Pure Competition

A perfectly competitive market is rare, but the ones that do exist are very large, such as the markets for agricultural products, stocks, foreign exchange, and most commodities. Pure competition also offers a simplified economic market model that yields useful insights into the nature of competition and how it provides the greatest value to consumers.

Perfectly competitive markets have 4 essential qualities:

  1. large number of firms supplying the product,
  2. standardized or homogeneous products,
  3. low entry and exit costs for firms entering or leaving the industry, and
  4. suppliers are price takers in that no individual supplier has any influence on the market price.

That a large number of firms create a highly competitive market results from the fact that the product is standardized or homogeneous and that the costs are low to enter or leave the industry. A high barrier to entry would otherwise limit the number of suppliers in the market. Hence, there will be many suppliers for standard products as long as the market price is above the average total cost of supplying the products.

The suppliers of the competitive market are price takers — they have no influence whatsoever on the market price because each supplier has only a tiny share of the total market. If some suppliers try to raise their price by even a few pennies, then consumers will simply buy from other suppliers. On the other hand, for the individual seller, market demand is completely elastic, so there is no reason for any supplier to sell even a penny less than the market price, since they can sell all that they want for the market price.

If the products were differentiated to some degree, then the market would be a monopolistic competition, by definition, which would allow some suppliers to charge a slightly higher market price if they can convince consumers, through advertising or other methods, that their product is worth the higher price.

Economics of a Purely Competitive Seller

Few markets as a whole are perfectly elastic, where consumers would buy whatever quantity was supplied without affecting the market price. However, sellers in a purely competitive market see a perfectly elastic demand — they can sell any quantity of the product at the market price. This makes both the average revenue, which is the average price of all products sold, and marginal revenue, which is equal to the price of the last item sold, equal to the market price.

Average Revenue = Marginal Revenue = Market Price

This, in turn, makes the total revenue of the seller equal to the market price multiplied by the number of units sold.

Revenue = Price × Quantity

Short-Run Profit Maximization

Since the competitive seller cannot charge anything but the market price, it can only maximize profits or minimize losses by minimizing costs. However, in the short run, suppliers can only minimize variable costs, not fixed costs. There are 2 methods to determine at what output a seller would maximize his profits or minimize losses: by comparing total revenue and total costs at each output level or by increasing output until the marginal revenue equals marginal cost.

Total Revenue And Total Cost

Under the total-revenue—total-cost approach, maximum profits occur when average total cost (ATC) reaches a minimum.

A firm has both fixed and variable costs. If the firm produces only a few units, then the average total cost will be high because the fixed costs must be covered by the few units produced. As more units are produced, then the average fixed costs will decline, which will also decrease the average total cost. Because a firm has fixed resources in the short run, there will be a point where increasing the quantity becomes more costly because of the law of diminishing marginal returns with fixed assets. Hence, at some point average total cost will start to rise and eventually become greater than the price of the product, which is the marginal revenue.

Graph showing the relation between total revenue and total cost for a firm under pure competition.
Because the average total cost curve includes a normal profit but not an economic profit, a breakeven point is achieved when the total cost curve becomes less than total revenue for the first time (#1 in the graph). There is a 2nd breakeven point that occurs as average total cost increases and the total cost curve again crosses the total revenue line (#2). Between these 2 breakpoints, the difference between total revenue and total cost yields economic profits (#3) for any quantity of products produced between the 2 breakeven points.

Marginal-Revenue—Marginal-Cost Approach

This approach compares how each additional unit of output adds to the total revenue and total cost. The additional revenue from the unit is the marginal revenue (MR) and the additional cost is the marginal cost (MC). A firm maximizes output when marginal revenue equals marginal cost.

MR = MC = Market Price

This results from the fact that as long as the marginal revenue is greater than the marginal cost, the firm is profiting from producing that unit. Once marginal revenue equals marginal cost, additional units will incur a marginal cost that is greater than the marginal revenue for that unit, causing total profits to decline, which is the result of the diminishing marginal product. This relationship is true for all firms, whether they are purely competitive, monopolistically competitive, oligopolistic, or monopolistic. The firm will maximize profit or minimize loss as long as producing is better than shutting down.

Because, for purely competitive firms, marginal revenue equals price, maximum revenue is also earned when the marginal cost of producing the last unit is equal to the market price. This makes sense since if the marginal cost was greater than the price, then the firm would incur losses for each additional unit. Note that by producing until marginal cost equals the market price maximizes total profit but not per unit profit.

If the market price is less than average total cost, then the firm cannot make a profit, but if it is higher than the minimum average variable cost, then the firm can at least minimizes losses.

If the price is less than the average minimum average variable cost, then the firm has reached the shutdown point where it can minimize losses in the short run by shutting down completely, since then the firm would lose more money if it produced any output, thereby increasing its losses. Thus, its total loss will be equal to its total fixed costs.

Marginal Cost And the Short Run Supply

The above discussion leads to the following conclusions regarding the relationship between marginal cost and the short run supply.

Note that the supply curve of an individual firm is different than for the industry. For the individual firm in a competitive market, demand is completely elastic, so the firm can sell all that it produces for the market price, so it will sell as many units as possible until marginal cost equals marginal revenue.

However, the supply curve of the industry slopes upward as in the classical case, wherein increased supply causes a decrease in the price.