Perfect competition

Assumptions

• Many buyers and sellers, each too small to affect price: firms are price takers.
• Homogeneous (identical) products.
• Perfect information for buyers and sellers.
• Freedom of entry and exit: no barriers.
• Firms aim to maximise profit.

Short-run equilibrium

The market price is set by industry demand and supply. The firm faces a horizontal demand curve at that price: P = AR = MR. It produces where MC = MR.

• If P > ATC at that output: supernormal profit.
• If P < ATC: losses (and the firm shuts down if P < AVC).

Diagram in words: two panels side by side, industry on the left (normal D and S setting price), firm on the right (horizontal AR = MR line at that price, U-shaped ATC and MC). Output is where MC cuts MR.

Long-run equilibrium

Supernormal profit attracts new firms (no barriers), so industry supply shifts right and price falls until only normal profit remains. Losses make firms leave, supply shifts left and price rises back. In long-run equilibrium P = MC = minimum ATC = AR = MR.

The firm's short-run supply curve is its MC curve above minimum AVC.

Efficiency and evaluation

In long-run equilibrium the firm is allocatively efficient (P = MC), productively efficient (at minimum AC) and X-efficient (competition removes slack). But there is little dynamic efficiency: only normal profit in the long run to fund research, and perfect information means any innovation is copied at once. The assumptions rarely hold fully; some agricultural and foreign exchange markets come close.

Worked example

The market price is $12. A firm's MC equals $12 at 400 units, where its ATC is $10. Find its profit and say what happens in the long run.

1. MC = MR = P = $12, so output = 400.
2. Supernormal profit = (12 - 10) x 400 = $800.
3. New firms enter, market supply shifts right, price falls to minimum ATC; supernormal profit is competed away.

Answer: $800 supernormal profit in the short run; normal profit in the long run.

Check yourself

1. In perfect competition, price is $50. At the output where MC = MR the firm produces 300 units and ATC is $44. Find supernormal profit.
   Show answer

   $1800. (50 - 44) x 300 = $1,800.

2. Price is $20. At the MC = MR output of 150 units, ATC is $23 and AVC is $18. Find the loss if the firm produces.
   Show answer

   $450. (23 - 20) x 150 = $450. Since P > AVC it should still produce in the short run.

3. A firm in perfect competition is a price taker because
   • the government sets the price
   • it is too small to influence the market price and its product is identical to others
   • it has a patent
   • it colludes with rivals
   Show answer

   it is too small to influence the market price and its product is identical to others. If it charged more, buyers would switch to identical products at the market price.

4. What causes supernormal profit to disappear in the long run in perfect competition?
   • Firms raise their prices
   • The government taxes the profit
   • New firms enter, shifting market supply right and lowering price
   • Demand becomes perfectly inelastic
   Show answer

   New firms enter, shifting market supply right and lowering price. No barriers to entry means profit attracts entrants.

5. In long-run equilibrium in perfect competition, which condition holds?
   • P = MC = minimum AC
   • P > MC and P > AC
   • MR = 0
   • P = AVC, with AVC at its maximum
   Show answer

   P = MC = minimum AC. Allocatively and productively efficient with normal profit.

6. Which is the main criticism of perfect competition in terms of efficiency?
   • It is allocatively inefficient
   • It is productively inefficient
   • Little dynamic efficiency, since there is no long-run supernormal profit to fund innovation
   • Prices are always too high
   Show answer

   Little dynamic efficiency, since there is no long-run supernormal profit to fund innovation. Static efficiency is good; dynamic efficiency is weak.

7. A perfectly competitive firm's short-run supply curve is
   • its MC curve from the minimum of AVC upwards
   • its AR curve
   • its ATC curve
   • a vertical line
   Show answer

   its MC curve from the minimum of AVC upwards. It produces where P = MC, as long as P covers AVC.

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Sources

• Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics specification (XEC11/YEC11), Unit 3 Business behaviour and Appendices 6 and 7

Last updated 8 November 2026. Spotted a mistake? Tell us.