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3.4.2 Perfect competition

Perfect competition 

Assumptions of perfect competition 

1. All firms produce homogenous products. All products are perfect substitutes for each other - meaning a perfectly elastic demand curve. 
2. All firms are profit maximisers (MC = MR)
3. There are no barriers to entry or exit. Firms can move into and out of the market freely. 
4. There is perfect information between firms, between consumers and between firms. 
5. There is a large number of buyers and sellers - each firm is a 'price taker' 
(6. All factors of production are perfectly mobile - perfect geographical and occupational mobility) 
(7. No externalities) 

Characteristics

Firms are price takers 

AR = MR 

Due to products being homogenous, there is a high number of substitutes and so the demand curve is perfectly elastic. 


Normal profits are made 

AR = AC 

Due to there being no barriers to entry or exit, firms can only make normal profits in the LR. 
Image result for perfect competition

In the SR, supernormal profits may be made, but as there are no barriers to entry, firms will move into the market, and market supply will shift out. This will decrease each individual firms' demand, and the AR curve will shift downwards. A new equilibrium will be reached at a lower price and output - where AR = AC once again, and normal profits are attained. 

Supernormal losses may also occur in the SR, but the opposite will happen (firms move out of market, individual demand shifts up, price increases, firms make normal profit). 


Both productive and allocative efficiency are attained 

In the LR,

AR = MR (price takers) 

MR = MC (profit maximisers), therefore... 


In the LR firms must operate at the bottom of the AC curve (due to the various conditions as above). As output is at the minimum of the AC curve, the lowest cost per unit is achieved and productive efficiency is attained. 


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