Perfect competition exists when the products are identical and can compete only on the basis of price. As the firms collide only based on price, the market is highly elastic. No player holds sufficient enough market share to dictate the price, in a perfect competition market firms are price takers. The profit gap decreases as the market price decreases with increase in competition.
In a perfectly competitive market marginal revenue, marginal cost, average total cost, and the price all will be equal where the economic profits are nil, and accounting profits are sufficient to run the firm in the short term.
Short run equilibrium Vs Long run equilibrium:
In the short run, the demand for the product increases, in tandem supply increases to compensate demand thus decreasing the price. In the real world, the process takes longer time that a new firm can enter the market to exploit the excess demand available for the niche.
If the profits are high many new firms foray into the market and decrease the price competitively. As price is reduced by new entrants or an existing firm the market is forced to reduce the price to the first mover, working in a highly elastic market the volume increases as the price drops, mind that the quantity is increased only in the firm and not in the market until the demand stays the same. The consumption is saturated and people tend to consume no more than that unless the income effect turns to be more positive for the population.
Whatever may be the quantity produced every additionally produced unit should be sold at the same or less the prevailing market price or more than the previous cost of production. Doing this keeps the firm adhere to economies of scale.
Firms enter the market until the marginal cost, marginal revenue, Average total cost and the market price become equal. This is the point at which the economic and accounting profits become zero and not profit can be seen at this level.
As far as the firms are producing products at the average total cost, tend to increase the supply until realising losses. Going below that introduces losses and the firm has to run in loss for a long term to turn profitable. Once the firm cannot fund the variable costs firms exit the market in the long term. Markets having variable shifting demand tend to shed firms.
When the demand for the product increases, the price increases for a constant supply of units. New firms enter into the business to exploit the price gap by increasing the supply. Thus decreasing the price to previous levels with an increased supply, demand is fed.
This forces shift market share from firms and some firms with lower share lose business and exit.
Profiting in a perfectly competitive market
Too many firms spoil the profits. Highly competitive with no pricing power. If too many players already manufacture the same product, its tough to make different products as the uniqueness would have been tried in the market by anyone of them at certain period of business promotions. Price competition prevails and the market share is distributed almost equally among the firms. The products are hard to differentiate and stuffing the market with same product leaves consumers with too many choices according to their comfortability and affordability range.
Why can’t any firm continue to run for long term without breaking even?
When companies fail to cover variable costs, they tend to shut down in the short term and exit the market. When firms struggle, but turnover more than the variable costs and can barely cover fixed costs, they can run in the short run to minimise losses than not running the business at all. The business can either cut volume and turn around operations or fail incurring too much of the losses.
How is price determined in a perfectly competitive market?
In a perfectly competitive market, firms take market price and try to reduce the production costs. When a firm is producing more than the selling cost, firms cannot withstand negative operating cash flows without funding streams like Private Equity or Venture capitals to turn positive in terms of cash flow.
Why valuation slice and dice cash flows rather than earnings?