Why is a perfectly competitive firm's demand curve horizontal or perfectly elastic?
A perfect competition firm exists in a market where all other firms are price takers, none of the firms has the capacity to influence the price, there are many buyers and sellers, firms can enter and exit the market without restrictions, the product is undifferentiated, and there is perfect information about the goods or services.
A perfect elasticity of demand refers to a situation where any increase in price forces the demand to drop. Therefore, perfect competition firms will exhibit a horizontal line in its individual demand curve, because exact substitutes are available in the market. Additionally, the prices of the other products or substitutes will be lower than the firm’s product, forcing the buyers to purchase the alternatives. Attempts to lower the prices by the individual firm will result in losses because all other firms are making just enough to stay profitable. It is also important to note the existence of perfect information, which will ensure that the buyer is immediately made aware of the price changes made by an individual firm. Thus, in matching the market price, an individual firm experiences a horizontal demand line.
A perfectly competitive market is just a fancy way of saying that all the suppliers within a given market are selling a product that is the same in every aspect. Therefore, a consumer does not have the motivation to choose one product instead of the other since both products are completely similar. This results in an economic equilibrium in which both suppliers find themselves reliant upon one another. For example, if one supplier raises their price, then they will be out-competed since they are selling a completely identical product. This results in a demand curve that is horizontal since it represents the static nature of a perfectly competitive market. In other words, the curve is horizontal (perfectly elastic) because it represents a market that is completely balanced and fair, where suppliers are able to consistently produce their goods at market price, earning just enough to keep their business running. Unfortunately, perfectly competitive markets are, for the most part, theoretical. Real-world markets rarely behave in this manner.
There are several features in a perfectly competitive marketplace. One feature is that there are many firms in the marketplace. This often is because there are few, if any, barriers to entering and leaving the marketplace. Perfect competition means that all sellers in the marketplace are selling the same exact product. There is no variation in the products being sold by the competing companies. As a result, there would be no incentive for companies to raise their price because consumers would just buy from the other companies selling that product. They also won’t lower their price because they won’t make a profit. As a result, the companies are price takers, creating a perfectly elastic demand curve. Another feature is that perfect knowledge and information are available. Agricultural markets tend to be a good example of perfect competition. For example, there usually is no variation when wheat is being sold. Wheat from one seller is identical to wheat from another seller.
This is because all firms in perfect competition are by definition selling an identical (homogeneous) product.
If all firms are selling an absolutely identical product, there is no possible reason why someone would pay a higher price to Firm A than they would pay to Firm B. Because of this, any firm that raised its price would lose all its market share.
The curve is also like this because firms in perfect competition make no economic profit. If they drop their price, they will go out of business.
So, they can't raise their prices and they can't lower their prices. That means their demand curves are horizontal.
Here is a video explaining the concept:
By definition, a perfectly competitive market is one in which there are many suppliers and no single supplier is dominant enough to influence either the market price or the total market supplies. This means that each supplier is able to meet at the most a small part of the total market demand.
Because of the limitation on total quantity of a good a supplier is able to produce, there is no effect on the total market supplies by action of a single supplier. Also a supplies is able to sell all the quantity it can produce at the prevailing market equilibrium price. However it will not be able to sell even one unit at a price higher than the market price, as there are other suppliers willing to supply the same good at the market price. This situation results in a firm in a perfectly competitive marked facing a horizontal or perfectly elastic demand curve.
A supplier, if it so wishes, may sell its product at a price lower than the market equilibrium price. But the supplier has no economic motivation to do so, as it can sell all it can produce at market prices.