2.11B Perfect Competition (HL)

Market Structures

1. Market power is a firm's ability to set its own price rather than accept the one the market gives it.
2. Every market sits somewhere between two extremes.
   1. Under perfect competition, no firm has any power over price.
   2. Under imperfect competition, firms are price makers with some power to set price.
3. Imperfect competition itself splits into three forms, in rising order of power: monopolistic competition, then oligopoly, then monopoly.

Four Assumptions of Perfect Competition

1. Perfect competition is the benchmark for a market with no market power.
2. It rests on four assumptions, and each one drives a later step in the theory.
   1. Many small firms, so no single one is big enough to sway the price.
   2. A homogeneous (identical) product, so buyers have no reason to prefer one seller.
   3. Free entry and exit, so firms can join or leave the market at will.
   4. Perfect information, so every buyer and seller knows the going price and quality.
3. Because no firm is large and no product stands out, each firm is a price taker that accepts the market price rather than setting it.
4. Each assumption then locks in one result.
   1. Many small firms and an identical product are what make the firm a price taker.
   2. Free entry and exit drive profit back to normal in the long run.
   3. Perfect information stops any firm charging more, since buyers can get the same good cheaper next door.

Why a Perfectly Competitive Firm Is a Price Taker

1. Price is set by the whole market, not by any single firm, so the analysis starts with the market and then zooms in on one firm.
2. In the market, supply and demand meet at the equilibrium price $P$ and quantity $Q$.
3. Every firm in the industry faces that same market price $P$.
4. A single firm is tiny next to the market, so nothing it does can shift $P$.
   1. It can sell as much as it likes at $P$, but the moment it asks for more, buyers switch to identical rivals and it sells nothing.
   2. So the firm's demand curve is a horizontal line at the market price.
5. That horizontal line is also the firm's average revenue and marginal revenue.
   1. Average revenue is total revenue divided by quantity, which equals $P$.
   2. Marginal revenue is the revenue from one more unit, also $P$, since every unit sells at the same price.
6. So for the firm, $D = AR = MR = P$.
7. Its demand is perfectly elastic, with price elasticity of demand effectively infinite.

Profit: Abnormal in the Short Run, Normal in the Long Run

1. A firm maximises profit where marginal cost equals marginal revenue.
2. For a price taker $MR$ is the flat price line, so the profit-maximising output sits where $MC$ crosses $P$.
3. What happens to profit then depends on how that price compares with average total cost.
   1. If $P$ sits above $ATC$, the firm earns abnormal profit, the extra return above normal profit.
   2. If $P$ sits below $ATC$, the firm makes a loss.
   3. If $P$ equals $ATC$, the firm earns normal profit, the return that just covers all costs, including the opportunity cost of staying in business.
4. In the long run, free entry and exit compete any abnormal profit or loss away.
   1. Abnormal profit attracts new firms, so market supply rises and the price falls to minimum $ATC$.
   2. A loss drives firms out, so supply falls and the price rises back to minimum $ATC$.
5. Either way the firm ends at normal profit in the long run.

Why Perfect Competition Is the Benchmark

1. Two efficiency ideas run through every market structure that follows.
   1. Productive efficiency means producing at the lowest cost per unit, at the minimum of the $ATC$ curve.
   2. Allocative efficiency means producing the quantity society values most, where $P = MC$.
2. Perfect competition is the benchmark because in the long run it reaches both.
   1. Free entry competes profit away until each firm produces at minimum $ATC$, which is productively efficient.
   2. At the same time price equals marginal cost, which is allocatively efficient.
3. Those gains come at a cost, so a real evaluation weighs the two sides.
   1. The benefit is immediate: no waste at minimum $ATC$, and output exactly where $P = MC$.
   2. But normal profit leaves nothing spare for research and development, which limits dynamic efficiency.
   3. The tiny firms never reach the economies of scale that would cut costs further.
   4. And the identical product gives buyers no variety.
4. It is also a benchmark that no real market fully meets.
   1. The closest cases are commodity markets like wheat and foreign exchange, where the product is near identical and no single seller moves the price.
   2. Even these lack the perfect information and costless entry the model assumes.

So perfect competition works best as a yardstick for judging other structures, not as a description of how most markets actually work.