The Economic Process of Perfect Competition

A wonderful thing about free markets and competition in the economy is that output is produced at the lowest possible cost. This fact is extremely important because it means that free markets are as economically efficient as possible at converting resources into the goods and services that people want to buy.

In addition, markets save society a lot of money because they produce efficiently without requiring human intervention. People don’t have to pay big salaries to experts to make sure that markets run efficiently; markets do the job in our economy for free.

How does perfect competition actually work? The following four steps explain:

1. The market price of the output sold by every firm in the industry is determined by the interaction of the industry’s overall supply and demand curves.
2. Each firm takes the market price as given and produces whatever quantity of output will maximize its own profit (or minimize its own loss if the price is so low that it’s not possible to make a profit).
3. Because each firm has an identical production technology, each will choose to produce the same quantity and will consequently make the same profit or loss as every other firm in the industry.
4. Depending on whether firms in the industry are making profits or losses, firms will either enter or leave the industry until the market price adjusts to the level where all remaining firms are making zero economic profit.

The fourth point in this process — firm entry and exit — is very important. To understand it clearly, let’s break it into two cases: one where every firm in the industry is making a profit because the market price is high and another where every firm in the industry is making a loss because the market price is low:

• Attracting new firms by making profits: If every firm in an industry is making a profit, new firms are attracted to enter the industry, too, in hopes of sharing the profits. But when they enter, total industry output increases so much that the market price begins to fall. As the price falls, profits fall, thereby lowering the incentive for further firms to enter the industry.

The process of new firms entering the industry continues until the market price falls so low that profits drop to zero. When that happens, the incentive to enter the industry disappears, and no more firms enter.

• Losing existing firms when making losses: If every firm in an industry starts out making losses because the market price is low, some of the existing firms exit the industry because they can’t stand losing money. When they do, total industry output falls. That reduction in total supply, in turn, causes the market price to rise. And as the market price rises, firms’ losses decrease.

The process of firms leaving and prices rising continues until the remaining firms are no longer losing money.

The fact that firms can freely enter or leave the industry means that after all adjustments are made, firms always make a zero economic profit. In other words, if there is perfect competition, you don’t have to worry about firms exploiting anyone; they just barely make enough money to stay in business.

The other important result of perfect competition — that competitive firms produce at minimum cost — becomes apparent if you flesh out the four-stage process of perfect competition by using cost curves.