Market Structure - Perfect Competition

Note: This subtopic is HL-only in the 2022+ syllabus. Standard Level students don't need it for Papers 1 or 2 but may find it useful preparation for HL or for understanding why economists treat competitive markets as a benchmark.

Assumptions of perfect competition:

1. MANY buyers and sellers, each too small to affect price.
2. HOMOGENEOUS (identical) products.
3. FREE ENTRY AND EXIT — no barriers.
4. PERFECT INFORMATION — all participants know prices and qualities.
5. No transport costs / externalities.

Implications:

• Firms are PRICE TAKERS — they accept the market price.
• Each firm's demand curve is HORIZONTAL at the market price (perfectly elastic).
• Therefore MR = P at every output level.

Profit maximisation. Firms produce where MR = MC. Since MR = P, this becomes P = MC.

Short run. Three possible outcomes depending on cost structure:

• Supernormal profit: P > ATC. Firm earns above-normal returns.
• Normal profit: P = ATC. Firm earns just enough to stay in business.
• Losses: P < ATC. Firm continues as long as P > AVC (covers variable cost).

Long run adjustment. Free entry/exit:

• Supernormal profits attract new entrants → industry supply rises → market price falls.
• Losses cause exit → industry supply falls → market price rises.
• Both processes continue until P = min ATC for all firms.

Long-run equilibrium: P = MR = MC = min ATC. All firms earn NORMAL PROFIT.

Efficiency claims:

• Productive efficiency: P = min ATC → firms produce at lowest possible average cost.
• Allocative efficiency: P = MC → resources allocated according to consumer preferences.

These are the THEORETICAL benefits of perfect competition — and why economists use it as the benchmark against which other market structures are compared.

Real-world examples are rare — agricultural commodity markets, some currency markets approximate perfect competition. Most markets have product differentiation, imperfect information, and barriers to entry.