented as a horizontal line, indicating that any price increase results in zero sales. Firms can freely enter or exit the market, ensuring competition. The equilibrium price, where supply meets demand, dictates the market dynamics, impacting profit decisions and production levels. Understanding these concepts is crucial for analyzing market structures and firm behavior in economics.

Characteristics of Perfect Competition

Alright. So the first thing we want to do is define the characteristics of a perfectly competitive market. We've talked about this before when we discussed supply and demand, but let's dive in a little deeper now. Alright. So we're going to call a market perfectly competitive when first the nature of the good. The goods for sale in a perfectly competitive market are identical, right? Remember when we were talking about perfectly competitive that was like agriculture, like wheat, right? You can't tell one farmer's wheat from another farmer's wheat, right? So they're going to be identical goods and when we set the price in this market, remember that the buyers and the sellers, they don't get to pick what the price is. Right? The price is set by the market, so we call them price takers. They don't get to make the price. They take the price as given by the market conditions, alright? So like we saw, there are going to be lots of buyers, right? And lots of sellers. We were saying almost infinite, right? And what that does is that they have no influence on the price. When they have no influence on the price, that makes them price takers. They just have to take the price as it comes. So there's lots of buyers, lots of sellers in this market. We've talked about these points before.

Now, I'm adding this one point right here because once we start talking about these market structures, the entry and exit into the market is also an important factor. Alright, so when we talk about entry and exit, it's whether a firm can just oh, I want to start producing wheat, so I'm going to just start producing wheat or I don't want to produce wheat anymore, I'm going to get out of this market, right? So entry and exit, when we talk about perfect competition, they can freely enter and exit. If you want to start a farm and start producing wheat, there's not really much stopping you. You just need to go get a farm and you just start growing wheat, right? So anybody can enter or exit a perfectly competitive market and like we've seen, wheat is a perfect example. Any kind of agricultural product is always a good example of a perfectly competitive product and that's probably what we'll focus on is some kind of agricultural product or foreign exchange markets. Right? When you think about you want to get a euro for a dollar or something right, you can't distinguish \$1 from another dollar or 1 euro from another, so those are perfectly competitive markets as well. Alright, let's go ahead and move on. In the next video, we'll talk about the demand curves in a perfectly competitive market. So let's go ahead and do that now.

Market Demand and Individual Firm Demand

Alright, so now let's see what an individual firm's demand curve in a perfectly competitive market looks like. When we go through the next few chapters, our focus is mainly going to be on the individual firm. How are they going to make their decisions about the price or the quantity that they put out about making profit, right? We want to see what the firm demand curve is going to look like in perfect competition. So let's start with the whole market. When we think about the market for wheat or some perfectly competitive product, it's like what we saw when we studied supply and demand, right? We're going to see that we're going to have some sort of downward demand, right? The double d's demand curve downward and then some upward supply curve in the market. There's going to be more supply as the price goes up and less demand as the price goes up. So that's kind of what we're used to, right? We've seen something like that. We've got our X and we know that right here in the middle, this point right here, that is our equilibrium in the market. So, remember when we were talking about price takers, this is the price that the firm has to take. It's this equilibrium price. So this is the price on the market right here. We're going to call it P star. That's the price on the market of equilibrium and this is the equilibrium quantity. That's the quantity that's going to be demanded and supplied at that price. So now let's think about the individual firm. How is their demand curve going to look? Remember they have to take this price and if you also remember there are so many firms in the market that no matter what we produce the price isn't going to change. We can increase our quantity, double, triple the quantity we are producing and still the price won't change because we are such a small fraction of the market, we don't have any influence. So what is going to happen is at this price that the market sets all the way across here, the individual firm is going to have a straight demand curve, a straight line just like that. Right? And what did we call that? We called that perfectly elastic, which is the horizontal demand curve. Let me get out of the way right here because right below me, I'm going to write horizontal in here because this is the only market structure with a horizontal demand curve. We're not going to see this when we go to perfect, excuse me, monopolistic competition, oligopoly, monopoly. None of them have this situation. So what does this entail for the perfectly competitive firm? So this is their demand curve right here, this flat demand curve. Well, just like we were discussing, at any quantity, they can produce any quantity. Maybe this quantity right here, this quantity here, it doesn't matter as long as they sell it at that price, they are going to sell all of their quantity, right? No matter how much they produce, it's all going to be bought up by the market. So this is a perfectly elastic demand curve. The firm faces perfectly elastic demand and that means that if they try to charge a higher price, if they try to even raise the price by a penny, they're not going to sell anything. They have to take that price from the market. So this price over here that was set in the market, that's the price firms must sell at. This is where all the trades will happen. So this is the demand curve. This is kind of a unique situation that we're seeing here in perfectly competitive markets, so let's see how this flat demand curve is going to affect our profit decisions and our cost, how we pick how much we're going to produce. Let's go ahead and dive into that topic now. Let's go, let's do that in the next video.

Here’s what students ask on this topic:

What are the main characteristics of a perfectly competitive market?

A perfectly competitive market has several key characteristics: identical goods, price takers, free entry and exit, and a perfectly elastic demand curve for individual firms. Goods are homogeneous, meaning they are indistinguishable from one another, like wheat or foreign currency. Firms are price takers, accepting the market price without influence. Entry and exit are unrestricted, allowing firms to join or leave the market freely. The demand curve for an individual firm is perfectly elastic, represented as a horizontal line, indicating that any price increase results in zero sales. These features ensure that no single firm can influence the market price, maintaining competition.

Why are firms in a perfectly competitive market considered price takers?

Firms in a perfectly competitive market are considered price takers because they have no influence over the market price. This is due to the large number of buyers and sellers, and the homogeneous nature of the goods being sold. Each firm's output is a small fraction of the total market supply, so changes in an individual firm's production do not affect the overall market price. As a result, firms must accept the equilibrium price determined by the intersection of market supply and demand. If a firm tries to charge a higher price, buyers will simply purchase from other sellers, leading to zero sales for the firm attempting to raise prices.

How does the demand curve for an individual firm in a perfectly competitive market look?

The demand curve for an individual firm in a perfectly competitive market is perfectly elastic, represented as a horizontal line. This means that the firm can sell any quantity of its product at the market price, but if it tries to charge even a slightly higher price, it will not sell any units. The horizontal demand curve reflects the fact that the firm is a price taker and must accept the market price. This unique situation arises because the firm's output is a negligible portion of the total market supply, so its production decisions do not influence the market price.

What role does free entry and exit play in a perfectly competitive market?

Free entry and exit are crucial in a perfectly competitive market as they ensure that firms can join or leave the market without significant barriers. This characteristic maintains competition and prevents long-term economic profits. If firms in the market are making profits, new firms will enter, increasing supply and driving down prices until profits are eliminated. Conversely, if firms are incurring losses, some will exit, reducing supply and driving up prices until losses are eliminated. This dynamic ensures that firms in a perfectly competitive market earn only normal profits in the long run, promoting efficiency and resource allocation.

What is the significance of the equilibrium price in a perfectly competitive market?

The equilibrium price in a perfectly competitive market is significant because it is the price at which the quantity of goods supplied equals the quantity demanded. This price is determined by the intersection of the market supply and demand curves. Firms in a perfectly competitive market must accept this price, as they are price takers. The equilibrium price ensures that resources are allocated efficiently, with no excess supply or demand. It also dictates the production and profit decisions of individual firms, as they must produce at a level where their marginal cost equals the market price to maximize profits.