A perfectly competitive market is hypothetically the most efficient market in terms of resource allocation thus bringing competition to its greatest possible level. Neo-classical economists believe that perfect competition would produce the best possible outcomes to the society. In order to understand profits and losses the perfectly competitive market, there are key characteristics that underlie this market as follows:
Perfect knowledge that is freely available to all participants with no information failure or time lags thus risk taking is kept to the minimum.
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With perfect knowledge and information, market players make rational decisions so that the producers maximize their profits while consumers maximize their utility
Firms produce goods/output.
The goods are perfectly divisible to an indefinite number of homogenous units.
Individual firms are price takers thus no single firm can influence the market.
There are no barriers to entry or exist in this market.
There are no externalities in the market that could potentially alter cost/price not even government intervention.
From the foregoing, perfectly competitive markets do not exist in the real world because it is not possible to meet all these conditions (McDermott, 2015). Economic profits are also called super-normal profits. Economic profit or loss is calculated by subtracting total costs from total revenue. Costs include explicit costs paid for factors of production as well as implicit cost such as the opportunity cost for producing product A instead of product B. In the short-run, firm in an industry can make economic profits or losses. While the industry is the price maker, individual firms are price takers. The industry equilibrium price is set by the demand and supply, thus the equilibrium price may be above the intersection point of the margin costs (MC) and the average total cost (ATC) thus firms make economic profits in the short run. The vice versa also holds true when the industry sets its equilibrium price below the intersection point of the firm’s Marginal cost (MC) and average total cost (ATC) thus the firm makes economic losses.
The ease of entry and exist of firms in an industry plays a major role in ensuring that there are zero economic profits or losses in the long run. If the industry is making super-normal profits, it attracts firms because there is perfect knowledge, current information about the industry and no barriers to entry. These new firms increase the supply in the industry shifting the supply curve to the right and consequently driving down the price to the point where the super-normal profits are depleted. If firms are making losses, the opposite will occur; firms will leave the industry because there are no barriers to exiting, supply will reduce shifting the supply curve to the left. Price will also rise thus the firms left will get normal profits. At this point, there is maximum productive and allocative efficiency. In the short-run equilibrium occurs where price equals marginal cost hence there is allocative efficiency. In the long run, equilibrium occurs at an output where marginal cost =average total cost and hence productive efficiency. Two assumptions made for the perfect completion market to attain zero economic profits or losses on the long run is that the expansion and contraction in the industry resulting from the exit and entry of firms does not alter the prices of factors of production that the firms in the industry use. Secondly, the public information affects the price efficiency in the industry (Chen et al, 2014).
References
Chen, Q., Huang, Z., & Zhang, Y. (2014). The Effects of Public Information with Asymmetrically Informed Short ‐ Horizon Investors. Journal of Accounting Research , 52 (3), 635-669.DOI:10.1111/1475-679X.12052
McDermott, J. F. (2015). Perfect competition, methodologically contemplated. Journal of Post Keynesian Economics , 37 (4), 687-703.DOI:10.1080/01603477.2015.1050355
