Perfect Competition (Cambridge AS & A Level – Topic 7.6)
7.6.1 – Definition & Core Characteristics
Definition: A market structure in which a very large number of firms sell an identical (homogeneous) product and no single firm can influence the market price.
- Very large number of buyers and sellers – each firm’s output is a tiny fraction of total market output.
- Homogeneous (identical) product – consumers are indifferent between suppliers.
- Perfect information – all participants know the prevailing price, technology and factor costs.
- Price‑taking behaviour – the firm accepts the market price; it cannot set price.
- Free entry and exit in the long run – no barriers to the creation or closure of firms.
- Perfect factor mobility – labour, capital and other inputs can move freely between firms and industries.
- No externalities – production and consumption affect only the parties involved.
- No government intervention – no taxes, subsidies, price controls or regulations are assumed.
Implications for an Individual Firm
| Characteristic |
Implication for the Firm |
| Price taker |
Accepts the market price; cannot influence it. |
| Horizontal (perfectly elastic) demand curve |
Quantity can be increased without affecting price. |
| Profit‑maximisation rule |
Produce where Marginal Cost = Marginal Revenue. Since MR = P, the rule reduces to P = MC. |
| Zero economic profit in the long run |
Free entry and exit drive any economic profit to zero; firms earn only a normal profit. |
| Allocative efficiency |
Resources are allocated where P = MC, i.e. the value consumers place on the last unit equals the cost of producing it. |
| Productive efficiency |
Output is produced at the lowest possible average cost, where MC = AC (the minimum of the AC curve). |
7.6.2 – Comparison with Other Market Structures
| Feature |
Perfect Competition |
Monopoly |
Monopolistic Competition |
Oligopoly |
| Number of firms |
Very many |
One |
Many |
Few |
| Product differentiation |
None (homogeneous) |
Unique |
Some (branding, variety) |
Often differentiated |
| Barriers to entry |
None (free entry & exit) |
High (legal, natural, strategic) |
Low (relatively easy) |
Significant (economies of scale, strategic, legal) |
| Price‑setting power |
Price taker (P = MC) |
Price maker (P > MC) |
Some discretion (P > MC but < MC) |
Strategic – may act as price taker, price maker or colluder (kinked‑demand, cartels) |
| Short‑run profit outcome |
Can earn >0, =0 or <0 profit |
Positive profit possible |
Positive profit possible |
Positive profit possible (especially if colluding) |
| Long‑run profit outcome |
Zero economic profit (P = AC) |
Positive economic profit may persist |
Zero economic profit (P = AC) |
Either zero or positive profit depending on behaviour (entry barriers, collusion) |
| Efficiency |
Both allocative and productive (no DWL) |
Inefficient – P > MC (dead‑weight loss) |
Less efficient than perfect competition (some DWL) |
Often inefficient (price above MC, possible DWL) |
7.6.3 – Short‑Run Supply Curve of an Individual Firm
- Supply curve: The portion of the firm’s Marginal Cost (MC) curve that lies **above** the Average Variable Cost (AVC) curve.
- Decision rule
- If P ≥ AVC → produce where P = MC (the MC‑above‑AVC segment).
- If P < AVC → shut down (produce zero output) because variable costs cannot be covered.
Worked example (shut‑down price)
| Output (Q) | AVC | MC |
|---|
| 0 | – | – |
| 1 | £12 | £10 |
| 2 | £9 | £9 |
| 3 | £8 | £11 |
The AVC curve reaches its minimum at Q = 2 where AVC = £9. Therefore the shut‑down price is £9. If the market price falls below £9 the firm will cease production in the short run.
7.6.4 – Long‑Run Industry Equilibrium & Zero Economic Profit
- All factors of production are variable; firms can freely enter or exit.
- Entry: If firms earn a positive economic profit (P > AC), new firms are attracted. Their entry shifts the industry supply curve rightward, reducing the market price.
- Exit: If firms incur losses (P < AC), some exit. Exit shifts the industry supply curve leftward, raising the market price.
- Equilibrium is reached when P = MC = AC. At this point each firm makes zero economic profit (normal profit only).
- The point where long‑run average cost (LRAC) is at its minimum is called the minimum efficient scale (MES)**. The LRAC curve is flat (perfectly elastic) at this output level, giving a horizontal long‑run industry supply.
- Because free entry and exit force the condition P = AC, the statement “free entry/exit ⇒ zero economic profit in the long run” is made explicit.
7.6.5 – Efficiency in Perfect Competition
- Allocative efficiency: Achieved where P = MC. The price consumers are willing to pay equals the marginal cost of the resources used.
- Productive efficiency: Achieved where output is produced at the lowest possible average cost – the minimum of the AC curve (MC = AC).
- Both efficiencies mean there is no dead‑weight loss (DWL); total welfare (consumer + producer surplus) is maximised.
- Contrast with monopoly: A monopoly sets P > MC, creating a DWL equal to the loss of surplus between the monopoly output and the socially optimal output (where P = MC).
- Example: In a perfectly competitive wheat market the price a farmer receives (£0.20 per kg) equals the marginal cost of producing an extra kilogram, and the farmer’s average cost is at its minimum, indicating both allocative and productive efficiency.
7.6.6 – Role of Factor Mobility & Government Intervention
- Perfect factor mobility: Labour, capital and other inputs can move freely between firms and industries. This underpins the perfectly elastic long‑run supply curve and the entry/exit adjustment process.
- Government non‑intervention (baseline model): No taxes, subsidies, price controls or regulations. Introducing any of these creates a wedge between price and marginal cost, leading to inefficiency.
- Consequences of common interventions:
- Tax on output: Raises MC → price rises above MC → allocative inefficiency (DWL).
- Subsidy to producers: Lowers MC → price falls below MC → over‑production and DWL.
- Price ceiling below MC: Forces firms to sell at a loss, causing shutdowns and a reduction in output below the efficient level.
7.6.7 – Profit‑Maximisation Summary
The profit of a perfectly competitive firm can be expressed as:
π = (P – ATC) × Q
- P = market price (also MR)
- ATC = average total cost at the chosen output
- Q = quantity produced
Short‑run outcomes:
- Positive economic profit if P > ATC.
- Normal profit (zero economic profit) if P = ATC.
- Loss if P < ATC, but the firm continues operating while P ≥ AVC.
7.6.8 – Welfare Implications
- Consumer surplus: Maximised because price equals marginal cost.
- Producer surplus: Sufficient only to cover normal profit; no excess economic profit is retained.
- Total surplus: At its highest possible level; there is no dead‑weight loss.
7.6.9 – Key Take‑aways
- Firms are price takers and produce where P = MC.
- Short‑run decisions depend on the relationship between price, AVC and ATC (shutdown rule).
- Free entry and exit ensure that, in the long run, all firms earn zero economic profit (P = MC = AC), i.e., the market operates at the minimum efficient scale.
- The structure achieves both allocative and productive efficiency, maximising total welfare and generating no dead‑weight loss.
- Perfect factor mobility and the absence of government intervention are essential assumptions for these conclusions.