Perfect Competition Review for AP Economics
Review questions for this study guide can be found at:
Main Topics: Structural Characteristics, Demand, Profit Maximization, Short-Run Profits, Decision to Shut Down, Long-Run Adjustment
Structural Characteristics of Perfect Competition
Each market structure is defined by structural characteristics. These characteristics determine, among other things, how the profit maximizing price and quantity are set in the short run, as well as how profits might be maintained in the long run. Perfect competition is typically described by four characteristics:
- Many small independent producers and consumers. Not small like Mini-Me small, but small like each firm is too small to have an impact on market price. No one firm can drive up the price by restricting supply, or drive down the price by flooding the market with output. No one consumer can, by changing the amount of the good that he consumes, impact the price.
- Firms produce a standardized product. There exist no real differences between one firm's output and the next.
- No barriers to entry or exit. There exist no significant obstacles to the entry of new firms into, or the exit of existing firms out of this industry. Profitability or lack thereof determines whether the industry is expanding or contracting.
- Firms are "price takers." This characteristic is actually a result of the first three. Because all firms are too small to affect the price, they must accept the market price and produce as much as they wish at that price. Even if they couldchange the price, they would not do so. To see this, suppose that the market determined competitive price of barley is $5. If farmer Katie increased the price to $5.01, she would now be the high price supplier of barley with thousands of competitors producing an identical product at a lower price; Katie is likely to lose all of her customers. If she lowers her price to $4.99, she would seemingly clean up her competition. But remember, the price-taking characteristic tells us that Katie can sell all she wants at the market price of $5. If you can sell all you want at $5, why would Katie sell even one unit at $4.99?
All four of the characteristics of perfect competition are rarely found in today's industries, but agricultural commodities are usually regarded as approximately perfectly competitive.
Demand for the Firm
Each perfectly competitive firm produces a standardized, or homogenous, product. Because each firm's output is such a small share of the total market supply, the demand for each firm's output is perfectly elastic. Perfectly competitive firms have no effect on the market price; they simply produce as much as they can at the going price. This implies a horizontal demand curve for their product. This does NOT imply that the market demand curve is horizontal. If the market price of barley falls, quantity demanded rises. Figure 9.1 illustrates the difference between market demand (D) and the demand for one firm's product (d).
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