AP® Microeconomics review sheet from Aim for Five (aimforfive.com/micro/units/3/3-7)
Unit 3 · Topic 3.7
3.7 Perfect Competition
In perfect competition, many small firms sell identical products and anyone can enter or leave. Each firm takes the market price as given. Short-run profits or losses trigger entry or exit until, in the long run, price equals minimum average total cost and every firm earns zero economic profit, which is both allocatively and productively efficient.
Key terms
- price taker
- price equals marginal revenue
- allocative efficiency
- productive efficiency
- long-run equilibrium
- constant-, increasing- and decreasing-cost industries
Features of perfect competition
Because one firm is tiny compared with the market, it's a price taker. If it charged even a cent above the market price, buyers would go elsewhere. It can sell all it wants at the market price, so there's no reason to charge less. Farm products like wheat are the classic example.
- Many buyers and sellers, each too small to affect the market price.
- Identical (standardized) products, so buyers don't care which firm they buy from.
- No barriers to entry or exit in the long run.
- Buyers and sellers have full information about prices.
Side-by-side graphs
Exam questions usually want two graphs side by side. On the left, the market: price on the vertical axis, quantity (often in thousands) on the horizontal, a downward-sloping demand curve and an upward-sloping supply curve crossing at the market price Pm. On the right, a single firm: price and cost on the vertical axis, the firm's quantity on the horizontal.
On the firm's graph, draw a horizontal line at Pm, carried straight across from the market graph. That line is the firm's demand curve, and it's also its MR and AR, because each extra unit sells for Pm. So for this firm, P = MR = AR = D. Add the MC curve and the U-shaped ATC curve. The firm produces where MC crosses the price line (P = MC).
Short run to long run
If the price line is above ATC at the firm's output, the firm earns an economic profit (a rectangle between P and ATC). New firms enter, market supply shifts right, and the market price falls until profit is gone.
If the price line is below ATC, firms take losses. Some exit, market supply shifts left, and the price rises until losses are gone.
Long-run equilibrium: P = MR = MC = minimum ATC. Each firm earns zero economic profit (normal profit), and there's no reason to enter or exit.
Efficiency
In long-run equilibrium, perfect competition is efficient in two ways. Allocative efficiency: P = MC, so the value buyers put on the last unit equals the cost of making it, and total surplus is as large as possible. Productive efficiency: P = minimum ATC, so goods are made at the lowest possible cost per unit. These two are the benchmark you'll compare monopoly and other market structures against in Unit 4.
In the short run, each firm still produces where P = MC, so a perfectly competitive market is allocatively efficient even while firms earn profits or losses. It's productively efficient only when price also equals minimum ATC, which is guaranteed only in long-run equilibrium.
The long-run supply curve
| Industry type | What happens to input costs as the industry grows | Long-run price after a demand increase | Long-run industry supply curve |
|---|---|---|---|
| Constant-cost | Input prices stay the same | Returns to the original level | Horizontal |
| Increasing-cost | Input prices rise (more firms compete for scarce inputs) | Ends up higher than before | Upward sloping |
| Decreasing-cost | Input prices fall (suppliers gain economies of scale) | Ends up lower than before | Downward sloping |
Worked examples
Try each one yourself first, then open the solution.
- Example 1Calculator allowed
From long-run equilibrium, through a demand increase, and back
Identical perfectly competitive firms each have total cost for 0–6 units of $60, $100, $130, $150, $180, $230, $300 (minimum ATC is $45 at 4 units). The market starts in long-run equilibrium. Then market demand increases and the price rises to $55. Describe the short-run outcome for a typical firm and the long-run adjustment in a constant-cost industry.
Show the solutionHide the solution
- Step 1: Long-run equilibrium start: P = minimum ATC = $45. The firm makes 4 units (MC of unit 4 is $30 ≤ $45; unit 5 is $50 > $45) and earns zero economic profit: $180 − $180 = $0.
- Step 2: Short run at $55: the market demand curve shifts right, raising the market price to $55. On the firm's graph, the horizontal price line moves up to $55. The firm raises output to 5 units (MC of unit 5 is $50 ≤ $55; unit 6 is $70).
- Step 3: Profit = ($55 − $46) × 5 = $45, a profit rectangle between $55 and ATC of $46, 5 units wide.
- Step 4: Long run: the profit attracts new firms. Market supply shifts right until the price falls back to $45 (constant cost). The typical firm returns to 4 units and zero economic profit, while the market as a whole now sells more.
Answer: Short run: the firm makes 5 units at $55 for a $45 economic profit. Long run: entry pushes price back to $45; each firm makes 4 units at zero economic profit, and market quantity is higher.
- Example 2
The firm's demand curve (classic trap)
The market demand curve for wheat slopes downward. A student draws a single wheat farm's demand curve sloping downward too. What's wrong, and what should the firm's graph show?
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- Step 1: The market's demand curve slopes down because, for the whole market, more wheat sells only at a lower price.
- Step 2: But one farm is a tiny part of the market. Whether it sells 100 bushels or 1,000, the market price doesn't change.
- Step 3: So the farm's demand curve is horizontal (perfectly elastic) at the market price, and it is also the farm's MR and AR curve.
Answer: A single perfectly competitive firm faces a horizontal demand curve at the market price, where P = MR = AR = D.
- Example 3
An increasing-cost industry
Demand for organic strawberries increases. As new farms enter, they compete for the limited land suited to organic growing, and land rents rise. Compare the new long-run price with the original price.
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- Step 1: Higher demand raises the price and creates short-run profits, so farms enter.
- Step 2: Entry raises the cost of a scarce input (land), which shifts each farm's cost curves up, including minimum ATC.
- Step 3: Entry stops when price equals the new, higher minimum ATC, so the long-run price ends up above where it started.
- Step 4: This is an increasing-cost industry, with an upward-sloping long-run supply curve.
Answer: The new long-run price is higher than the original, because this is an increasing-cost industry.
Common mistakes
- Drawing a downward-sloping demand curve for a single perfectly competitive firm. It's horizontal at the market price.
- Showing the firm's curves shifting when the market price changes. The price line moves; the firm's cost curves stay put unless costs change.
- Saying firms earn zero accounting profit in the long run. They earn zero economic profit, which is a normal profit.
- Mixing up the two efficiencies: allocative is P = MC; productive is P = minimum ATC.
On the exam
- Expect side-by-side graphs: describe the market (supply, demand, Pm, Qm) and the firm (P = MR = D line at Pm, MC, ATC, the firm's quantity) with the price carried across from one graph to the other.
- Questions often ask what happens in the long run after a change. Trace it step by step: profit or loss, entry or exit, market supply shift, new price, back to zero economic profit.
Connected topics
Videos
Check yourself
4 questions on 3.7 Perfect Competition. Pick an answer to see if you got it, and why.
A perfectly competitive industry is in long-run equilibrium. Side-by-side graphs show the market on the left (price and quantity on the axes, with an upward-sloping supply curve and a downward-sloping demand curve) and a typical firm on the right (dollars and output on the axes, with U-shaped average total cost, a marginal cost curve crossing it at its minimum, and a horizontal line at the market price).
Then a new fashion trend causes a lasting increase in demand for the industry's product. The industry has constant costs: entry by new firms doesn't change any firm's costs.
Hypothetical side-by-side graphs described in words
In the short run, after demand increases, what happens to the typical firm?
What happens in the long run?
If the industry were instead an increasing-cost industry, how would the new long-run equilibrium price compare with the original price?
On a graph with price on the vertical axis and output on the horizontal axis, the demand curve facing a single perfectly competitive firm is
0 of 4 answered