The model of perfect competition is built on four assumptions
(http://www.bized.ac.uk/stafsup/exams/revec_pc.htm)
- There are many firms each selling an identical product
- There are many buyers
- There are no restrictions on entry to the industry
- Firms in the industry have no advantage over potential new entrants
- Firms and buyers have complete information about the market
Since in perfect competition there are many firms selling a homogenous product, no single firm can influence the market to a greater extent than any other, hence all firms must accept the market price for their product. They are price takers. Each firm can sell freely as much as it chooses without fear of spoiling the market. However on the other side, no firm would be able to charge more than the market price without loosing the whole of its custom to its competitors.
As it can be seem from the figure 1(Web CT), the price level is determined by the whole demand and supply curves (S&D) of the market. Since the demand curve facing each firm is perfect elastic, every firm can only be a price taker. They all face a price curve as a horizontal line.
The different among each firm is only the amount of their output. All firms no matter under which kind of market structure, they all seek for maximum their profit. There is a simple profit-maximizing rule: “if profit are to be maximized,MR must equal MC”(Sloman)The simplest way to explain the method is to see what would happen if MC did not equal MR.It can be seen from the figure below(figure 2---sloman)
On the left side of point “e” where output is less than 3, MC curve is below than MR curve. (MR>MC) It simply means there will be a chance to add extra profit to total revenue by producing more units. “As long as MR exceeds MC, profit can be increased by increasing production.”(Sloman)By contrast, when output level higher than 3, MC will exceeds MR. (MR<MC) obviously, under this position one more production will add negative profit to total revenue.
Thus under a pure perfect competition, the point which firm can make maximum profit is where MC curve across MR curve(MC=MR).As shown before, each firm in perfect competition market has no choice but accept the market price as its own price, so that MR equal to Price(MR=P). Then P must equal MC. Thus the supply curve and the MC curve will follow the same line. Meantime, for price taker firm MR will the same as P (AR).The firm will make its maximum profit when is output at the level of Q.
(Web-CT)
If there is a change in market price, the profit-maximizing firms will transfer to a new equilibrium by changing its output.
In short run under perfect competition, which means most of the factors of production are fixed and there is no time to set up any new firms. If existent firms could make total revenue higher then total cost which also shows as AR is bigger than ATC, therefore they will continue to produce. As a result of the productive activates, the firms will make supernormal profit. One key point must be emphasized that a profit-maximizing firm will not supply at a price below ATC. The figure below shows the cost and revenues of a representative firm under perfect competition during a short-run. The market price is higher than ATC and the firm earns supernormal profit (grayest rectangle).
“In the long run, if typical company are making supernormal profits, new firms will be attracted into the industry.”(Sloman) Similarly, if existent firms can make supernormal profit by increasing their output, they will do since all factors of production are variable in long-run. Thus the total amount of supply will increase; the supply curve will shift to the right .This situation trend to lead a fall in market price. Supply will continually increase until the firm can only earn normal profit. In a figure,it will be illustrated as demand ”curve” for the firm just touches the bottom of its long-run AC curve where LRAC is equal AC,MC,MR and AR
Relating to economics welfare, as common sense allocative efficiency will achieve when the “value which society places on each goods or services will be just equal to the society’s real cost or sacrifice in producing that unit” (Price=Marginal Cost) (Market power&Economics welfare) When this situation is satisfied, total economics welfare is maximum. Hence it can be argue that allocative efficiency and economics welfare are all achieving maximum under perfect competition where MR equals to MC and P.
At the equilibrium point B, the output will be made at the level of Qc. Thus at this level MR equal MC.The total revenue therefore is Pc B Qc 0.The total cost as showing on figure is B Qc 0 C. Producer makes a producer surplus as triangle B C Pc which is considered to be its profits. The area 0 A B Qc represents the total utility gained by the buyer of production. That is the amount the consumers are willing to pay. However the consumer actually are only paying the price at Pc so there is a consumer surplus of triangle A Pc B. “The producer surplus plus consumer surplus is the total economics welfare created by perfect competition market.”(WEB-CT)
