Perfect competition is the model of a market with no market power at all. It rests on four features.
Four features
Very many firms
Each is too small to move the price.
Identical products
One farmer's wheat is the same as the next.
No barriers to entry
Firms come and go freely.
Perfect information
Everyone knows every price and profit.
The points to remember
- Each firm's demand is flat at the market price: D = AR = MR = P.
- It produces where MR = MC, like every firm.
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A firm produces where MR = MC, like any firm. In the short run it can make abnormal profit.
Our example (made-up numbers)
| Market price | Output (MR = MC) | Average cost | Profit |
|---|---|---|---|
| €6 | 80 crates | €4.50 | €120 abnormal profit |
| €4 | 40 crates | €4.00 | Normal profit |
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Why does the profit vanish? Because anyone can join the market.
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Short run, long run, and losses
Abnormal profit
Firms enter, supply rises, the price falls.
Losses
Firms leave, supply falls, the price rises.
Shut down now
If the price falls below AVC, the firm stops at once.
Remember it as: Free entry and exit drive every firm to normal profit at the lowest point of AC.
Quick reminder
- Axes: Costs, revenue (the firm) or P (the market) up the side, Q along the bottom
- Curves: D = AR = MR, MC and AC for the firm; D, S1 and S2 for the market
- Marks: P1, P2, Q1 and Q2, and the abnormal profit box
- Dots with dashed lines to the axes, an arrow for the shift
- No numbers, no title
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Next to it, draw the market: entry shifts supply right, so the price every firm takes falls from P1 to P2.
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Paper 1 asked this in May 2024, as part (a) for 10 marks.
Explain why in perfect competition abnormal profits are only made in the short run.
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How the 10 marks are given
| Marks | What your answer needs |
|---|---|
| 9–10 | Theory fully explained, terms used correctly all the way through, the diagram included and fully explained |
| 7–8 | Theory explained, terms mostly right, the diagram included and explained |
| 5–6 | Theory partly explained, some terms, the diagram included |
| 1–4 | Theory only described or stated; few relevant terms |