A Perfectly Competitive Market is one where there are many buyers and sellers, products are homogeneous, and no individual firm can influence the market price. Each firm is a price taker, not a price maker. The market determines the price through overall demand and supply, and each firm adjusts its output to maximize profit at that price.
Price Determination under Perfect Competition:
In perfect competition, the price is determined by the forces of market demand and market supply.
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Market Demand Curve slopes downward, showing an inverse relationship between price and quantity demanded.
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Market Supply Curve slopes upward, showing a direct relationship between price and quantity supplied.
The equilibrium price is established at the point where demand equals supply. Each firm must accept this equilibrium price — it cannot charge more or less.
Thus, the firm’s average revenue (AR) and marginal revenue (MR) curves are both horizontal (perfectly elastic) at the market price.
Output Determination by a Firm:
Once the market price is fixed, the firm decides how much output to produce to maximize profit. The firm follows the profit-maximizing condition:
Profit is maximized when MR = MC
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MR (Marginal Revenue) = Market Price (P)
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MC (Marginal Cost) = Cost of producing one additional unit
Therefore, a firm produces that level of output where MC = MR = P.
Short-Run Equilibrium of a Firm:
In the short run, some factors of production are fixed, and the firm can earn:
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Supernormal Profit: When AR > AC
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Normal Profit: When AR = AC
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Losses: When AR < AC (but continues if AR ≥ AVC to cover variable costs)
Hence, the firm’s equilibrium output occurs where MC = MR and MC cuts MR from below.
Long-Run Equilibrium of a Firm:
In the long run, all factors are variable, and new firms can enter or exit the industry.
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If firms earn supernormal profit, new firms enter → supply increases → price falls.
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If firms incur losses, some exit → supply decreases → price rises.
This continues until all firms earn only normal profit, i.e., AR = MR = MC = AC.
In long-run equilibrium, firms operate at the minimum point of the Average Cost (AC) curve, ensuring productive and allocative efficiency.