Perfectly Competitive Market
This is a market structure in which a large number of sellers offer a homogeneous product to many buyers with a constant threat from new entrants into the market.
A large number of sellers
The number of firms is so large that each firm has a small market share. There is a lack of market power and the small sellers cannot influence the price. The existence of abnormal profit in the short run attracts more firms to the industry in the long run as there are no barriers hindering them from entering the market.
The sellers offer identical products which are not in any way differentiated or branded. The buyers do not have a preference for the product offered by a particular seller and will not buy it if the price is raised.
Absence of entry and exit barriers
Sellers are free to enter and exit the industry without restrictions. This explains why the number of firms increases in the long run and abnormal profit disappears. The firm makes an abnormal profit in the short run which attracts other firms to enter the industry. Examples of barriers or hindrances include a huge capital requirement, economies of scale, etc.
The huge capital requirement makes it harder for new firms to enter the industry and limits the number of players in the industry,e.g. pharmaceutical companies, oil exploration, etc.
A new entrant cannot compete with long-standing companies that already enjoy lower unit cost or are legally protected for a new invention. So economies of scale constitute a barrier to entry.
Besides, advertising cost can be a deterrent to new firms. It leads to brand preference and consumers tend to find it difficult to switch to other products. Advertising makes the demand for a product inelastic and leads consumers to perceive it as unique.
If a firm finds it difficult to recover some costs in case of failure, they may not want to enter the market, e.g. Research and Development expenditure, advertising costs, costs of highly specialised machines that cannot be easily disposed of when leaving the business. These costs are called sunk costs. Barriers to exit are redundancy payments, supply contracts and lease agreements.
Furthermore, existing firms can hide the existence of abnormal profit in the short run by lowering their prices. This will discourage new firms from entering the market and help them protect their market share.
There is no asymmetrical information as buyers and sellers have perfect knowledge. The customers cannot pay a higher price than the ruling price. Sellers also have equal access to information about products, production methods and technology so nobody has an advantage over others.
Firms also seek to maximise profit, i.e. make the highest amount of profit possible. The equilibrium level of output is where the Marginal Revenue is equal to the Marginal Cost (MR = MC). In other words, the revenue from the extra unit (MR) must be equal to the cost of producing the extra unit (MC). A firm makes an abnormal profit in the short run and normal profit in the long run. Normal profit is made when Average Revenue is equal to Average Cost (AR=AC). When AR is more than AC, an abnormal profit is made.
Firms charge the same price
No firm can influence the market price as they have no market power to do so. The market is made of many small firms. Consumers have no reason to pay more than the market price because identical products are offered by many sellers. Any attempt to raise price will make a firm lose its market share to competitors.
SHORT-RUN AND LONG-RUN EQUILIBRIUM
The industry, as a whole, attains equilibrium when industry market demand is equal to the market supply. The market demand is the sum of the demand of all the consumers while market supply is the sum of all supplies. Each firm cannot alter output to the extent that it will affect the market supply because its market share is insignificant. Therefore, the supply curve slopes upward. Also, no buyer can influence demand as there are many of them, making the demand curve maintain its downward sloping nature. As more firms join the market in the long run, the market supply increases lowering the market price.
The firm produces the output level where MR and MC are equal. The AC is below the AR leading to abnormal profit in the short-run (rectangle PRST in Figure 1 below). In the long run, however, normal profit is made as AC and AR are equal (Figure 2). It is possible for the firm to make a loss in the short run instead of abnormal profit. In this case, AC exceeds the AR resulting in a loss (rectangle TSRP in Figure 3).
Figure 1: Short-run abnormal profit in perfect competition
Figure 1: Long-run normal profit in perfect competition
Figure 3: Short-run loss in perfect competition