Four Market Model Summary: Perfect Competition - Online Tutor, Practice Problems & Exam Prep

In perfect competition, numerous firms exist, making it impossible for any single firm to influence market prices. Barriers to entry are non-existent, allowing free entry and exit. Firms maximize profit where marginal revenue equals marginal cost. In the long run, firms earn no economic profit as price stabilizes at the average total cost. Here, price equals average revenue and marginal revenue, leading to productive and allocative efficiency. Understanding these dynamics is crucial for grasping market structures and their implications on economic outcomes.

Four Market Model Summary: Perfect Competition

Alright guys, we've done it; we've discussed perfect competition in quite a lot of detail. So let's go ahead and go back to that first page, our market model summary page, and let's fill in that column for perfect competition. So let's do that. So here we go, I've chopped off all the other columns and we've got our perfect competition column. We started, we knew our number of firms right? The number of firms was going to be almost infinite, there are so many firms in this market that no single firm can influence the price, right? They can produce as much as they want, but it's still just a tiny fraction of the total supply of the whole market, right?

So there's an almost infinite amount of firms and we saw some examples, right? We usually talk about wheat, right? Or some sort of agricultural product when we talk about perfect competition, and we also discussed foreign exchange markets, right? When you're trading a dollar for a euro or something like that, you can't tell $1 from another dollar, 1 euro from another euro, right? And there's going to be this price that you have to take on the market in foreign exchange. Cool? So wheat, and foreign exchange, those are good examples.

Barriers to entry. Okay, so we haven't really discussed what a barrier to entry is yet, but the idea here is a barrier to entry would be something stopping you from entering the market, right? A firm wants to enter the market, and they can't. But we said here, firms can freely enter and exit the market, right? If you wanted to start producing wheat, you just buy a farm and start producing wheat, right? So there's no barriers to entry here. Anybody can get involved, there's none, right? No barriers to entry.

And how about that profit maximizing quantity? Well, we've been discussing this, right? Left and right, it's always going to be marginal revenue equals marginal cost. We're going to find where marginal revenue equals marginal cost, and then, at that point, we're going to look on our quantity axis and we'll see what quantity we want to produce to maximize profit, okay? So marginal revenue equals marginal cost, that's our profit maximizing quantity.

How about this next one? Long run profitability. What we saw in the long run, firms were not going to be able to make an economic profit, right? No economic profit. And that's because in the long run, the price stabilizes at the minimum of the average total cost; price will be equal to average total cost and there's no profit there. Okay, so in the long run, no economic profit. But remember, economic profit includes opportunity cost, right? So there is accounting profit when we just think about dollar amounts. Cool.

How about the relationship between the price and remember, price is always going to equal average revenue, right? We did the proof of that in our revenue video, so price always equals average revenue for all market structures, but for perfect competition, the price is also going to equal the marginal revenue. Price equals the marginal revenue; here I'm going to write all three in there because we've been using this equation quite a bit, right? Price equals the average revenue equals the marginal revenue. They're all one line and we see that flat line where the price equals the marginal revenue, and this is the only case where we're going to see price equals the marginal revenue.

In all the other cases, we're going to have to draw a separate curve for our marginal revenue. So last but not least, the relationship between price and marginal cost - well, we saw in perfect competition that the price equals the marginal cost as well, right? And this is what led us to those conclusions about efficiency where we were being productively efficient or allocatively efficient. Either way, we see that the price equals the marginal cost because we produce, remember we're producing where marginal revenue equals marginal cost. So if the price equals marginal revenue and the price equals marginal cost. That is going to be the point where we produce. We're going to find the point where marginal cost crosses that price line, and that's where we produce; so marginal cost equals marginal revenue and they both equal price. Cool, so one more quick note here, This isn't all-encompassing, right? We've talked about other things in this chapter, we talked about the short run shutdown, the long run exit, we mentioned efficiency as well, so this doesn't really catch everything that we've discussed. There are more details than we can just put on this sheet, but this is a good summary of a lot of the big picture stuff that we've discussed.

Alright, so let's go ahead and move on to our next market structure, in the next unit. Cool? Alright, guys, I'll see you there.

Here’s what students ask on this topic:

What are the characteristics of a perfectly competitive market?

A perfectly competitive market has several key characteristics: numerous firms, homogeneous products, no barriers to entry or exit, and perfect information. The large number of firms ensures that no single firm can influence the market price. Homogeneous products mean that goods are identical, making it impossible to distinguish one firm's product from another's. The absence of barriers to entry and exit allows firms to freely enter or leave the market. Perfect information means that all consumers and producers have full knowledge of prices, products, and production methods. These characteristics lead to firms being price takers, where the market dictates the price.

How do firms in perfect competition determine their profit-maximizing output level?

In perfect competition, firms determine their profit-maximizing output level by producing where marginal revenue (MR) equals marginal cost (MC). Since the price (P) in a perfectly competitive market is constant and equal to both average revenue (AR) and marginal revenue (MR), the condition for profit maximization can be written as:

$P=\mathrm{MR}=\mathrm{MC}$

At this point, the firm maximizes its profit because producing any additional unit would increase the cost more than the revenue, and producing any less would mean not taking advantage of potential profit. This ensures that the firm is operating efficiently.

Why do firms in perfect competition earn zero economic profit in the long run?

In the long run, firms in perfect competition earn zero economic profit due to the free entry and exit of firms in the market. When firms earn positive economic profit, new firms are attracted to the market, increasing supply and driving down the price. Conversely, if firms incur losses, some will exit the market, reducing supply and driving up the price. This process continues until the price stabilizes at the point where it equals the average total cost (ATC), resulting in zero economic profit. This equilibrium ensures that firms cover all their opportunity costs but do not earn excess profit.

What is the relationship between price, average revenue, and marginal revenue in a perfectly competitive market?

In a perfectly competitive market, the price (P) is equal to both average revenue (AR) and marginal revenue (MR). This relationship can be expressed as:

$P=\mathrm{AR}=\mathrm{MR}$

This occurs because firms are price takers, meaning they accept the market price as given. Each additional unit sold adds the same amount to total revenue, which is the market price. Therefore, the revenue gained from selling one more unit (marginal revenue) is equal to the price, and the average revenue, which is total revenue divided by quantity, is also equal to the price.

How does perfect competition lead to productive and allocative efficiency?

Perfect competition leads to both productive and allocative efficiency. Productive efficiency occurs when firms produce at the lowest possible cost, which happens when price (P) equals marginal cost (MC). Allocative efficiency occurs when the price of the good equals the marginal cost of production, ensuring that resources are allocated to their most valued uses. In a perfectly competitive market, the equilibrium condition:

$P=\mathrm{MC}$

ensures that both types of efficiency are achieved. This means that goods are produced at the lowest cost and the quantity produced is exactly what consumers demand, maximizing total welfare in the economy.