The Market Benchmark
Perfect competition is the ideal market benchmark driven by four strict rules: many small firms, a homogeneous product, free entry and exit, and perfect information.
Every firm is a price taker, meaning it accepts the market price as given. Its demand curve is a horizontal line.
To maximise profit , the firm sets output where price equals marginal cost:
Total surplus is maximised with zero deadweight loss. This is the first theorem of welfare economics: competitive equilibrium is Pareto efficient.
Supply & Shutdown
A firm's short-run supply is its marginal cost curve above minimum average variable cost. The shutdown point occurs when .
| Condition | Decision |
|---|---|
| Produce; positive profit | |
| Produce at a loss; covers fixed costs partially | |
| Shut down; minimise losses |
Pitfall: Shutting down when profit is merely negative. Between and , producing is better than closing because revenue covers all variable costs and part of fixed costs.
In long-run equilibrium, free entry drives economic profit to zero, so .