Perfect Competition – Short Run Equilibrium In the model of price and output determination under perfectly competitive market conditions, price is determined by the impersonal market forces of supply and demand, and not by individual actions of buyers and sellers. The individual rm in such a market may be said to be a price-taker. Perfect competition is used by economists not so much as an attainable goal, but as a pure state against which all other markets can be measured.
For a market to be perfectly competitive, the following necessary conditions must, in general, prevail.
(1) There must be many firms acting independently. Each rm is small enough relative to the size of the market, so that a single firm’s decision to either stop production entirely or to produce to full capacity will not have any perceptible effect on market supply to cause a change in market price.
(2) Entry and exit from the market are free and friction less for both the firms and consumers.
(3) The products offered for sale are homogeneous and divisible into small units.
(4) Buyers and sellers have perfect knowledge about the market conditions.
(5) Price is determined by the impersonal market forces of supply and demand, and not by individual actions of buyers and sellers. The individual rm in such a market may be said to be a price-taker.
(6) There is perfect knowledge among consumers about the price at which goods are being sold in the market. Sellers thus cannot manipulate the commodity price and thereby exploit the consumer.
(7) There is perfect mobility of goods and factors of production among firms. Uniformity in factor prices is prevalent in the market.
If these necessary conditions prevail, the firm can lose its entire market if it sets its price above the market price. It can also expect no gain by lowering price, since it can sell all it wishes to produce at the market price. The competitive firm has no price discretion. Market price will not be affected by the independent action of a single firm. No firm is able to influence market price.
The objective of each firm is to maximize profit. Profit is the difference between revenue and cost of production. Marginal cost (MC) is the cost incurred to produce an additional unit of the product. If the per unit price of a commodity is greater than the marginal cost, the firm will be interested in producing more of the commodity. On the other hand if price falls below marginal cost, the firm will curtail its production. Equilibrium condition will prevail at a point where profit is maximized. This happens where price is equal to marginal cost (P = MC). Also at the point of equilibrium, the marginal cost curve must be upward sloping.
In the diagram the given price is P. Again the firm will produce the level of output for which MC = MR. This occurs at point E, giving a level of output of Q. Notice that at this point, AR = AC, so the firm is making normal profit. So, in the short run, a perfectly competitive rm could be making super normal profit, or a loss, or just normal profit, depending on the given market price. Note that if the rm’s losses get too big in the short run (i.e. AR < AVC) then it will have to shut down.
