Microeconomics guide, Unit 3, step 15 of 28Previous step Next step

Step 15: Perfect Competition

By the EconTutorials team. 10-minute read with 6 practice questions.

SyllabusAP Micro 3.7 · Cambridge 7.6

In 30 seconds

Perfect competition has many buyers and sellers, identical products, free entry and exit, and perfect information. Each firm is a price taker, so $ P = AR = MR $.
Every firm maximises profit where $ MC = MR $. Profit is $ (P – ATC) \times Q $.
In the short run, a firm making a loss keeps producing if $ P > AVC $ and shuts down if $ P < AVC $.
In the long run, entry and exit drive economic profit to zero, so $ P = MC = $ minimum ATC. The market is both allocatively and productively efficient.

Video lesson coming soonA short animated lesson for this step will appear here.

What perfect competition looks like

Imagine a huge fruit market with hundreds of stalls all selling the same bananas, every price written on a board everyone can see, and new sellers free to set up a stall any morning. If one seller asks for more than everyone else, shoppers simply walk to the next stall. No single seller can change the market price. That is the idea behind perfect competition.

A market is perfectly competitive only if it has all four of these features:

Many buyers and many sellers. Each firm is a tiny part of the market.
Identical (homogeneous) products. Wheat from Farm A is the same as wheat from Farm B. No brands, no quality differences.
Free entry and exit. No patents, licences or huge start-up costs keep firms out or trap them in.
Perfect information. Everyone knows the market price and the quality of the product.

No real market fits perfectly, but agricultural commodities such as wheat come close. Perfect competition matters because it is the benchmark: every other market structure is judged against it.

Key termPrice taker: a firm that must accept the market price because charging more would lose all its customers and charging less is pointless, since it can sell all it wants at the market price.

Because the firm can sell any amount at the market price but nothing above it, its demand curve is a horizontal line at that price. It is perfectly elastic. Each extra unit sold adds exactly P to revenue, so price, average revenue and marginal revenue are all equal: $ P = AR = MR $.

The profit-maximising rule: MC = MR

Should a strawberry farmer pick one more box? Compare what the box adds to revenue with what it adds to cost. If the extra revenue is bigger, pick it. If the extra cost is bigger, don’t. Keep going until the two are equal.

Key termMarginal revenue (MR): the extra revenue from selling one more unit, which in perfect competition equals the market price.

This gives the most important rule in the theory of the firm, and it applies to every market structure: produce where MC = MR. If MC < MR, produce more. If MC > MR, produce less. In perfect competition, MR = P, so the rule becomes “produce where MC = P”.

Once you know the output, profit is the gap between price and average total cost, multiplied by the quantity:

\[ \text{Profit} = (P – ATC) \times Q \]

$ P > ATC $: economic profit (a rectangle on the diagram).
$ P < ATC $: economic loss.
$ P = ATC $: zero economic profit, also called normal profit.

Worked example

A strawberry farmer faces a market price of $15 a box. MC = $15 at 400 boxes, and at that output ATC = $11. How much does she produce, and what is her profit?

Step 1$ MR = P = 15 $; produce where $ MC = MR \Rightarrow Q = 400 $

Step 2$ P – ATC = 15 – 11 = 4 $

Step 3$ \text{Profit} = 4 \times 400 = \$1{,}600 $

She earns $4 above her average cost on every box, so $1,600 of economic profit. On a diagram this is the rectangle between P and ATC, up to Q = 400.

The short-run shutdown decision

Suppose the price falls and the firm is making a loss. Should it close? Not necessarily. In the short run it must pay fixed costs (rent, loan repayments) even if it produces nothing. So the real question is: does the price at least cover variable costs?

$ P > AVC $: keep producing. Revenue covers all variable costs and helps pay some of the fixed costs. Shutting down would mean paying all the fixed costs with no revenue, which is a bigger loss.
$ P < AVC $: shut down. Every unit adds to the loss. Better to produce nothing and pay only the fixed costs.
$ P = AVC $: the shutdown point, at the minimum of AVC. The firm is indifferent.

Key termShutdown point: the price equal to minimum AVC, below which a firm should stop producing in the short run.

This means the firm’s short-run supply curve is its MC curve above minimum AVC.

Worked example

A bakery faces P = $9. At its best output of 300 loaves, ATC = $10 and AVC = $7. Should it keep producing?

Step 1Loss if it produces: $ (9 – 10) \times 300 = -\$300 $

Step 2Fixed cost: $ (ATC – AVC) \times Q = (10 – 7) \times 300 = \$900 $, so the loss if it shuts is $900

Step 3$ P = 9 > AVC = 7 $, so produce

Producing loses $300; shutting down loses $900. The bakery should stay open in the short run, because each loaf covers its own variable cost and adds $2 towards the fixed costs.

Common mistakeComparing price with ATC to decide whether to shut down. P < ATC only tells you the firm is making a loss. The shutdown test compares P with AVC. A firm can make a loss and still be right to keep producing. Another common error is drawing the perfectly competitive firm’s demand curve sloping downward: it must be horizontal.

The long run: zero economic profit

Short-run profits do not last. Free entry and exit push profit to zero:

If firms earn profit, new firms enter. Market supply shifts right, the market price falls and profit shrinks. Entry stops when $ P = ATC $.
If firms make losses, some leave. Market supply shifts left, the price rises and losses shrink. Exit stops when $ P = ATC $.

