The consequence of the preceding assumptions is that all exchanges in a perfectly competitive market will quickly converge to a single price. Since the good is viewed as being of identical quality and utility, regardless of the seller, and the buyers have perfect information about seller prices, if one seller is charging less than another seller, no buyer will purchase from the higher priced seller. As a result, all sellers that elect to remain in the market will quickly settle at charging the same price.
In Chapter 2 "Key Measures and Relationships" and Chapter 3 "Demand and Pricing", we examined the demand curves seen by a firm. In the case of the perfect competition model, since sellers are price takers and their presence in the market is of small consequence, the demand curve they see is a flat curve, such that they can produce and sell any quantity between zero and their production limit for the next period, but the price will remain constant (see Figure 6.1 "Flat Demand Curve as Seen by an Individual Seller in a Perfectly Competitive Market").
It must be noted that although each firm in the market perceives a flat demand curve, the demand curve representing the behavior of all buyers in the market need not be a flat line. Since some buyers will value the item more than others and even individual buyers will have decreasing utility for additional units of the item, the total market demand curve will generally take the shape of a downward sloping curve, such as Figure 6.2 "Demand Curve as Seen for All Sellers in a Market".
Figure 6.1 Flat Demand Curve as Seen by an Individual Seller in a Perfectly Competitive Market
Any amount the firm offers for sale during a production period (up to its maximum possible production level) will sell at the market price.
The downward sloping nature of the market demand curve in Figure 6.2 "Demand Curve as Seen for All Sellers in a Market" may seem to contradict the flat demand curve for a single firm depicted in Figure 6.1 "Flat Demand Curve as Seen by an Individual Seller in a Perfectly Competitive Market". This difference can be explained by the fact that any single seller is viewed as being a very small component of the market. Whether a single firm operated at its maximum possible level or dropped out entirely, the impact on the overall market price or total market quantity would be negligible.
Although all firms will be forced to charge the same price under perfect competition and firms have perfect information about the production technologies of other firms, firms may not be identical in the short run. Some may have lower costs or higher capacities. Consequently, not all firms will earn the same amount of profit.
Figure 6.2 Demand Curve as Seen for All Sellers in a Market
Although one seller sees a fixed price for its supply, if all sellers were to increase production, the maximum price that customers would pay to buy all the units offered would drop.
As described in the description of the shutdown rule in Chapter 2 "Key Measures and Relationships", some firms only operate at an economic profit because they have considerable sunk costs that are not considered in determining whether it is profitable to operate in the short run. Thus not only are there differences in profits among firms in the short run, but even if the market price were to remain the same, not all the firms would be able to justify remaining in the market when their fixed costs need to be replenished, unless they were able to adapt their production to match the more successful operators.
What would happen if firms faced no competition in their market? If all of their products were the same and no one was able to hold the monopoly power over any good or service? Well, then, the market would be perfectly competitive. But what does that mean for consumer demand, and how does the individual firm cope with these conditions? What would a demand curve in perfect competition look like? Those are just some of the questions we will find answers to in this text. Let's get to it!
Perfect Competition Demand and Supply Curve
In perfect competition, the demand and supply curves present differently than how we are used to seeing them depicted. Before we go into that, let's define perfect competition. Perfect competition is a hypothetical situation where the participants in the market are so plentiful and are perfectly informed about their options that neither buyers nor sellers can influence the price of a good, which makes it impossible to form a monopoly. In perfect competition, there are no barriers to entering and exiting the market, the products they are selling are identical, and there is no price control.
Perfect competition is a hypothetical market situation where the abundance of buyers and sellers who have perfect information on the market makes it impossible for market participants to influence the price of a good.
Since there are so many buyers and sellers in a perfectly competitive market, the price of a good is set by market demand. If a seller were to price their goods above market price, their demand would drop to zero because the consumer can easily get the good for cheaper from another firm. Since there are so many buyers, demand is considered infinite. This results in a perfectly elastic demand curve. This means that any price increase will result in demand falling to zero because consumers are infinitely sensitive to a change in price. In a perfectly competitive market, the demand curve is also equal to the firm's marginal revenue, which is the revenue it gains from each additional unit it produces.
In perfect competition, firms are at their most competitive because they sell identical products with nearly endless demand. What this means for the firm is that it can supply as much as it can produce at the given market price. The supply curve for an individual firm is the same as its marginal cost curve. The marginal cost curve shows the increase in cost to the firm for each additional unit produced. Because the supply curve shows how each increase in the price increases the quantity supplied, the marginal cost curve is the supply curve in perfect competition.
The quantity that the firm should produce is where the firm's marginal cost is equal to a firm's marginal revenue, which is the market price.
If you are interested in learning more about elasticity,check out our explanation - Elasticity of Demand.
Marginal Revenue and Demand Curve in Perfect Competition
Marginal revenue and the demand curve in perfect competition are equal when we look at them from an individual firm's perspective. Because a firm's demand curve is perfectly elastic in perfect competition, demand is equal to the market price for every quantity they produce.
The marginal revenue is the additional revenue a firm earns from producing one more unit, so as consumers buy one more unit at the market price, the firm's total revenue will rise by exactly the amount the unit sold for, which is the market price! Therefore, if we plot the marginal revenue curve on the same graph as demand, the two curves are the same.
