What are the assumptions of the model of perfect competition? Explain why each is important for short-run and long-run equilibrium

Answer 1

There are four assumptions:
1 . Numerous small firms and customers. Each buyer and each seller is so small that each has only a negligible portion of the whole market. Therefore, none is able to control price or output of the industry.
2 . Homogeneity of product. Or, no product differentiation, including brand names or trademarks. Because the product offered by any seller is identical to that offered by any other seller, consumers do not care from which firm they buy. Therefore, no producer is able to charge a higher price.
3 . Freedom of entry and exit. New firms can enter the market with no impediments, and firms are able to leave the industry with no problems. If there are economic profits in the industry, we expect firms to enter, increasing industry supply and driving price lower. If there are economic losses, we expect firms to exit, decreasing industry supply and pushing prices higher.
4 . Perfect information. Each firm and each customer is well informed about the available products and prices. They are able to compare prices and seek the lowest price.

The result is that the firm has no control over price and is a price taker. Market demand and market supply determine the price. The firm will maximize short-run profits by equating MR = P = MC > AVC and by producing at the quantity at which this equilibrium occurs. If P < minimum AVC, the firm will minimize losses by shutting down. In the long run, firms will enter or leave the industry based on profit opportunities, and there will be no economic profits or losses. If the price should rise or fall enough to cause economic profits or losses, there will be entry or exit of firms until economic profits of all firms in the industry are zero.