David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

CHAPTER 8 Perfect competition and pure monopoly
and drive up the market price, the consequent rise in revenues and profits would simply attract new firms
into the industry, thereby increasing total supply again and driving the price back down.
Conversely, as we shall shortly see, when firms in a competitive industry are losing money, some firms will
close down and, by reducing the number of firms remaining in the industry, reduce the total supply and
drive the price up, thereby allowing the remaining firms to survive.
To sum up, each firm in a competitive industry faces a horizontal demand curve at the going market price.
To be a plausible description of the demand conditions facing a firm, the industry must have: ( 1) many
firms, each trivial relative to the industry; (2) a homogeneous product, so that buyers would switch between
firms if their prices differed; (3) perfect customer information about product quality, so that buyers know
that the products of different firms really are the same; and ( 4) free entry and exit, to remove any incentive
for existing firms to collude.
Why do we need to study perfectly competitive
markets?
II
A perfectly competitive market is characterized by many firms producing an identical product and so each
firm is a price-taker, firms have freedom of entry and exit, and buyers are perfectly informed about the
product sold in the market. All those assumptions rarely hold together in a given market, and therefore we
rarely see a perfectly competitive market in reality.
Why do we need to study something that may not exist in the real world?
The answer is that we need to study perfectly competitive markets, for two main reasons. First, a perfectly
competitive market may be considered a good approximation for many markets. For example, markets such
as those for agricultural products or houses, the stock market and so on, can be reasonably well described by
using the theory we are going to build in this chapter (together with the one built in Chapter 3).
Second, a perfectly competitive market can be seen as a benchmark, an almost ideal situation, that we can use
for comparison with other, possibly more realistic, market structures (like the monopoly that we are going to
discuss later in this chapter, and the ones we are going to analyse in Chapter 9). The reason is that a perfectly
competitive market has some desirable properties in terms of efficiency of the market outcome, as we will
discuss later in this chapter and in Chapter 13 on welfare economics.
A perfectly competitive firm's supply decision
Chapter 7 developed a general theory of supply. The firm uses the marginal condition (MC = MR) to find
the best positive output. Then it uses the average condition to check whether the price for which this
output is sold covers average cost.
This general theory must hold for the special case of perfectly competitive firms. The special feature of
perfect competition is the relationship between marginal revenue and price. A competitive firm faces a
horizontal demand curve. Making and selling extra output does not bid down the price for which existing
output is sold. The extra revenue from selling an extra unit is simply the price received. A perfectly
competitive firm's marginal revenue is its output price:
MR =P (1)
172