In long-run equilibrium, each firm produces where $ P = MC = \text{minimum } ATC $.

Key termNormal profit: the minimum return needed to keep the owner in the industry, which equals zero economic profit because all costs, including the owner’s opportunity cost, are covered.

Zero economic profit does not mean the owner earns nothing. Economic profit subtracts the opportunity cost of the owner’s own time and money, which accounting profit ignores. A farmer earning a normal profit is still being paid enough to stay in farming.

Why perfect competition is efficient

In long-run equilibrium, perfect competition achieves two kinds of efficiency at the same time:

Allocative efficiency (P = MC). The price consumers pay for the last unit equals the cost of making it. Nothing is made that costs more than people value it, and nothing is left unmade that people value more than it costs. Total surplus is maximised.
Productive efficiency (P = minimum ATC). Firms produce at the lowest possible average cost. Firms that cannot do this are driven out.

No other market structure achieves both in the long run, which is why perfect competition is the yardstick for judging monopoly and the others.

Exam tipKnow three diagrams by heart, each with MC, ATC, AVC and a horizontal $ D = MR = P $ line: (1) profit, with P above ATC; (2) loss but still producing, with P between AVC and ATC; (3) the shutdown point, with P at minimum AVC. For the long run, draw P just touching the bottom of ATC where MC crosses it, and write “$ P = MC = \min ATC $”.

Practise: 6 questions

Try each one on paper first, then check the worked answer.

EasyQ1. A perfectly competitive firm has P = $8 and ATC = $6 at its profit-maximising output of 100 units. Calculate economic profit. Show worked answer

$ \text{Profit} = (8 – 6) \times 100 = \$200 $

EasyQ2. Why would a wheat farmer in a perfectly competitive market sell nothing if she charged $7 a bushel when the market price is $6? Show worked answer

Wheat is identical across farms and everyone knows the market price. Buyers would simply buy the same wheat from another farm at $6. She is a price taker: her demand curve is horizontal at $6.

MediumQ3. A firm faces P = $10. At Q = 200, where MC = $10, ATC = $12. Is it making a profit or a loss, and how much? Show worked answer

$ \text{Profit} = (10 – 12) \times 200 = -\$400 $
A loss of $400, because P is below ATC.

MediumQ4. A firm has P = $20. At its MC = MR output of 150 units, ATC = $23 and AVC = $18. Should it produce or shut down in the short run? Show the losses in each case. Show worked answer

Loss if it produces: $ (20 – 23) \times 150 = -\$450 $
Fixed cost: $ (23 – 18) \times 150 = \$750 $, so shutting down loses $750.
$ P = 20 > AVC = 18 $: keep producing. It loses $450 instead of $750.

MediumQ5. Firms in a perfectly competitive market are earning economic profit. Explain step by step what happens in the long run. Show worked answer

1. Profit attracts new firms (free entry).
2. Market supply shifts right.
3. The market price falls, so each firm’s horizontal $ D = MR = P $ line moves down.
4. Profit per firm shrinks.
5. Entry continues until P equals minimum ATC and economic profit is zero: $ P = MC = \min ATC $.

ExamQ6. A perfectly competitive market has 1,000 identical firms, each with $ MC = 2Q $. Market demand is $ Q_d = 12{,}000 – 500P $. (a) Write one firm’s supply function. (b) Write the market supply function. (c) Find the market price and total quantity. (d) How much does each firm produce? [5 marks] Show worked answer

(a) Firms produce where $ P = MC = 2Q $, so $ Q = P/2 $. [1 mark]
(b) $ Q_s = 1{,}000 \times P/2 = 500P $. [1 mark]
(c) $ 12{,}000 – 500P = 500P \Rightarrow 12{,}000 = 1{,}000P \Rightarrow P = \$12 $. $ Q = 500 \times 12 = 6{,}000 $. Check: $ 12{,}000 – 6{,}000 = 6{,}000 $ ✓ [2 marks]
(d) Each firm: $ Q = 12/2 = 6 $ units. Check: $ 1{,}000 \times 6 = 6{,}000 $ ✓ [1 mark]

Check yourself

1. A perfectly competitive firm’s demand curve is:

The firm can sell any amount at the market price and nothing above it.

2. In the short run, a firm should shut down if:

Below AVC, each unit adds to the loss; below ATC alone, it should still produce.

3. In long-run equilibrium, which conditions hold together?

P = MC gives allocative efficiency; P = min ATC gives productive efficiency.

Your score: 0 out of 3

The short version

Four features: many firms, identical products, free entry and exit, perfect information. Each firm is a price taker with $ P = AR = MR $.
Produce where MC = MR (here, MC = P). Profit = $ (P – ATC) \times Q $.
Shutdown rule: produce if P > AVC; shut down if P < AVC. Short-run supply is MC above minimum AVC.
Long run: entry and exit drive economic profit to zero, so $ P = MC = \min ATC $.
Perfect competition is allocatively and productively efficient: the benchmark for all other markets.

This guide covers the core of the chapter. For the full Chapter 11, with firm and market diagrams, the global wheat market case study and 15 exam-style questions with a complete answer key, see the book Economics Made Simple.

Step 15: Perfect Competition

What perfect competition looks like

The profit-maximising rule: MC = MR

The short-run shutdown decision

The long run: zero economic profit

Why perfect competition is efficient

Practise: 6 questions

Check yourself

The short version

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