Assumptions behind a perfectly competitive market (conditions):
· Large number of buyers and sellers with insignificant market share.
· Freedom of entry and exit into the market. There are no barriers to entry and exit in the long run, the market is open to new suppliers.
· Consumers have perfect knowledge about prices.
· All firms have equal access to resources (e.g. technology) – perfect factor mobility.
· Homogenous products that are perfect substitutes for one another.
· Independent action by firms will not influence the market price as each individual firm is too small. This means that the firm is a price taker.
· No externalities of production or consumption.
Perfectly competitive markets are rare, however close examples include:
· Foreign currency – homogenous product, each trader is relatively small in the market and the trader has to take the given price.
· Fruits and vegetables – homogenous product, firms are price takers, large number of buyers and sellers…etc.
When the firm is a price taker, there is little percentage difference in prices within the market. But most firms sell at the prevailing, ruling market price.
Short run equilibrium
The market ruling price is P1, at equilibrium. The diagram on the left illustrates the whole market, while on the right is the diagram showing the individual firm in the market. As the firm is a price taker, AR=MR=P which also equals market demand because there is lack of brand loyalty, making the demand curve perfectly elastic, and because the firm cannot influence the price.
From the diagram on the right of the individual firm, the firm is producing at profit maximisation, Q1. The shaded area shows the abnormal/supernormal profits being made since the area OP1XQ1 shows total revenue and OP2YQ1 shows total costs. Profits = revenue – costs, therefore profits are equal to OP1XQ1 - OP2YQ1, supernormal profits. The firm is only able to make abnormal profits in the short run in a perfectly competitive market because new firms are attracted by the prospects of making abnormal profits in the long run and enter the market, this erodes the abnormal profits.
However, not all firms make abnormal profits in a perfectly competitive market in the short run. This depends on the position of the AC curve.
For the firm above, there are subnormal profits being made because average costs are greater than average revenues. Selling at the market ruling price of P1 will therefore only enable the firm to make subnormal profits.