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Perfect competition

Foundations06 / NOTE

Foundations note — the four assumptions, why the firm sets P = MC, the short-run shutdown rule, and how free entry drives long-run profit to zero at the efficient scale.

A foundations note — keeping the building blocks sharp.

Perfect competition is the field’s benchmark market. Four assumptions define it:

  1. Many small buyers and sellers — no single agent is large enough to move the price.
  2. A homogeneous product — buyers don’t care whose unit they get.
  3. Price-taking — each firm can sell any quantity at the going market price P, and none above it.
  4. Free entry and exit in the long run, with full information.

The immediate consequence: an individual firm faces a horizontal (perfectly elastic) demand curve at P. So average and marginal revenue both equal the price:

AR = MR = P

The firm’s choice. Maximising profit π = TR − TC gives the first-order condition MR = MC, which here becomes the signature equation

P = MC

on the rising portion of MC (so the second-order condition holds).

Short run. Capital is fixed, and the firm compares P with average cost AC and average variable cost AVC:

  • P > AC → positive economic profit.
  • P = AC → just normal profit.
  • AVC ≤ P < AC → a loss, but keep producing (you recover part of fixed cost).
  • P < AVC → shut down (operating loses more than the fixed cost alone).

So the shutdown point is min AVC, and the firm’s short-run supply curve is the MC curve above that point.

Long run. Free entry and exit competes away any excess. Positive profit attracts entrants → supply up, price down; losses drive exit → price up. Equilibrium settles at

P = MR = MC = min AC,    π = 0

Each firm produces at the bottom of its average-cost curve — the efficient scale — and economic profit is zero. Because P = MC, the value buyers place on the last unit equals its marginal cost: the outcome is allocatively efficient, with no deadweight loss. This zero-profit, price-equals-marginal-cost outcome is the welfare benchmark against which monopoly and oligopoly are judged.

Common slips: reading zero economic profit as zero accounting profit (it still includes a normal return, so accounting profit is positive); writing the shutdown rule with AC instead of AVC (short-run shutdown is about AVC); and confusing the firm’s flat demand with the market’s downward-sloping demand.