Summary
Even though perfect competition is hard to come by, it’s a good starting point to understand market structures. A deep understanding of how competitive markets work and are formed is the cornerstone to understand why it’s so hard to reach them. In this first Learning Path on perfect competition, we start by analysing firms’ cost structure, before analysing their interaction in the market.Cost analysis in the long run is quite different from short run cost analysis. Period analysis tells us that in the long run all factors are variable; this flexibility of factors will consequently be reflected in the long-run cost curves. This long-run curve will be formed by different period short-run curves and will serve as an envelope for all of them. Isoquants are used to compare the short-run periods with the long-run one. At each period we have a combination of labour and capital such that the firm will choose to minimise costs at each output level. The curve that joins the points of tangency between different isocost lines and isoquants is known as the expansion path.
One of the key features of the long-run is the possibility of firms entering and/or exiting the market. Economic profits will attract new entries to the market while economic losses will throw firms out of it. This process will occur whenever profits are different to 0. The equilibrium price will be influenced by the number of firms in the market, decreasing as the number of firms increases. Let’s say we start at E1, where the firm we consider has profits equal to area A. It is able to supply products from point X onwards, due to its minimum efficiency requirements. Since there are profits, other firms will be attracted and will enter the market. Due to a new firm entering the market, market supply will shift to the right, since there are now more firms supplying the same goods. This increase in supply will force prices down to p2. The firm we’re analysing still has profits at this point, but these profits decreased because of the new firm entering the market. Let’s say another firm enters the market, pushing again market supply to the right. This has the same effects, but this third firm has pushed marginal costs to its minimum, as well as average costs. Now, the three firms (including the one we’re analysing) supply such a quantity at such a price that there are no profits, nor losses, which will mean this market has reached its equilibrium, with no firms entering or exiting it.
Once this market equilibrium is reached, one might ask: what happens if there is an increase in demand? First, this will shift market demand to D’, increasing prices because supply (for the moment) is given. This increase in prices allows for profits to be made, at point 1. However, as seen before, these profits will attract new firms, which will force supply to the right (S’), going to an equilibrium such as E2, where our firm will produce the exact same initial quantity (point 2).
The long-run market equilibrium is conformed of successive short-run equilibrium points. The supply curve in the long run will be totally elastic as a result of the flexibility derived from the factors of production and the free entry and exit of firms (imagine the firm-entry process portrayed before a few more times). In the long run, market demand will only affect the number of firms but not to the quantity produced by each of these firms. Therefore we can assume that the equilibrium in the long run is the point where profits are maximised (although each firm achieves zero economic profit), there are no firms entries nor exits and there is market clearance.
In the next LP on perfect competition, we analyse how taxes also affect firms’ cost structures, how welfare is measured and what market clearance is.
