Perfect Competition
What is Perfect Competition?
Perfect competition is a market structure with many small firms, identical products, free entry and exit, and perfect information.
Firms in perfect competition are price takers and face a perfectly elastic demand curve. In the long run, economic profit is zero due to free entry and exit, leading to allocative and productive efficiency.
Perfect Competition: a worked example
A wheat farm sells at the going market price of $12 per bushel. It produces where marginal cost equals that price, 500 bushels, and its average total cost at 500 bushels is $10, so economic profit is ($12 - $10) x 500 = $1,000. Those profits attract new farms, market supply rises and the price falls; once price reaches the farm's minimum average total cost of $9, economic profit is zero and entry stops. That zero-profit, minimum-cost outcome is the long-run equilibrium of perfect competition.
The mistake students make with perfect competition
Students read long-run zero economic profit as the firm earning nothing and being on the verge of closing. Economic profit already subtracts opportunity cost, including the return the owner could have earned in the next best use of their money and time, so zero economic profit means revenue covers every explicit cost plus that normal return. The owner is doing exactly as well as in the best alternative, which is why nobody enters and nobody leaves.
Perfect Competition questions
Why is the demand curve for a perfectly competitive firm horizontal?
A perfectly competitive firm faces a horizontal demand curve because it is tiny relative to the market and can sell any quantity it wants at the going price, but would sell nothing if it charged even slightly more, since buyers can get an identical product elsewhere. The market demand curve for the industry as a whole still slopes downward.
What is the profit maximizing rule in perfect competition?
A perfectly competitive firm maximizes profit by producing the quantity where marginal cost equals the market price, because price and marginal revenue are the same for a price taker. Producing past that quantity adds more to cost than it adds to revenue.
Are there any real examples of perfect competition?
No real market meets every condition of perfect competition, but markets for standardized commodities such as wheat, corn and foreign currency come close, because the products are near identical and no single trader can move the price. Perfect competition is mainly used as the efficiency benchmark that other market structures are measured against.
This is the live Perfect Competition sandbox. Drag the curves, or open the full version.
Related terms
Common comparisons
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