The individual firm will view its demand as perfectly elastic. A perfectly elastic demand curve is a horizontal line at the price. The demand curve for the industry is not perfectly elastic, it only appears that way to the individual firms, since they must take the market price no matter what quantity they produce. Therefore, the firm’s demand curve is a horizontal line at the market price. Marginal revenue (MR) is the increase in total revenue resulting from a one-unit increase in output. Since the price is constant in the perfect competition. The increase in total revenue from producing 1 extra unit will equal to the price. Therefore, P= MR in perfect.
Perfect competition examples in real life
In the short run, the interaction between demand and supply determines the “market-clearing” price. A price P1 is established and output Q1 is produced. This price is taken by each firm. The average revenue curve is their individual demand curve. Since the market price is constant for each unit sold, the AR curve also becomes the marginal revenue curve (MR) for a firm in perfect competition. For the firm, the profit maximising output is at Q2 where MC=MR. This output generates a total revenue (P1 x Q2). Since total revenue exceeds total cost, the firm in our example is making abnormal (economic) profits. This is not necessarily the case for all firms in the industry since it depends on the position of their short run cost curves. Some firms may be experiencing sub-normal profits if average costs exceed the price – and total costs will be greater than total revenue.
The adjustment to the long-run equilibrium in perfect competition If most firms are making abnormal profits in the short run, this encourages the entry of new firms into the industry This will cause an outward shift in market supply forcing down the price The increase in supply will eventually reduce the price until price = long run average cost. At this point, each firm in the industry is making normal profit. Other things remaining the same, there is no further incentive for movement of firms in and out of the industry and a long-run equilibrium has been established. This is shown in the next diagram. Assuming in the diagram above that there has been no shift in market demand. The effect of increased supply is to force down the price and causes an expansion along the market demand curve. But for each supplier, the price they “take” is now lower and it is this that drives down the level of profit made towards normal profit equilibrium. Characteristics of competitive markets
The common characteristics of markets that are considered to be “competitive” are: Lower prices because of many competing firms. The cross-price elasticity of demand for one product will be high suggesting that consumers are prepared to switch their demand to the most competitively priced products in the marketplace. Low barriers to entry – the entry of new firms provides competition examples and ensures prices are kept low in the long run. Lower total profits and profit margins than in markets which dominated by a few firms. Greater entrepreneurial activity – the Austrian school of economics argues that competition is a process. For competition to be improved and sustained there needs to be a genuine desire on behalf of entrepreneurs to innovate and to invent to drive markets forward and create what Joseph Schumpeter called the “gales of creative destruction”. Economic efficiency – competition will ensure that firms move towards productive efficiency. The threat of competition should lead to a faster rate of technological diffusion, as firms have to be responsive to the changing needs of consumers. This is known as dynamic efficiency. The importance of non-price competition
Source: perfect competition examples