Perfect competition: price and output in the short run and long run, equilibrium of firm and industry

1. Meaning and features

Perfect competition is a market with a very large number of buyers and sellers of a homogeneous product, where no single buyer or seller can influence the price. Its features:

1. Large number of buyers and sellers: each firm’s output is a tiny share of the market.
2. Homogeneous product: units of different sellers are perfect substitutes.
3. Free entry and exit of firms.
4. Perfect knowledge of the market among buyers and sellers.
5. Perfect mobility of factors of production.
6. No transport cost differences, and no government interference.

The result is a single uniform price. The firm is a price-taker: it faces a horizontal demand curve at the market price, so AR = MR = P. Pure competition requires only the first three features; perfect competition requires all of them.

2. Price determination by the industry

The industry is the group of all firms producing the product. Price is set where industry demand equals industry supply. Marshall: just as both blades of a pair of scissors cut, both demand and supply determine price. At a price above equilibrium, supply exceeds demand and price falls; at a price below, demand exceeds supply and price rises.

Time element (Marshall):

• Market period (very short): supply is fixed (a vertical supply curve), so price is determined by demand alone. This is the market price.
• Short period: firms can vary output with existing plant; supply is somewhat elastic.
• Long period: plant can be changed and firms can enter or leave; supply is most elastic, and price tends to the normal price, equal to minimum long-run average cost.

3. Equilibrium of the firm: conditions

A firm is in equilibrium when it has no incentive to change its output, i.e. when it maximises profit.

1. MR = MC. If MR > MC, an extra unit adds more to revenue than to cost, so output should expand; if MR < MC, it should contract.
2. MC must cut MR from below (MC rising at the point of equilibrium). Where MC falls through MR, profit is at a minimum, not a maximum.

Under perfect competition MR = P, so the condition becomes P = MC.

4. Worked schedule

A firm with TFC = Rs. 40.

• Price Rs. 50: P = MC at 6 units (MC rising). TR = 300, TC = 250, supernormal profit Rs. 50.
• Price Rs. 40: P = MC (rising) at 5 units. TR = 200, TC = 200: the firm earns only normal profit (P = minimum ATC, the break-even point).
• Price Rs. 30: P = MC (rising) at 4 units. TR = 120, TC = 160, loss Rs. 40, which equals TFC. Price just covers minimum AVC (Rs. 30). The firm is indifferent between producing and closing: this is the shut-down point.
• Below Rs. 30 the firm cannot cover even its variable cost and shuts down.

Note that MC also equals Rs. 30 at 2 units, but there MC is falling; profit is at a minimum, so this point is rejected by the second condition.

5. Short-run equilibrium of the firm (described)

Draw the firm’s SAC, AVC and SMC curves with a horizontal price line AR = MR. Equilibrium is at E, where SMC cuts MR from below. Then three cases:

• Supernormal profit: price line above SAC at E; profit per unit = AR − AC, total profit the rectangle between them.
• Normal profit: price line tangent to the lowest point of SAC.
• Loss: price line below SAC but above AVC. The firm continues in the short run because it covers variable cost and part of fixed cost; closing would mean losing the whole fixed cost.

The portion of the SMC curve above minimum AVC is the short-run supply curve of the firm.

6. Long-run equilibrium of the firm

In the long run firms can enter and leave. If existing firms earn supernormal profit, new firms enter, industry supply increases, and price falls. If they make losses, some leave, supply falls, and price rises. The process stops when each firm earns only normal profit. Then:

P = AR = MR = LMC = LAC (minimum)

Each firm produces at the lowest point of its LAC curve, the optimum size, with no excess capacity. This is why perfect competition is said to give the most efficient allocation of resources.

7. Equilibrium of the industry

The industry is in equilibrium when (i) total demand equals total supply, so the price is stable, and (ii) there is no tendency for firms to enter or leave, i.e. all firms earn normal profit. In the short run the first condition can hold while the second does not (firms are earning supernormal profit and new entry is coming). Full equilibrium of the industry is reached only in the long run, when both conditions hold and every firm is also in equilibrium at the minimum point of LAC.

Principles of Economics covers the features and a shorter version of price determination in perfect competition and monopoly.

How this is examined

January 2026 set “Explain price and output determination under perfect competition” as Q.6 (16 marks, 100-mark paper) and Q.4(a) (10 marks, 80-mark paper); February 2025 asked “Explain the equilibrium of firm and industry” (16 marks). For the first, write features, industry price, time element, the firm’s conditions, short run with three cases and long run. For the second, put the weight on sections 3, 6 and 7 and end with the comparison table.