Perfect Competition In Microeconomics: Theory, Main Characteristics, And Horizontal Demand Curve

The individual firm faces a horizontal demand curve in perfect competition because under perfect competition firms are price takers and thus cannot influence the price due to their insignificant sizes. Each firm is assumed to be a very small part of the market; therefore, their behaviour is not capable of changing the equilibrium market price. This means that each individual demand is perfectly elastic and is calculated through this formula:

e=(ΔQ/Q)/(ΔP/P)=∞

If a firm would try and offer the same good at a higher price, it would be excluded from the market because the consumer would always choose the cheapest option of a good. On the other hand, if a firm tried to undercut the market and sell the good at below equilibrium price (P=minAVC) it would lead to firm failure. The reason behind this is through the combination of two factors. The size of the firm is being very small so the company has not accrued enough capital (through profit) to allow for them to survive a period of time of making losses by using their reserves to bail them out. The second factor is the industry of perfect competition prevents companies from making any profit because their produce sells exactly at Demand which is equal to Average Revenue = Marginal Revenue.

The market demand curve slopes downward because if the price of that good increases, the quantity demanded will decrease. Once the price is determined by the market, firms can not influence the price.

For example, the agriculture industry houses perfect competition. The market demand for wheat verses the demand for the production of wheat on a single farm. What happens on that one farm has no impact on the price of wheat; the market price of wheat will be decided by the market powers and consumer demand. The single farm can sell as much wheat as they want, but the price per unit will always be the same price. From the farm’s point of view, the demand curve is horizontally flat because not matter what they will always sell the wheat at whatever the market price is. But the industry demand curve is downward sloping because if the world price of wheat goes up, there will be less demand for it.

There are a few main characteristics of perfect competition. The first is that perfect competition contains a large number of small firms. Each firm is very small when compared to the size of the market. This ensures that no single firm can exert market control over price or quantity. If one firm decides to double its output or stop producing entirely, the market will be unaffected. The market price will not change and there will be no discernible change in quantity exchanged.

Perfect competition includes companies that all sell an identical product, known as homogenous goods. The feature of this characteristic is not so much that the goods are exactly the same, but that the buyers are unable to discern any difference. Therefore, buyers cannot actually tell which firm produces a given product. There are no brand names or distinguishing features that differentiate products by firm.

This means that every firm produces a good that is a perfect substitute for the output of every other firm in the market. Therefore, no firm can charge a different price than received by other firms. If the firm would try to increase the price, the buyers would immediately switch to other goods that are perfect substitutes.

One of the limitations of perfect competition is that it leaves no incentive for firm to innovate or add more features to the product because perfect competition leads to fixed profit margins and the inability for a firm to charge higher than the market price because consumers will move to other brands, hence sellers are forced to sell the standardised product at market price.

Limited consumer choice is another limitation. It does not take into account various consumer preferences as all goods are homogenously produced.

In terms of perfect competition, the best location is likely to generate more sales than a firm that is not located at a prime location. This is negative because the success of a company does not depend on how efficient the company is or how well managed it is but depends on fertile ground and good location. This means that new firms entering the industry are likely to have a poor selection of locations because all the best ones will be taken by the existing firms in the market.

The agricultural market is an example of perfect competition where farms are price takers, set by market price which is set by the quantity demanded of the consumers.

The theory of perfect competition suggests that supernormal profit can only be earned in the short term and they will make normal profit in the long term.

Supernormal profit is made where the average revenue exceeds the average cost. In perfect competition, firms are price takers which means that average revenue is not only equal to marginal cost, but is also constant and equal to the market price. Costs are kept as low as possible in order to avoid being priced out of the market. Output is determined by the profit maximising condition where marginal revenue is equal to marginal cost. Demand for produce could increase for an arbitrary reason. The firms in the market then meet the new demand for the produce (presented as a move from D1 to D2 on the graph above). During this period of time they supply the same amount to the market but at a higher price and in turn make supernormal profits. This is short lived because there are no barriers to entry in perfect competition. Outside firms see that supernormal profits are being made which incentivises them to join and with no barrers to entry, they do so with ease. As the new firms join the market, industry supply increases which pushes the market price back down tto its original position and reduces the supernormal profits in tandem with averge revenue. Firms continue to entre the market until there is no more incentive to do so.

In the long run, equilibrium will settle where only normal profit is made, consequently compettitive pressures ensure that supernormal profits for a firm in perfect competition only occurs in the short run.

Perfect competition could be seen as unstable because in the long run, firms can only gain normal profit as supernormal profits are a result of short-term market changes that are quickly extinguished through new firms joining the industry trying to catch the wave of supernormal profits. Due to only normal profits in the long run, firms do not have sufficient resources and incentives to conduct research and improve the quality of the product. This means that no innovation will occur, and the produce will be technologically stagnating because the market does not allow for innovation.

Firms trying to get rich will have to innovate by a different method. Innovation has to be found in creating new products because there are no restrictions of patents and copyright. Once a new innovation has been created, the output is quickly followed by other manufacturers. This leads to normal profit in the long run as the supply for the product is quickly being met by new firms entering the industry, being incentivised by temporary supernormal profits. As a result, firms realise that innovating is not profitable as profitability cannot be maintained in an industry with an absence of barriers to entry. This leads to a stagnant industry where there is no advancements in quality of product.

Perfect competition also does not take into account the various consumer preferences there are for goods as they are all produced homogenously in perfect competition. This could lead to long term decrease in consumer demand as they could get bored of the same product with no variation. This would have negative ramifications of the market because less demand will mean some firms will need to leave the industry as there is an overflow of supply.