The document discusses the model of perfect competition. It outlines the key assumptions behind a perfectly competitive market, including many suppliers and buyers, homogeneous products, perfect information and no barriers to entry or exit. It also examines characteristics such as firms being price takers. The model shows how markets reach a long-run equilibrium where price equals average cost and normal profits are earned. Perfect competition is said to promote both productive and allocative efficiency. However, the model is largely theoretical as very few real world markets exhibit all the strict assumptions of perfect competition.

1. The Model of Perfect
Competition
A2 Microeconomics
Tutor2u, November 2013

2. Key issues
•
•
•
•
•
The meaning of perfect competition
Characteristics of perfect competition
Price and output under competition
Competition and economic efficiency
Wider benefits of competition in markets

3. Assumptions Behind a Perfectly
Competitive Market
• Many suppliers - each with an insignificant share of
the market
• Each firm is too small to affect price via a change in
market supply – each business is a price taker
• Identical output produced by each firm – i.e.
homogeneous products that are perfect substitutes
for each other
• Consumers have complete information about prices

4. Assumptions Behind a Perfectly
Competitive Market
• Transactions are costless - Buyers and sellers incur
no costs in making an exchange
• All firms (i.e. industry participants and new entrants)
have equal access to resources (e.g. technology)
• No barriers to entry & exit of firms in long run – the
market is open to competition from new suppliers
• No externalities in production and consumption

5. Examples of Perfectly Competitive
Markets?
• It is rare to find a pure example of perfect
competitions
• But there are some close approximations:
– Foreign exchange dealing
• Homogeneous product - US dollar or the Euro
• Many buyers & sellers
• Usually each trader is small relative to total market and
has to take price as given
• Sometimes, traders can move currency markets

6. Examples of Perfectly Competitive
Markets?
Agricultural markets
• Pig farming, cattle
• Farmers markets for apples, tomatoes
• Wholesale markets for vegetables, fish, flowers
• Street food markets in developing countries

7. Approximations to perfect competition
The law of one price with
tens of bookmakers on a
race course
Finding market clearing
prices at a fish auction

8. Approximations to perfect competition
Chinese restaurants in
Chinatown London
Fruit sellers at a weekly
local market

9. Price Taking Firms
• Competitive firms in competitive markets have little
direct influence on the ruling market price
• Examples of price-taking behaviour:
– Local farmers selling to large supermarkets
– A local steel firm selling as much as it can at the
ruling international price of steel
• The law of one price may hold true – most of the
existing firms sell at the prevailing price

10. Short run price and output
Price
Market forces
determine the price
MC
Price
MS
AC
P1
MD
Output
Output

11. Short run price and output
Price
Market forces
determine the price
MC
Price
MS
AC
P1
MD
Output
Output

12. Short run price and output
Price
Market forces
determine the price
MC
Price
MS
AC
Price Taking
P1
MD
Output
Output

13. Short run price and output
Price
Market forces
determine the price
MC
Price
MS
P1
AC
Price Taking
P1
AR=MR
MD
Output
Output

14. Short run price and output
Price
Market forces
determine the price
Price
MS
P1
Assume profit
maximising firms
MC
AC
P1
AR=MR
MD
Output
Output

15. Short run price and output
Price
Market forces
determine the price
Price
Assume profit
maximising firms
MC
MS
P1
AC
P1
AR=MR
MD
Output
Q1
Output

16. Short run price and output
MC
Price
Price
MR=MC
MS
AC
Maximum
Profits
P1
P1
AR=MR
MD
Output
Q1
Output

17. Short run price and output
MC
Price
Price
MR=MC
MS
AC
Maximum
Profits
P1
P1
AR=MR
AC1
MD
Output
Q1
Output

18. Short run (abnormal) profits
MC
Price
Price
Profits =
(P1-AC1) x
Q1
MS
P1
AC
P1
AR=MR
AC1
MD
Output
Q1
Output

19. Abnormal profits
MC
Price
Profits =
(P1-AC1) x
Q1
AC
P1
AR=MR
Possible for firms in a
perfectly competitive market
to make abnormal (i.e.
Supernormal) profits in the
short run
This is where price > AC
AC1
Remember that normal profit
is assumed to be included in
the AC curve
Q1
Output

20. Effect of a rise in market demand
MC
Price
Price
MS
P1
AC
P1
AR=MR
MD
Output
Q1
Output

21. Effect of a rise in market demand
MC
Price
Price
MS
P1
AC
P1
AR=MR
MD2
MD
Output
Q1
Output

22. Effect of a rise in market demand
MC
Price
Price
MS
AC
P2
P1
P1
AR=MR
MD2
MD
Output
Q1
Output

23. Effect of a rise in market demand
MC
Price
Price
MS
AC
P2
AR2=MR2
P2
P1
P1
AR=MR
MD2
MD
Output
Q1
Output

24. Effect of a rise in market demand
MC
Price
Price
MS
AC
P2
AR2=MR2
P2
P1
P1
AR=MR
MD2
MD
Output
Q1 Q2
Output

25. Effect of a rise in market demand
Price
Price
New level of
supernormal
profits
MC
MS
AC
P2
AR2=MR2
P2
P1
P1
AR=MR
MD2
MD
Output
Q1 Q2
Output

