key term - Perfect Competition

Definition

Perfect competition is an economic model that describes a market structure where numerous small firms sell identical products, and no single firm can influence the market price. This model is characterized by the free entry and exit of firms, perfect information, and the absence of barriers to competition.

5 Must Know Facts For Your Next Test

1. In perfect competition, firms are price-takers, meaning they have no control over the market price, which is determined by the interaction of market demand and supply.
2. Perfectly competitive firms must produce the quantity where their marginal cost equals the market price in order to maximize profits.
3. The long-run equilibrium in a perfectly competitive market is characterized by zero economic profits, as new firms will enter the market until all profits are eliminated.
4. Perfect competition leads to the most efficient allocation of resources, as the price equals the marginal cost of production, and resources are allocated to their highest-valued uses.
5. The absence of barriers to entry and exit in a perfectly competitive market ensures that resources can flow freely to their most productive uses, promoting economic efficiency.

Review Questions

• Explain how perfectly competitive firms make output decisions to maximize profits.
  • Perfectly competitive firms make output decisions to maximize profits by producing the quantity where their marginal cost equals the market price. This is the point where the firm's marginal revenue (which is equal to the market price) equals its marginal cost. By producing at this level, the firm ensures that the additional revenue from producing one more unit is equal to the additional cost, maximizing its overall profits.
• Describe how the entry and exit of firms in the long run affects the perfect competition market.
  • In the long run, the entry and exit of firms in a perfectly competitive market will drive economic profits to zero. If firms are earning positive economic profits, new firms will enter the market, increasing the supply and driving down the market price until profits are eliminated. Conversely, if firms are earning negative economic profits (losses), the least efficient firms will exit the market, reducing the supply and allowing the remaining firms to earn normal profits. This process continues until the market reaches a long-run equilibrium with zero economic profits.
• Analyze how the efficiency of perfect competition compares to other market structures, such as monopoly and monopolistic competition.
  • Perfect competition is considered the most efficient market structure because it leads to allocative efficiency, where the price equals the marginal cost of production, and resources are allocated to their highest-valued uses. This is in contrast to monopoly, where the firm restricts output to raise prices and earn higher profits, leading to a deadweight loss and a less efficient allocation of resources. Monopolistic competition also falls short of the efficiency of perfect competition, as firms have some degree of market power and can charge prices above the marginal cost of production.

Related terms

Profit Maximization:

The primary goal of firms in perfect competition is to maximize their profits by producing the quantity where marginal revenue equals marginal cost.

Allocative Efficiency:

Perfect competition leads to allocative efficiency, where resources are allocated to their most valued uses, and the price equals the marginal cost of production.

Equilibrium Price:

In perfect competition, the equilibrium price is determined by the intersection of the market demand and supply curves, and firms are price-takers, unable to influence the market price.