Table 1 shows us how marginal revenue is equal to price, no matter the quantity demanded. If we plot the demand curve, like in Figure 1 below, using the price and quantities from Table 1, the marginal revenue curve would be plotted right over the top. Hence why the market price, a firm's marginal revenue, and its demand curve are equal in a perfectly competitive market.
The Shape of Demand Curve Under Perfect Competition
The shape of the demand curve under perfect competition depends on whether we are looking at an individual firm's demand curve or the entire market. In the case of an individual firm, the demand curve will be horizontal. But why is that?
Well, since the firms are price takers, meaning they cannot influence the price of their goods, no matter how much they supply, the price will not change. Also, because there are many consumers in the market, the quantity a firm supplies into the market does not affect the quantity demanded. This results in a constant level of demand. If the firm faces consistent demand at the market price, no matter how many units they produce, its demand curve will be flat. Its sales do not impact market price.
Figure 2 shows the horizontal demand curve of a firm when it participates in a perfectly competitive market. The demand curve is flat, and the price that the firm charges for all of the goods it supplies is PM, which is the market price. As seen in Figure 2, the price the firm can charge at Q1 and Q2 is identical since the firm's supply in the market does not affect the whole market.
However, if we look at the demand curve for the whole market, it will have a negative slope to it. This is because, unlike with an individual firm, the entire market includes all consumers, not just the ones willing to pay the market price. At a given market price, the firm only considers those who are willing to pay the market price, whereas when we look at the whole market, we must consider all of the consumers who want the good. Even given the market price, there will be some consumers who would still buy the good if the price was higher or lower. If the price was higher, fewer would buy the good, and if it was lower, more would buy it.
Figure 3 depicts the demand curve of the whole market in perfect competition. In this case, unlike with the individual firm, we consider all the consumers in the market, not just those looking to buy the goods. If the market price (PM) was lower, consumers who were unwilling to join the market at the higher price are now willing to join. Conversely, if the market price were higher, some consumers would exit the market, reducing the quantity demanded.
Does that last sentence sound familiar? That is because it is the Law of Demand: as the price of a good rises, the quantity that consumers demand decreases. Want to learn more about demand? Have a look at this explanation - Demand!
The slope of the demand curve in a perfectly competitive market is negative, and the curve slopes downward. This is different from the demand curve of the individual firm. In a perfectly competitive market, the market demand curve slopes downward because it measures how much of a good all the consumers in the market will demand at each price. In this case, the market follows the law of demand, where the quantity demanded increases as the price falls.
Since the market is made up of individual people and households, the market demand curve is derived by adding together all the individual and household demand curves. Because everyone has different incomes and levels of tolerance for prices, as the price decreases, the quantity demanded increases, as we can see in Figure 2.
Once the market settles on its equilibrium levels of supply and demand and the market price is established, the firms accept these market prices, which is what makes them price takers.
Firm's Demand Curve in Perfect Competition
A firm's demand curve in perfect competition is perfectly elastic, meaning it is horizontal as opposed to the downward-sloping demand curve we are accustomed to. Since an individual firm's demand curve is horizontal, it is perfectly elastic, which tells us that the firm is a price taker. Being a price taker, the firm will produce as many units of a good as it wants to and will be able to sell them all for the same market price.
In Figure 3, we can see that the firm's demand curve is horizontal. For every quantity the firm produces, it can sell it at the same price. So how does the firm know how much to produce? The firm has its marginal cost curve (MC), which is equivalent to its supply curve. Where the marginal cost curve intersects the demand curve is where the firm should produce to maximize its profits.
If the firm were to try to raise its prices in a perfectly competitive market, the firm's demand for its product would immediately fall to zero because consumers would be able to adapt instantly to buy from a different firm that still charges the lower market price. The firm would also not gain anything by charging a lower price than its competitors. The firm will be able to sell any quantity of its goods for the same market price because demand at that price is infinite. Therefore, all that would happen for the firm if they decreased their price is a decrease in revenue since they would still be selling the same quantity of goods, just at a lower price.
Now, if the firm's demand curve itself changes, then the firm would still produce the same quantity demanded, but its profit would change.
Figure 6 sees an increase in the firm's demand curve. This happens when the market demand and market price increase. In Figure 6, this means the market price rises from PM1 to PM2. At first, the firm charged PM1, where the average total cost (ATC) curve intersected with the marginal cost (MC) curve. Then, as the market price increased, the firm was able to charge a higher price than its average total cost to produce. When a firm can change a price that is above its average total cost, these profits are called supernormal profits and are shaded in Figure 6. Supernormal profits are not sustainable in the long run because the lack of barriers to entry makes it easy for other firms wanting to cash in on those profits to enter the market, which would increase the market supply and push prices down. The price would then return to a level where the firms are only earning normal profit again.
If the firm were to experience a decrease in the market price, its demand curve would shift down because, in perfect competition, any and all quantities are demanded at the given market price. This would cause the ATC curve to sit above the demand curve, which is also an unsustainable position for the firm because it means that it is below its break-even point and only just covering its variable and fixed costs. As long as the price stays above the average variable cost (AVC) curve, the firm has not yet reached its shut-down price.
We invite you to continue learning from our articles:- Perfect Competition;
- Short-Run Production Decision;- Long Run Entry and Exit Decisions.
Demand Curve in Perfect Competition - Key takeaways