26. What is a Long Run Equilibrium?
• Usual interpretation of a long run equilibrium is as follows:
• (1) The quantity of the product supplied in the market equals
the quantity demanded by all consumers
• (2) Each firm in the market maximizes its profit, given the
prevailing market price
• (3) Each firm in the market earns zero economic profit (i.e.
normal profit) so there is no incentive for other firms to enter
the market
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27. Long run equilibrium price
MC
Price
Price
MS
P1
AC
P1
AR=MR
MD
Output
Output

28. Long run equilibrium price
MC
Price
Price
MS
AC
MS2
P1
P1
AR=MR
P2
MD
Output
Output

29. Long run equilibrium price
MC
Price
Price
MS
AC
MS2
P1
P1
AR=MR
AR2=MR2
P2
MD
Output
Output

30. Long run equilibrium price
MC
Price
Price
MS
AC
MS2
P1
P1
AR=MR
AR2=MR2
P2
MD
Output
Q2
Output

31. The long run equilibrium
Price
Price
MS
In the long run
equilibrium, normal
profits are made i.e.
price = average cost
MC
AC
MS2
AR2=MR2
P2
MD
Output
Q2
Output

32. The long run equilibrium
Price
Normal profit is the profit
just sufficient to keep a
business in their current
market in the long run
In the long run
equilibrium, normal
profits are made i.e.
price = average cost
It is also the opportunity
cost of capital
MC
AC
AR2=MR2
Profits act as an incentive
for enterprise
Q2
Output

33. Competition and Economic Efficiency
• Economic efficiency has several meanings:
– Productive efficiency
• when output is produced at the lowest feasible average
cost (either in the short run or the long run)
– Allocative efficiency
• Achieved when the market provides goods and services
that meet consumer needs and wants
• Achieved when the price of output reflects the true
marginal cost of production
• This is where price=marginal cost

34. Productive Efficiency
Cost per
unit
Productive efficiency occurs when the equilibrium output is supplied at minimum
average cost. This is attained in the long run for a competitive market
AC1
AC2
AC3
LRAC
Q1
Q2
Q3
Output

35. Allocative efficiency
• Allocative efficiency
– achieved when it is impossible to make someone better off
without making someone else worse off
• Also called Pareto Optimality
• No trades are left that would make one person better off
without hurting someone else
• Occurs when price = marginal costs of production
• This occurs in the long run under perfect competition

36. Allocative Efficiency
Price
Consumer
Surplus
When price is equal to
marginal cost (P=MC),
allocative efficiency is
achieved. At the ruling
price, consumer and
producer surplus are
maximised.
Market
Supply
P1
Producer
Surplus
Market
Demand
Q1
Output
No one can be made
better off without
making some other
agent at least as worse
off – i.e. we achieve a
Pareto optimum
allocation of resources

37. Allocative Inefficiency
Price
Consumer
Surplus
Market
Supply
P2
Deadweight loss
of welfare
P1
Producer
Surplus
Q2
Market
Demand
Q1
Output

38. Competition and Economic Efficiency
– Technological efficiency
• where maximum output is produced from given inputs
– Dynamic Efficiency
• Refers to the range of choice and quality of service
• Also considers the pace of technological change and
innovation in a market

39. Importance of a Competitive
Environment
• The standard view is that competition drives an improvement
in welfare and efficiency
• Competition forces under-performing firms out of the market
and shifts market share to more efficient firms in the long run
• Competition encourages firms to innovate and adopt bestpractise techniques

40. How useful is model of perfect
competition?
• Assumptions are not meant to reflect real world markets
where most assumptions are not satisfied
– Pure competition is devoid of what most people would call
real competitive behaviour by businesses!
– The model provides a theoretical benchmark used to
compare and contrast imperfectly competitive markets
– Consider perfect competition as an interesting point of
reference but one with few real world applications
• Useful when considering
– The effects of monopoly / imperfect competition
– The case for free international trade

41. Real world – imperfect competition!
1. Most suppliers have a degree of control over market supply
2. Some buyers have monopsony power against suppliers
because they purchase a significant percentage of total
demand
3. Most markets have heterogeneous products due to product
differentiation and constant innovation
4. Consumers nearly always have imperfect information and
their preferences and choices can be influenced by the
effects of persuasive marketing and advertising
5. Finally there may be imperfect competition in related
markets such as the market for essential raw
materials, labour and capital goods.

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resources, quizzes and
worksheets for your economics
course.
Revision notes on perfectly competitive markets