5.4 Perfect competition.
Structure:
- Many buyers and sellers.
- Firms have no market power (market power=ability to set prices). Price taker: If a firm accepts the market price.
- Homogeneous products.
- No barriers to exit or entry. Barriers to entry: Make entry into a market by new competitors difficult. Exit barriers: Make exit from a market by existing competitors difficult.
- Perfect information.
- Perfectly elastic demand for a perfectly competitive firm. (D=AR=MR=P)

Profit maximization:
Step 1: The firm maximizes profits by producing the profit maximizing level of output associated with MC=MR
Step 2: What does is cost to produce the profit maximizing output? Simply draw the line up from the profit maximizing output until short-run average total cost line, SATC. In this case 8.
Step 3: What revenue will the firm earn by selling the profit maximizing output? Simply draw the line up from the profit maximizing output until average revenues, AR. In this case 10.
Step 4: Profit per unit is AR minus AC, so 10-8=2.
Step 5: Total profit is profit per unit x the number of units produced. The rectangle defined by AR-AC and the profit maximizing output.

Accounting Profits: Revenues – (raw material cost + wages + depreciation).
Economic Profits: Revenues – the costs of all factors of production.
Normal economic profits: Equal to the average rate of return which can be gained in the economy.
Supernormal profits: Financial returns greater than normal profits.

Changes in demand and adjustments to long-run equilibrium.
- Income levels in the economy increase. Demand shifts right.
- The market price increases and the firm’s marginal revenue and average revenue rise relative to costs.
- The profits attract new entrants and supply shifts right.
- Cost of labour increases, marginal cost shifts left and average cost rise. Profits decrease, exit occurs. Supply shifts left.
Productive efficiency: Means that the firm is operating at the minimum point on its long-run average cost curve. Moreover, in long-run equilibrium the firm is charging a price that is equal to the marginal cost. This means that the firm is also allocatively efficient.
Allocative efficiency: Occurs when price equals marginal cost, P=MC.