Perfect competition is a market characterization in which there are a large number of small sellers or producers, there is a homogeneous, standardized product, individual sellers are not able to influence price, sellers freely enter or exit the market and there is unnecessary nonprice actions. A firm is therefore free to adjust its inputs in the long run. This can bring about the entry into the market by new firms and the existing ones leave. The perfect competition model predicts that during long run equilibrium, the cost of production will be at its lowest level and also that all economic losses and profits will be eliminated (Petroff par. 1).
In perfect competition, economic profits and economic losses are very vital. New firms are attracted in an industry if there exist economic profits in the long run. This entry of new firms will shift the supply curve to the right leading to a fall in prices and profits. Firms will keep coming into the industry until the economic profits fall to zero. When this happens, firms will starts experiencing economic losses, start leaving, shifting the supply curve to the left and eventually prices will increase reducing losses and bringing the economic profits to zero again (Rittenberg & Tregarthen par. 2).
The large number of firms in perfect competition shows that individual firms are very small as compared to the total market.
This means that if one of them becomes big, then competition will be eliminated or reduced. Products in perfect competition are similar or standardized in that it does not matter to customers who are selling the products. The firms dealing in such a competition have no control over the price of commodities, they are price takers. The free entry and exit from a market ensures that no firm dominates over the others keeping the number of firms in the market at a constant number. Actions such as advertising, after sale service or warranty are not necessary as customers will still buy at the prevailing prices and extra expenses will only lead to losses to the firm. Demand in this type of competition is elastic.
The marginal revenue of firms in perfect competition is represented by the horizontal demand curve. Additional revenue or marginal revenue from an extra unit sold is just equal to the prevailing price. For maximum profit firms must sell output volume that will give total revenue exceeding total cost by the largest amount. If the firm realizes fewer revenues that can not cover its costs, then the firm must shut down. This is called the "Close down Decision." Another thing that firms in perfect competition should look at in order to maximize profits is that they should be beyond their break-even point.
This is the volume of output in total revenue is equal to total cost. Profit maximization can also come about if the marginal revenue marginal cost rule is applied. Profit maximization will occur if marginal revenue equals marginal cost. This also works for loss minimization. But if these two costs intersect below average variable cost, this will show that revenues are not enough to cover fixed costs. In such a situation, the firm should close down (Petroff par. 8).
Firms in perfect competition can only experience long run equilibrium if demand is tangent to the minimum average total cost. The firm does not gain or lose from engaging in that particular business. There will be no pure or economic profits but normal profits might be covered. When demand rises above the average total cost, a firm in perfect competition will realize pure profits. This in turn attracts other firms to the industry. Many of them will increase market supply thereby reducing price, this in turn drives demand for each firm down making them to incur losses and eventually starting leaving the industry. And cycle will repeat itself over again. The long run supply curve is perfectly elastic for firms in an industry in perfect competition.
The emergency of many firms participating in global trade and competition has seen many similar products being produced by these firms. This therefore called for perfect competition as customers will always dictate the market prices. No firm will therefore want to work on its own as no one will buy from it. Perfect competition also helps bring about allocative efficiency and productive efficiency. Marginal social benefits and marginal social cost are measurements used to determine the change in benefits over change in quantity. Marginal social benefit is equal to the marginal social cost at the point of intersection of their curves. This is regarded as the most economically efficient production and consumption point. This point is also important environmental wise because it captures the fundamentals of tradeoffs (Anderson par. 6)
Assumptions made in the perfect competition model make sure that every party making decision is a price taker, because price in the market is determined by the interaction of demand and supply. Maximization of profits by firms in perfect competition is done by producing an output level whereby marginal revenue is equal to marginal cost. If an industry's firms are earning economic profits, more firms will come in driving down price until a long run equilibrium value of zero is achieved.
This is same to firms making losses; they will exit until the long run equilibrium of zero is achieved. Long run equilibrium can only change if there is a change in production cost or demand that can affect supply. This can bring about economic losses or profits in the short run, but will be done away with in the long run by entry or exit of firms.