Perfect competition refers to a market where many buyers and sellers are selling homogeneous/ identical products. It is common in the agricultural sector e.g. maize, egg.
Characteristics of Perfect Competitive Market Structure
- It is a market which has many buyers and sellers such that no single person can influence the market price and output.
- Products sold are homogeneous.
- There are no barriers to entry and exit of market.
- No government control e.g. no price control.
- Demand curve facing the firm is perfectly elastic. For example a small price increase in one firm causes a big decrease in demand
- Both buyers and sellers are price takers: no one can influence the market.
- Both buyers and sellers have perfect knowledge about the market. They know product price and quantity.
- There is perfect mobility of factors of production. Factors of production are free to move from none profitable activities to profitable activities.
- Firms are price takers
Market Demand and Individual Firm Demand Curve
Prices in this market are determined by the market forces of demand and supply. This is where demand and supply curve meet. There are many sellers such that no single sellers can influence the market price such that each seller must sell the product at market price.
In this case the market price is the individual firm price and the market demand curve is the individual firm represented by a horizontal straight line.
Equilibrium of a Perfect Competitive Firm
A firm maximizes profits or is at equilibrium when it produces the level of output at a point where MR = MC and as long as MC cuts MR from below. It is possible for a Perfectly Competitive firm to make losses, abnormal profits or normal profits in the short run depending on the position of the AC curve. Firms in this market make normal profits in the long run.
The firm is at equilibrium when it produces the level of output at point at X where MR = MC and produces output Qe. At point X, AR = AC meaning TR = TC; TR – TC = O (normal profits)
Why normal profits are generated in the long run in perfect competitive market
Firms in this type of market structure at first make abnormal profits attracting many firms since entry is free. Supply increases and prices start decreasing and now firms start making losses. Losses force some firms to exit the market since exit is also free. This consequently reduces supply and prices start increasing such that in the long run firms are at equilibrium when they make normal profits. Normal profits are experienced when TR = TC meaning TR – TC = 0 (normal profits). At this point existing firms cannot quit the market and new firms cannot enter the market.
Advantages of Perfect Competition
- Consumers have choice in terms of many sellers to choose from
- One of the most important advantages of a perfect competition is that there are no monopolies who may overcharge consumers by overcharging
- Entry is free for firms in a perfectly competitive market structure
- Exit is also free in this type of market structure
- Competition among sellers in a perfect competition market leads to production of high quality products enjoyed by consumers
- Another advantage of a perfect competition is that there is no wasteful competition.
Disadvantages of Perfect Competition
- one of the disadvantages of a perfect competition market structure is that consumers lack variety of products because products are homogeneous.
- Stiff competition among firms in a perfect competition causes weak firms to close down.
- Closing down of weak firms in a perfectly competitive marjet structure causes unemployment in the country.
- Firms make only normal profits in the long run.
- There is no room to produce public goods to benefit the public since the aim of the firm is to make profits.
- Since firms aim at making profits, they might not account for externalities. E.g. pollution.