A perfectly competitive firm is a firm operating in a perfectly competitive market. A perfectly competitive market has the following three essential characteristics.
- There are many firms producing and selling identical product. None of these firms is large or dominant enough to influence the market price.
- Firms desiring to enter or exit the market for the product can do so easily without incurring any additional cost for such entry or exit.
- Buyers and sellers have sufficient market knowledge and the analytical ability to make the best decision in their interest.
Each firm in a perfectly competitive marked faces a completely horizontal curve. This means that a firm can sell any quantity of its product a the market price, but not even one unit at a price higher than the market price. Because of this, each firm can increase it profit by increasing its production up to a point when the marginal cost of production is equal to the market price, and increasing production further will take the marginal cost of production above the market price.
In the short run it is possible that average cost of the company at this equilibrium point is lower than the market price. In this situation the company will be making loss rather than a profit. However, in short-run it will still be worthwhile for the company to produce if the marginal variable cost and average variable cost are both lower than the market price, as this will enable the company to recover at least a part of its fixed costs. If the lowest possible average variable cost is higher than the market price than it is best to close down production and exit the business immediately.
In the long run in a perfectly competitive market only those firms will continue who are able to produce at average cost equal to the market price.