This page presents interactive graphs to better understand perfectly competitive markets. Perfect competition arises in markets where there are many buyers and many sellers who produce an identical good. There are two defining features of perfect competition:
- Buyers and sellers are price-takers. This feature follows from the assumption of an identical good and many buyers and sellers -- so no buyer or seller can influence the price.
- No barriers to entry, so in the long-run firms can freely enter or exit the market whenever firms are realizing profits or losses. This feature implies that in the long-run perfectly competitive firms will earn zero economic profits.
This page highlights the problem of the firm in perfectly competitive markets. So, the illustrative tool that we use is a graph of the individual firm's costs and the market's supply-demand graph.
Firm Cost Curves
Recall, from the discussion of firms' cost curves:
- Marginal costs (MC) are increasing over the range of production relevant to firms' decision-making.
- Average total costs (ATC) are decreasing in production, at first, as fixed costs are the predominant cost at low quantities. But, as production increases so does average total costs as variable costs become more important.
- The MC curve intersects the ATC at the minimum of ATC. (Intuition: imagine your grade in Econ 20A as the marginal grade, when you get an A what does it does to your grade point average?)
The graph above illustrates the important points about a firm's profit-maximizing decision in a perfectly competitive market.
- As price-takers, firms will produce where the Market Price=Marginal Cost. (Recall, for a price-taking firm marginal revenue is equal to the price.) This is illustrated in the above graph where MC (blue line) intersects the Market Price (red dashed-line). That intersection point gives how much an individual firm produces. For market supply, we have to multiply that quantity by the number of firms in the market.
- Firms are maximizing profits when they produce up until P=MC. Profits are (P-ATC)*Q. Illustrated as the green rectangle in the graph. If firms produced more than that, they would be taking a loss on the extra production. If they produced less, i.e. P>MC, they could earn additional profits by producing more.
- This graph can not be a long-run equilibrium. In the long-run, potential entrants would see the profits being earned by firms and would enter the market (since there are no barriers to entry). That will increase the supply and push the price down until all firms earn zero economic profits.
The interactive graph below allows you to shift the market demand and supply curves and see how that affects individual firms. Recall, a change in demand or supply will affect short-run profits, but in the long-run firms enter/exit until long-run firm economic profits are equal to zero.