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FEDERAL FUNDS RATE: The interest rate that banks charge each other when loaning bank reserves through the federal funds market. This is a key interest rate in the economy because helps to determine banks' minimum cost of getting funds. If the federal funds rate is higher, then banks are likely to raise the interest rates they charge, like the prime rate, home mortgage rate, or rate on car loans.

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PERFECT COMPETITION:

An ideal market structure characterized by a large number of small firms, identical products sold by all firms, freedom of entry into and exit out of the industry, and perfect knowledge of prices and technology. This is one of four basic market structures. The other three are monopoly, oligopoly, and monopolistic competition. Perfect competition is an idealized market structure that is not observed in the real world. While unrealistic, it does provide an excellent benchmark that can be used to analyze real world market structures. In particular, perfect competition efficiently allocates resources.
Perfect competition a market structure characterized by a large number of firms so small relative to the overall size of the market, such that no single firm can affect the market price or quantity exchanged. Perfectly competitive firms are price takers. They set a production level based on the price determined in the market. If the market price changes, then the firm re-evaluates its production decision. This means that the short-run marginal cost curve of the firm is its short-run supply curve.

Characteristics

The four characteristics of perfect competition are: (1) large number of small firms, (2) identical products, (3) perfect resource mobility, and (4) perfect knowledge.
  • Large Number of Small Firms: A perfectly competitive industry contains a large number of small firms, each of which is relatively small compared to the overall 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 is unaffected. The price does not change and there is not discernible change in the quantity exchanged in the market.

  • Identical Products: Each firm in a perfectly competitive market sells an identical product, what is often termed "homogeneous goods." The essential feature of this characteristic is not so much that the goods themselves are exactly, perfectly the same, but that buyers are unable to discern any difference. In particular, buyers cannot tell which firm produces a given product. There are no brand names or distinguishing features that differentiate products.

  • Perfect Resource Mobility: Perfectly competitive firms are free to enter and exit an industry. They are not restricted by government rules and regulations, start-up cost, or other barriers to entry. While some firms incur high start-up cost or need government permits to enter an industry, this is not the case for perfectly competitive firms. Likewise, a perfectly competitive firm is not prevented from leaving an industry as is the case for government-regulated public utilities.

  • Perfect Knowledge: In perfect competition, buyers are completely aware of sellers' prices, such that one firm cannot sell its good at a higher price than other firms. Each seller also has complete information about the prices charged by other sellers so they do not inadvertently charge less than the going market price. Perfect knowledge also extends to technology. All perfectly competitive firms have access to the same production techniques. No firm can produce its good faster, better, or cheaper because of special knowledge of information.

Demand and Revenue

Demand Curve,
Perfect Competition
Perfect Competition Demand
The four characteristics of perfect competition mean a perfectly competitive firm faces a horizontal or perfectly elastic demand curve, such as the one displayed in the exhibit to the right.

Each firm in a perfectly competitive market is a price taker and can sell all of the output that it wants at the going market price, in this case $2.50. A firm is able to do this because it is a relatively small part of the market and its output is identical to that of every other firm. As a price taker, the firm has no ability to charge a higher price and no reason to charge a lower one.

Because it can sell all of the output it wants at the going market price, it has no reason to charge less. If it tries to charge more than the going market price, then buyers can simply buy output from any of the large number of perfect substitutes produced by other firms.

Because the price facing a perfectly competitive firm is unrelated to the quantity of output produced and sold, this price is also equal to the marginal revenue and average revenue generated by the firm. If a firm is able to sell any quantity of output for $2.50 each, then the average revenue, revenue per unit sold, is also $2.50. Moreover, each additional unit of output sold, marginal revenue, generates an extra $2.50.

Short-Run Production

Short-Run Production,
Perfect Competition
Short-Run Production
The analysis of short-run production by a perfectly competitive firm provides insight into market supply. The key assumption is that a perfectly competitive firm, like any other firm, is motivate by profit maximization. The firm chooses to produce the quantity of output that generates highest possible level of profit, based on price, market demand, cost conditions, production technology, etc.

The short-run production decision for perfect competition can be illustrated using the exhibit to the right. The top panel indicates the two sides of the profit decision--revenue and cost. The straight green line is total revenue. Because price is constant, the total revenue curve is a straight line. The curved red line is total cost. The shape of the total cost curve is based on increasing then decreasing marginal returns. The difference between total revenue and total cost is profit, which is illustrated by the lower panel as the brown line.

A firm maximizes profit by selecting the quantity of output that generates the greatest gap between the total revenue line and the total cost line in the upper panel, or at the peak of the profit curve in the lower panel. In this example, the profit maximizing output quantity is 7. Any other level of production generates less profit.

