3.4.2 Perfect Competition

Edexcel A-Level Economics (9EC0) | Theme 3.4.2

Specification Coverage: Edexcel unit 3.4.2 - Perfect Competition. Students should be able to identify the key characteristics of perfect competition, explain why firms are price takers, analyse short-run profit and loss positions, explain the adjustment process to long-run equilibrium, and apply efficiency conditions in the long run.

Key Characteristics

  • There are many buyers and sellers.
  • Products are homogeneous or identical.
  • There is perfect information.
  • There are no barriers to entry or exit.
  • Firms are price takers, so they accept the market price.

The Firm's Demand Curve

Because firms in perfect competition are price takers, the demand curve facing an individual firm is perfectly elastic, so it is horizontal.

This means \( P = MR = AR \).

The market price itself is determined by industry supply and demand.

Market price in perfect competition diagram
Figure 1: The market price in perfect competition is determined by industry supply and demand. The firm's demand curve is perfectly elastic at this price.

Short-Run Equilibrium: Profit and Loss

The firm maximises profit where \( MC = MR \).

Short-run supernormal profit in perfect competition diagram
Figure 2: In the short run, a firm in perfect competition can earn supernormal profit if the price is above the average cost. The shaded area represents supernormal profit.
Short-run loss in perfect competition diagram
Figure 3: In the short run, a firm in perfect competition can incur a loss if the price is below the average cost. The shaded area represents the loss.

Long-Run Equilibrium: Normal Profit Only

Because there is freedom of entry and exit, perfect competition moves to a long-run equilibrium where firms earn only normal profit, so \( AR = AC \).

From Short-Run Supernormal Profit to Long-Run Equilibrium

  • In the short run, firms may make supernormal profit.
  • These profits attract new firms into the industry.
  • Industry supply increases and shifts to the right.
  • The market price falls.
  • The firm's horizontal demand curve falls until it becomes tangent to the minimum point of the AC curve.
  • At this point, \( P = AR = AC = MC \) and supernormal profit is eliminated.

From Short-Run Loss to Long-Run Equilibrium

  • In the short run, firms may make losses.
  • Some firms leave the industry.
  • Industry supply decreases and shifts to the left.
  • The market price rises.
  • Price rises until the firm's demand curve is tangent to the minimum point of AC and firms earn normal profit.
Profit to long-run equilibrium in perfect competition diagram
Figure 4: The adjustment process from short-run supernormal profit to long-run equilibrium in perfect competition. The firm's demand curve shifts down as new firms enter, eliminating supernormal profit and reaching the long-run equilibrium where \( P = AR = AC = MC \).
Loss to long-run equilibrium in perfect competition diagram
Figure 5: The adjustment process from short-run loss to long-run equilibrium in perfect competition. The firm's demand curve shifts up as firms exit, eliminating losses and reaching the long-run equilibrium where \( P = AR = AC = MC \).

Efficiency in Long-Run Equilibrium

Productive efficiency: Yes, because the firm produces at minimum AC.

Allocative efficiency: Yes, because \( P = MC \).

Dynamic efficiency: Unlikely, because firms do not earn supernormal profit to fund research and development.

Exam Preparation

  • List the characteristics of perfect competition.
  • Draw the firm's horizontal demand curve and explain why it has that shape.
  • Illustrate short-run supernormal profit and loss, and explain the adjustment process to long-run normal profit using industry supply shifts.
  • Identify the long-run equilibrium point on the firm's diagram, where \( P = MC = \text{min AC} \).
  • Analyse the efficiency of perfect competition in the long run.