Understanding Profit Maximization and Equilibrium in Perfect Competition

The CFA Level 1 exam often tests you on the mechanisms that cause firms in a perfectly competitive market to have zero long term economic profits. In this post we upack the market structure and look at the profit maximizing decisions of individual firms and the long-term equilibrium of the market as a whole.

Side Note: In the short run in perfect competition fim’s will continue to expand their production until MR/Price = MC (unless the optimal decision is to shut down).

But this post is all about what happens in the long run?[1]

Long-run equilibrium in Perfect Competition

What's going on in these graphs?

Let’s say we start at point A earning positive economic profits.

Because barriers to entry are low and positive economic profits are attractive, new firms new firms will inevitably enter the market.This increased competition  will cause the market supply curve to shift down and to the right. The increase in quantity and the decrease in price will continue until eventually P = ATC and there are zero economic profits to attract more firms.

Thus the long run equilibrium with perfect competition occurs where P= MC = ATC.

The individual firm perspective

From the perspective of the individual firm any change in price/MR will impact their optimal output decision. If the change in either demand or supply is permanent a firm will adjust in the long run by either increasing their capacity or exiting the market. If we’re dealing with a situation of negative economic profit, as those firms exit the market supply curve will shift and prices will increase until we reach a new equilibrium.

 You should be able to model this effect for shifts in the demand curve as well and be able to think through how the market will respond to temporary movements in price.

Other popular compare/contrast questions on Level 1 ask you to talk about how perfect competition's long-term equilibrium is different than monopolistic competition (or any scenario where any individual firm is facing a downward sloping demand curve).


[1] http://www.topcoaching.com/faq/showDoubt/12078/How-can-a-firm-under-Perfect-compition-earn-Super-normal-profits