In this video we’ll learn about perfect competition.
We’ll focus on the characteristics of perfect competition first and then move to the long-run
diagram.
I’ve timestamped the video in the description if you want to jump ahead to the diagram.
Since we covered the characteristics of market structures in the previous video I’ll use
them to illustrate what makes a market perfectly competitive.
It’s important to remember that perfect competition is a theoretical model and it
is very difficult to find a pure example of it in the real world.
In perfect competition there are a large number of buyers.
This means that no single buyer has an influence over market price.
Also on the seller side, there are many sellers.
There are so many that no individual seller has any control over price.
If one seller tries to increase their price, consumers will shop from their competition.
In perfectly competitive markets, the products for sale are completely identical.
There are no unique features to anything offered by any seller.
The product for sale is exactly the same.
The best example of this would be a dollar for sale in a foreign exchange market.
Each dollar is worth exactly the same amount and is no better or worse than any other.
Firms in perfect competition have perfect information.
This means no competitive edge can be maintained and consumers are fully aware of prices offered
by all suppliers.
There are no information advantages between firms, or even between firms and consumers.
There are also no barriers to entry or exit which means that firms can enter and exit
the market and face no costs or restrictions.
The industry is completely open to new entrants.
Now let’s get to the diagram.
This is usually the source of a lot of confusion for economics students so I’ll break it
down into small steps and try to help you understand it that way.
If you have questions at any point, write them in the comments and I will do my best
to answer.
To make this very clear we should look at two diagrams side by side.
The industry we’ll use is the hypothetical market for widgets.
On the left we have the diagram for the widget industry which is the supply and demand diagram
you learned earlier in economics.
On the right however is the perfectly competitive firm’s costs and revenue curves.
As we learned before, the industry supply consists of all the firms in a market.
The diagram on the right represents just one of those widget firms.
Returning to the left, we can now draw in our market demand and market supply curves.
Market demand is the sum of all consumer widget demand in this market.
Market supply is the sum of all producer widget supply in this market.
We have an equilibrium price and quantity of P* and Q*.
This market price is the price at which the individual firm must sell.
Because the market dictates price, we say that the perfectly competitive firm is a price
taker.
It must take the price that has been set in the market and has no control over price.
Therefore it will always sell widgets at a price of P* regardless of how much it produces.
That means the average revenue and marginal revenue will always be equal.
The demand curve is a horizontal line at this price, P*.
Next we include the firm’s marginal cost curve as well as its average cost curve.
The reasons for the shape of these curves has been explained earlier.
If you need a refresher, check the video description for the links.
In order to profit maximise, this firm should produce where marginal revenue equals marginal
cost.
We look for the intersection of MR and MC then drop down to the X-axis to find the firm’s
profit maximising level of output, Q1.
The firms’ total cost at this point is equal to its average cost times output, which also
happens to be P* and Q1.
We determine our average cost at this level of output by following the profit maximising
level of quantity up to the average cost curve and across to the Y-axis.
The firm’s total revenue at this point is equal to its average revenue times output,
or P* times Q1.
Total cost and total revenue are equal at this price and output, so the firm earns zero
economic profit, or what is also called normal profit.
This means the total revenue of the firm covers its implicit and explicit costs.
Since the price consumers pay is equal to the marginal cost of production, perfectly
competitive firms are said to exhibit allocative efficiency.
Also, they are producing at the lowest point of their average cost curve which means they
are productively efficient.
This diagram represents the long-run equilibrium for the firm.
There can be changes in the short-run that allow firms to make supernormal profits.
There can also be firms that run economic losses in the short-run.
We’ll examine both situations in the videos that follow.
By now you should be comfortable with the characteristics of perfect competition and
be able to draw a perfectly competitive firm in long-run equilibrium.
In the videos that follow we’ll look at perfectly competitive firms in short-run equilibrium,
how they earn supernormal profits or run economic losses and how the firm returns to long-run
equilibrium.
It’s all a little complicated so if you have any questions, leave a comment below
and I’ll do my best to answer.
That’s us done for now and I will see you in the next one!