Perfect competition is a extreme situation where firms in a competitive business experience the following:
1) They sell identical products (IBM
s vs Compaq
2) There are no penalties for entering and exiting the industry
3) Older firms in the industry cannot have advantages over the newer ones
4) Sellers and buyers are informed about competitive prices
Industries that are similar to this are farming
, and paper milling
. These industries do not exemplify perfect competition but are similar to it and is used in many examples to explain the concept.
This situation comes together if the minimum efficient scale
of a single producer is small in relative comparison to the demand of the good or service they are providing. Furthermore, all producers in this industry are known as price taker
s. A result of this situation is that due to the price being flatlined across the board and the fact that the entities involved are price taker
s, the price is equivalent to the marginal revenue
. So for each additional unit that they sell, they earn the same amount as they did the first time.
In this situation, decisions are considered either in terms of short-term or long-term. In short-term decisions, companies decide:
1) If producing, how much to produce (in essence to maximize profit
and minimize loss
2) Whether to produce or simply shut down
In the long run, companies decide:
1) Change or keep the plant size?
2) Whether to stay in the industry or leave it?
In the short-run situation, when making the decisions above, the entity involved must realize what situation they are in, whether they are simply achieving enough profit to stay even, make money or lose money. When making money, they have to determine the profit maximizing output, depending on the cost and diminishing marginal returns
. In a situation when the revenue they achieve is equivalent to the average variable cost per output, they achieve a situation called the Shutdown point
. In this case, they decide whether to stay or not. Below this, they will shut down. When they are above the shutdown point
, firms will optimize profit by producing at each price and quantity determined by their marginal cost
Of course, like most other competitions, when entities leave or enter the industry, the supply and price changes. In this extreme situation, what happens is that the short run industry supply curve dictates an equilibrium point where even after market fluctuation due to exit and entry the industry will eventually revert back to. With exit of firms, the price rises and the loss of each remaining firm decreases. With entry of firms, the price decreases and profits are decreased.
In the long run, firms change size simply if they can lower costs and increase economic profit. Also, given enough time, the industry will allow plant size shifts for each individual firm and they will reach an equilibrium where they will simply break even
, or have a situation where economic profit
Also in the long run, the price can fluctuate but depend on external economies
and external diseconomies
. Without these two factors, the firm's cost never changes while industry output increases. These factors allow the industry to keep, raise or lower its market price (depending if the costs are maintained, increased or lowered.
Like any other type of competition and industry, it possesses some of the same characteristics. It reaches its own equilibrium point
where resources are efficiently allocated in its highest valued use. On the other hand, it also is susceptable to situations that decrease efficiency, such as monopoly
, public goods
and external costs
and external benefits