At one end of the spectrum, we have Perfect Competition -- a competitive ideal which represents a standard by which we evaluate all other types of competitive behavior. At the other end, Monopoly which represents an absolute lack of competition such that the single firm in the industry has a high degree of price-making ability.

Perfect Competition

Perfect Competition defines one end of the competitive spectrum with each firm behaving as a price taker in their respective industry. What this means is that, with a large number of firms, a high degree of product similarity (homogeneous products), and perfect market information available, each individual firms has absolutely no influence on market price. In a perfectly competitive industry, prices are strictly established by the interaction of market supply (a summation of individual business firm supply choices) and market demand (the summation of all individual consumer demand choices). Each firm then responds to this market price by making output choices that maximize the profits of that firm.

In a competitive market, profit maximization choices are based the notion of a producer optimum. This condition with respect to labor input is defined as:

MP_L = w/P

or with simple algebraic manipulation,

P = w/MP_L

and taking note that: Marginal Costs (MC) are defined as (Δ Total Costs / ΔX)

MC = Δ Variable Costs/ Δ X
MC = Δ (wL) / ΔX
MC = w(ΔL) / ΔX) = w/(ΔX / ΔL)
MC = w/MP

Thus profit maximization implies that:

P = MC

Since the perfectly competitive firm is a price-taker, the price of the good being sold is set by the interaction of competitive supply and demand forces in the industry in which the firm competes. If the profit maximizing level of output for the representative firm (one with an industry average cost structure) results in abnormal profits (i.e., P > ATC), then new firms will be induced to enter the industry. This is possible since there are no barriers to entry.

(Note: Abnormal profits act as signal for the market entry of new firms resulting in an allocation of factor inputs towards the production of the product being produced and sold).

This market entry will lead to an outward shift in supply, creating a surplus of product and pushing prices downward. The process will continue until the abnormal profits have been eliminated. The ultimate equilibrium for the representative firm will be a level of output where:

P = MC = min[ATC]

If the profit maximizing level of output for the representative firm results in losses (i.e., P < ATC), then some existing firms (those operating below their shut-down point) will leave the industry and restrict their losses to the Fixed Costs.

(Note: Losses act as signal for the market departure of existing firms resulting in an allocation of factor inputs away from the production of the product being produced and sold).

This market departure will lead to an inward shift in supply, creating a shortage of product and pushing prices upward. The process will continue until the losses for the remaining firms have been eliminated.