Supply and Marginal Cost

A key implication obtained from the short-run analysis of perfection competition is positive relation between price and the quantity of output supplied. In particular, the supply curve for a perfectly competitive firm is positively sloped.

This relation is generated for two reasons:

  • First, a perfectly competitive firm produces the quantity of output that equates price and marginal cost.

  • Second, the marginal cost curve, guided by the law of diminishing marginal returns, is positively sloped.
Taken together these two observations indicate that a higher price entices a perfectly competitive firm to increase the quantity of output produced and supplied. In particular, a perfectly competitive firm's marginal cost curve is also its supply curve.

This conclusion, however, only applies to perfect competition. Firms operating in market structures that do not equate price and marginal cost, but rather equate marginal revenue and marginal cost. As such, the marginal cost curve is not the supply curve for the firm.

Long-Run Production

In the long run, with all inputs variable, a perfectly competitive industry reaches equilibrium at the output that achieves the minimum efficient scale, that is, the minimum of the long run average cost curve. This is achieved through a two-fold adjustment process.
  • The first of the folds is entry and exit of firms into and out of the industry. This ensures that firms earn zero economic profit and that price is equal to average cost.

  • The second of the folds is the pursuit of profit maximization by each firm in the industry. This ensures that firms produce the quantity of output that equates price (and marginal revenue) with short-run and long-run marginal cost.
The end result of this long-run adjustment is a multi-faceted equilibrium condition:
P = AR = MR = MC = LRMC = ATC = LRAC
This condition means that the market price (which is also equal to a firm's average revenue and marginal revenue) is equal to marginal cost (both short run and long run) and average cost (both short run and long run). With price equal to marginal cost, each firm is maximizing profit and has no reason to adjust the quantity of output or factory size. With price equal to average cost, each firm in the industry earns only a normal profit. Economic profit is zero and there are no economic losses, meaning no firm is inclined to enter or exit the industry.

A Benchmark of Efficiency

Perfect competition is an idealized market structure that achieves an efficient allocation of resources. Although unrealistic, the characteristics of perfect competition ensure efficiency. In fact, a primary purpose of perfect competition is to illustrate perfection, to illustrate the best of all possible resource allocation worlds, and to provide a benchmark for comparison with real world market structures that inevitably fall short of this perfection.

Efficiency is achieved with perfect competition because the price is equal to marginal cost. Price indicates the value of the good produced and thus the satisfaction generated from production. Marginal cost indicates the opportunity cost of goods not produced and thus the satisfaction lost from foregone production.

Because the satisfaction obtained (price) is equal to satisfaction foregone (marginal cost) overall satisfaction cannot be increased by increasing or decreasing production. If price and marginal cost are not equal, then satisfaction can be increased by changing production.

The Other Three Market Structures

Market Structure Continuum
Market Structure Continuum
Perfect competition is one of four common market structures. The other three are: monopoly, oligopoly, and monopolistic competition. The exhibit to the right illustrates how these four market structures form a continuum based on the relative degree of market control and the number of competitors in the market. At the far left of the market structure continuum is perfect competition, characterized by many competitors and no market control.
  • Monopoly: To the far right of the market structure continuum is monopoly, characterized by a single competitor and extensive market control. Monopoly contains a single seller of a unique product with no close substitutes. The demand for monopoly output is THE market demand.

  • Oligopoly: In the middle of the market structure continuum, residing closer to monopoly, is oligopoly, characterized by a small number of relatively large competitors, each with substantial market control. A substantial number of real world markets fit the characteristics of oligopoly.

  • Monopolistic Competition: Also in the middle of the market structure continuum, but residing closer to perfect competition, is monopolistic competition, characterized by a large number of relatively small competitors, each with a modest degree of market control. A substantial number of real world markets fit the characteristics of monopolistic competition.

<= PER UNIT TAXPERFECT COMPETITION, CHARACTERISTICS =>


Recommended Citation:

PERFECT COMPETITION, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2014. [Accessed: July 31, 2014].


Check Out These Related Terms...

     | perfect competition, characteristics | perfect competition, demand | perfect competition, efficiency |


Or For A Little Background...

     | total revenue | average revenue | marginal revenue | short-run production analysis | long-run production analysis | profit | profit maximization | market structures | marginal cost | total cost | average cost | supply | efficiency | satisfaction |


And For Further Study...

     | short-run analysis, perfect competition | long-run analysis, perfect competition | long-run industry supply curve | monopoly | oligopoly | monopolistic competition | minimum efficient scale | factor market analysis | perfect competition, factor market analysis |


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