Perfect competition

Lessons 3 to 6 assumed competitive markets without looking closely at the firms inside them. This lesson does. Perfect competition is a model of an industry with so many sellers of an identical product that no single firm can influence the price. Few industries meet every condition exactly, but agricultural commodities such as wheat and canola, some financial markets, and many small-business sectors come close. The model matters for two reasons: it explains how prices and output are determined in competitive industries, and it provides the efficiency benchmark against which monopoly and oligopoly, in lessons 10 and 11, are judged.

The conditions of perfect competition

A perfectly competitive market has four features. There are many buyers and sellers, each small relative to the market. The product is homogeneous: buyers regard every seller's product as identical, so they have no reason to pay more to one seller than another. There is free entry and exit in the long run: firms can start up or shut down without special legal or technical barriers. And buyers and sellers have good information about prices and products. Under these conditions, each firm is a price taker: it can sell as much as it wants at the market price, but nothing at a higher price, because buyers would go to other sellers. The demand curve facing an individual firm is therefore horizontal at the market price, even though the market demand curve slopes downward.

A Saskatchewan wheat farmer illustrates price taking. Her harvest, however large, is a tiny fraction of the world wheat market. She can sell her whole crop at the going price, and if she asked more, grain buyers would simply buy elsewhere. Her decisions are about how much to grow and how to grow it, not what price to charge.

Revenue for a price taker

For a price-taking firm, total revenue is price times quantity, and marginal revenue (MR), the extra revenue from selling one more unit, equals the price, because the firm can sell additional units without lowering its price. Average revenue also equals the price.

Choosing output to maximize profit

A firm maximizes profit by producing the quantity at which marginal revenue equals marginal cost. If MR exceeds MC, producing one more unit adds more to revenue than to cost, so profit rises; if MC exceeds MR, cutting output raises profit. For a price taker, MR equals the price, so the profit-maximizing rule becomes: produce where \( P = MC \), on the rising part of the marginal cost curve. This rule applies to every firm, competitive or not, in the form \( MR = MC \); what is special about perfect competition is that MR equals price.

Once the firm has chosen its output, its profit is \( (P - ATC) \times Q \). If the price is above average total cost at that output, the firm makes an economic profit; if it is below, the firm makes a loss.

# Profit-maximizing output for a price-taking farm (illustrative numbers)
# Output in hundreds of tonnes; fixed cost $30,000; variable costs rise with diminishing returns
fixed = 30_000
vc = {0: 0, 1: 22_000, 2: 40_000, 3: 56_000, 4: 74_000, 5: 96_000, 6: 124_000, 7: 160_000}
for price_per_100t in (30_000, 23_000, 17_000):
    best = max(vc, key=lambda q: price_per_100t * q - fixed - vc[q])
    profit = price_per_100t * best - fixed - vc[best]
    sign = "-" if profit < 0 else ""
    avc = f"${vc[best] / best:,.0f}" if best else "n/a (shut down)"
    print(f"price ${price_per_100t:,} per 100 t: produce {best} (00 t), profit {sign}${abs(profit):,}, AVC {avc}")
print("marginal cost of each extra 100 t:", [vc[q] - vc[q - 1] for q in range(1, 8)])

price $30,000 per 100 t: produce 6 (00 t), profit $26,000, AVC $20,667
price $23,000 per 100 t: produce 5 (00 t), profit -$11,000, AVC $19,200
price $17,000 per 100 t: produce 0 (00 t), profit -$30,000, AVC n/a (shut down)
marginal cost of each extra 100 t: [22000, 18000, 16000, 18000, 22000, 28000, 36000]

At a price of $30,000 per hundred metric tons, the farm produces 600 metric tons, where the marginal cost of the last hundred metric tons ($28,000) is just below the price and the next hundred would cost $36,000, and earns a profit of $26,000. At $23,000 it produces 500 metric tons and loses $11,000, because the price is below average total cost. But producing still beats shutting down, which would lose the full $30,000 of fixed cost. At $17,000 the best choice is to produce nothing: the best positive output, 300 metric tons, would lose $35,000, more than the $30,000 of fixed cost it loses by shutting down. The next section explains this shutdown rule.

The shutdown decision

In the short run, a firm making a loss must decide whether to keep operating or shut down temporarily. If it shuts down, it earns no revenue but still pays its fixed costs, which are sunk in the short run. If it operates, it earns revenue and pays both fixed and variable costs. It should operate if revenue covers variable costs, because then it earns something toward its fixed costs and loses less than by shutting down. The short-run shutdown rule is therefore: shut down if the price is below average variable cost at the best output.

In the long run, when fixed costs can be avoided by leaving the industry, a firm exits if the price is below average total cost, because it cannot cover all its costs. The short-run supply curve of a competitive firm is therefore the part of its marginal cost curve above the minimum of average variable cost. This is the deep reason the market supply curve slopes upward: it is the sum of firms' marginal cost curves.

Long-run equilibrium: entry and exit

Free entry and exit drive the long-run outcome. Suppose the market price is high enough that firms earn economic profits. Those profits attract new firms, and existing firms expand. Market supply shifts right, the price falls, and profits shrink. Entry continues until economic profits are zero. Conversely, if firms are making losses, some exit, supply shifts left, the price rises and losses shrink until the remaining firms earn zero economic profit. In long-run equilibrium, then, the price equals the minimum of average total cost, and each firm earns a normal profit.

This result has striking implications. First, competitive firms produce at the lowest possible average cost, at the bottom of their ATC curves: this is productive efficiency. Second, because price equals marginal cost, the value buyers place on the last unit equals its cost of production: this is allocative efficiency, the condition for maximizing total surplus from lesson 5. Third, profits in a competitive industry are temporary signals: they attract resources into industries where consumers want more output and drive them out of industries where consumers want less. Zero economic profit does not mean that owners earn nothing; it means they earn exactly what they could earn elsewhere.

The long-run supply curve

What does the industry's long-run supply curve look like? If the industry can expand without affecting input prices, new firms can enter with the same costs as existing ones, and the long-run supply curve is horizontal at the minimum of average total cost: a constant-cost industry. An increase in demand raises the price temporarily, but entry brings it back down. If expansion bids up the prices of scarce inputs, such as specialized labor or suitable land, costs rise as the industry grows, and the long-run supply curve slopes upward: an increasing-cost industry. Some industries even become cheaper as they grow, because a larger industry supports specialized suppliers and a pool of skilled workers: a decreasing-cost industry.

How well does the model fit?

Real markets depart from perfect competition in many ways. Products are often differentiated by brand, location or quality; information is imperfect; entry can be costly; and many industries have a few large firms. Yet the model's predictions about entry, exit and the erosion of profits hold widely. When a new food trend, such as bubble tea or poke bowls, proves profitable, new shops open quickly and margins fall. When demand falls, as for video rental stores after streaming arrived, firms exit. The model also explains why many economists see competition as the best protection for consumers: it pushes prices toward cost and rewards firms that cut costs or improve products. Farm policy illustrates a different point: because agricultural markets are close to competitive and demand is inelastic, prices and incomes are volatile, which is why both Canada and the United States run programs to stabilize farm incomes.