Perfect CompetitionEconomic Theory of Free Markets

PerfectCompetition

MonopolisticCompetition Oligopoly Monopoly

economic theory/model =>Unlimited # of competitors

Most competitive & Lowest Price

Least competitive & Highest Price

4 Market Structures

1 company => PGE, local water company

3-10 large companiesCar companies, airlines,Wireless service, smart phones

Many CompaniesRestaurants, hair salons,Bicycle shops, car repair

Market Characteristics• 4 market characteristics:

– # of Firms

– Type of Product

– Ease of entering or exiting industry

– Amount of Information

Determine pricing control of eachmarket structure

Perfect Competition

• Perfect Competition is an economic theory/model – “built” by economists to simulate a “perfect” self regulating economy

• It does not exist in the “real” world– The market for wheat & corn is close

• It produces the lowest price & highest quantity of all market

structures

Perfect Competition Market Characteristics

• Many/Unlimited small Firms

• Homogenous products (exactly the same!)

• Complete freedom to enter or exit industry– No costs to move, occurs immediately

• Perfect information

• Price Taker: – No price control—sell at Market Price

Perfect Competition Equilibrium

Price

Qty

T-Shirts

D1

S1

---------------------------

$10

Q1

E1

Price

Qty

A small firm can sell all of their production at the market price (price taker)

$10

Entire Industry 1-Individual Firm

D1

T-Shirts

“Zero” Economic Profit

• Competitive markets can earn profit or loss in the short run

• In long run profits are pushed to zero economic profit– It means you earn a “normal/fair” economic profit

• i.e. includes the Opportunity Cost of working

• You still earn a “fair living” based on your human capital

Perfect Competition in “Action”• The market is naturally “self-regulating”

• New firms will enter the market as if economic profit > zero– Due to easy & cheap entry/exit

• Firms exit the market whenever profits are less than zero

• Firms move between industries in search of higher profit

• In long run, inefficient producers are forced to leave & economic profit falls to zero (normal or fair profit level)

Worksheet

T-SHIRTSProfit = 100 day

BICYCLESProfit = 200 day

FOODProfit = 100 day

The Self-Regulation of Perfect Competition

S1

D1

S1

D1

S1

D1

------- P1 P1------- ---------------

Q1

E1

Q1--------

Q1

E1

--------

Q1

E1P1

S2 S2Firms exitmarket

Firms exitmarket

S2

Firms entermarket

Firms: exit markets with low profits enter markets with high profits

In long run, all firms will earn zero economic profit•In this example, assume $150 per day accounting profit