Putting It Together: Perfect Competition

Summary

The goal of this module was analyze a firm’s profit maximizing decisions under conditions of perfect competition. You learned how to:

• Define the characteristics of Perfect Competition
• Understand the difference between the firm and the industry
• Calculate and graph the firm’s fixed, variable, average, marginal and total costs
• Measure variable and total costs as the area under the average variable and average total cost curves
• Determine the break-even, and the shutdown points of production for a perfectly competitive firm
• Explain the difference between short run and long run equilibrium
• Understand why perfectly competitive markets are efficient

Examples

Let’s return to the questions posed at the beginning of the module. Why do all tomatoes of the same type cost the same price in a farmer’s market? The answer is because a farmer’s market or a bunch of roadside tomato stands fit the characteristics of perfect competition: many firms (or sellers at the market), all selling a similar if not identical product, where it is easy for buyers and sellers to see what everyone is charging. In this situation, if one seller charged a higher price, none of the customers would do business with that seller, since they could get an identical product from another seller at the lower price. Why would a seller charge a lower price if they can sell all their inventory by the end of the day at the going price?

By contrast, why do different gas stations on the same strip of highway charge different amounts per gallon of gasoline? Why do different pizza restaurants charge different prices for the same product, say a large one topping pizza? We’ll learn the answers to these questions in future modules.

Finally, what’s so perfect about perfect competition? The answer is that perfect competition shows markets operating at their best. Perfect competition is productively efficient, because in the long run firms produce their products as cheaply as possible (i.e. at minimum average cost). What this means in a larger context is that the economy is operating on its production possibilities frontier, rather than inside the frontier (for more on the production possibilities frontier, click HERE).

It’s also allocatively efficient, meaning it’s producing the optimal quantity of output (i.e. where price equals marginal cost), because that quantity maximizes total economic surplus (for a review of surplus, click HERE). What this means is that it’s producing at the right point on the production possibilities frontier.

Watch the following video for a summary and example of perfect competition:

There is a lot going for the model of perfect competition.  As a result, it’s the model we typically use to compare real world industries against.

Let’s turn now to those real world industries.