2.8. Perfect Competition + Contestable Markets Flashcards
Perfect Competition Assumptions
1) Many buyers and many small sellers with no market power.
2) Firms are price takers (sell at the market price).
3) No barriers to entry / exit (free movement).
4) Products are homogenous (identical).
5) Buyers and sellers have perfect knowledge of market conditions.
6) Firms are profit maximisers (MC = MR).
Perfect Competition Revenue Curves
- y-axis revenue
- x-axis output
- Total revenue curve upward sloping from origin
- MR = AR = D - demand is perfectly elastic
Long Run Equilibrium - Normal Profits (DRAW DIAGRAM)
- Price is set by the market (S = D).
- Firms sell all goods at market price.
- At the profit maximising (MC = MR) level of output, normal profits (AR = AC) are made.
- At this point D = AR = AC = MR = MC. (just enough profits to keep resources in their current use)
Short Run Equilibrium - Abnormal Profits (DRAW DIAGRAM)
Price is set by the market (S = D). Firms sell all goods at market price. At the profit maximising (MC = MR) level of output, abnormal profits will be made (AR > AC).
Adjustment to LR equilibrium (normal profits)
- Supply increases (S1 to S2) as new firms, attracted by the abnormal profits, enter the market due to the absence of barriers to entry.
- The market price falls (P1 to P2), causing AR and MR to fall until only normal profits are made, where AR = AC.
Short Run Equilibrium - Subnormal Profits (DRAW DIAGRAM)
Price is set by the market (S = D). Firms sell all goods at market price. At the profit maximising (MC = MR) level of output, subnormal profits will be made (AC > AR).
Adjustment to long-run equilibrium (normal profits)
- Supply decreases (S1 to S2) as firms, attracted by larger profits elsewhere, exit the market due to the absence of barriers to exit.
- The market price rises (P1 to P2), causing AR and MR to rise until only normal profits are made, where AR = AC.
The firm’s supply curve
Short-run supply curve is the part of MC curve above point a because:
- Firms need to pay fixed costs in the SR.
- Any revenue over and above variable cost makes a contribution to fixed costs.
- Firm will shutdown if P < AVC.
Long-run supply curve is the part of the MC curve above point b because:
- There are no fixed costs in the LR, therefore AVC = ATC.
- Firms will shutdown if P < ATC
Productive Efficiency in Short run and long run
- NONE in the Short-run
- Present in the Long-run
Allocative Efficiency in Short run and long run
Present in the both Long-run and Short-run
Dynamic Efficiency in Short run and long run
NONE in either Short-run and Long-run
- Firms under perfect competition are dynamically inefficient due to perfect knowledge, where invention by one firm can be copied by all other firms.
- Also, in the LR they do not make abnormal profits, which is a major source of investment funds.
Advantages
- Allocative efficiency (SR and LR).
- Productive efficiency (LR).
- X-efficient.
- Competitive prices.
- Consumer surplus.
- Consumer sovereignty / welfare.
- Consumers have free movement between sellers.
- Perfect knowledge for producers and consumers.
- Provides a theoretical extreme for real life markets to be compared to.
Disadvantages
- Productive inefficiency (SR).
- Dynamic inefficiency.
- No innovation / R&D.
- No scope for economies of scale.
- No choice of products due to homogeneity.
- If externalities are present this will cause market failure.
- No / very few real life examples.
Contestability
the ease with which firms can enter and leave a market
Contestable Markets
A market where there is freedom of entry to the industry and where costs of exit are low.
Characteristics of Contestable Markets
- Low / no barriers to entry / exit
- -> No sunk costs
- -> Low / no consumer loyalty
- Firms have same access to same technology
- Number / size of firms is not important
- Firms are profit maximisers (MC = MR)
Implications of Contestable Markets
- Existing firms face the threat of new (potential) firms entering
- Firms will try to deter the entry of new firms
- New (potential) firms could perform “hit-and-run” tactics
- The threat of entry ensures prices are low and only normal profits are made
