Assumptions of the model -
- There are many buyers and sellers, none of whom are able to influence the market (= ”price-taker”)
- Each firm is very small relative to the industry.
- Products are identical (homogenous).
- There are no barriers to entry or exit.
- There is perfect knowledge of prices, costs of production, a product quality
Example – Wheat farms in Canada, milk producers in China
The demand curve facing the industry and the firm in perfect competition:
The graph shows that price, demand, average revenue, (p x q / q leaving p), and marginal revenue (the revenue of selling one more unit of the good) are all equal. The y-axis is price (and costs too if you want) and the x-axis is quantity in whatever units used.
Profit-maximizing level of output:
The profit maximizing level of output is where MC = MR.
Below, we see possible SR profit situations (abnormal profits, normal profits and losses, all moving towards long-run normal profits).
There are three SR possibilities: abnormal profits, losses and normal profits. If firms are making abnormal profits, the profit maximizing level of output dashed line hits the average cost curve (AC1) below where p* equals MC, AR, MR and D. The box that is constructed using the line by which the average cost curve hits the profit maximizing line represents abnormal profits (blue box above).
On the flip side, if average costs are higher than where p* equals MC, AR, MR and D, we have losses which can be shown by the corresponding red box in the graph (AC2).
It is theoretically possible to be at normal profits in the short run. This has no box and is simply shown by having the AC curve hit MC, p*, AD, MR and D.
It's important to use the vertical line which passes through the point by which MC=MR to construct these diagrammatical representations.
It is possible to achieve abnormal profits or losses in the short-run. However, normal profits prevail in the long-run. This is due to adjustments in the industry supply and demand curve. If firms are making SR abnormal profits, soon enough producers will enter the market to shift out the industry supply curve. This lowers the price (and thus the D, AR, MR curve) to the point at which normal profits are made. Alternatively, if firms are making SR losses, soon enough producers will leave that the industry supply curve will shift inwards and find equilibrium at a higher price. This shifts the firm's D, AR, MR curve up and will continue until normal profits are made. Note I have not included an industry supply and demand curve in this post, but it looks like the one in the supply and demand post earlier.
productive efficiency : occurs when a firm produces at the lowest possible cost per unit, AC = MC
allocative efficiency (=socially efficient level of output) : occurs when output is at society's optimum level, AR = MC
Perfect competition (PC) is both productively and allocatively efficient. However, all products are consider to be identical so there is no chance to choose between slightly differentiated products.
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