3.4.2 - Perfect competition

Question 1

What are the assumptions of perfect competition ?

Answer 1

• Firms aim to maximise profits.
• There are many participants (both buyers and sellers).
• The product is homogeneous. (cant be differentiated)
• There are no barriers to entry to or exit from the market.
• There is perfect knowledge of market conditions.
• There are no externalities.

Question 2

Profit maximisation as an assumption

Answer 2

May think that firms are unlikely to do consumers any favours but it transpires that this does not interfere with the operation of the market

Question 3

Many participants as an assumption

Answer 3

There is an assumption that there are so many buyers and so many sellers that no individual trader is able to influence the market price.

The market price is thus determined by the operation of the market.

Question 4

Homogenous products as an assumption

Answer 4

This assumption means that buyers of the good see all products in the market as being identical, and will not favour one firm’s product over another.

Question 5

No barriers to entry and exit as an assumption

Answer 5

Firms are able to join the market if they perceive it to be a profitable step and they can exit from the market without hindrance.

Question 6

Perfect knowledge as an assumption

Answer 6

It is assumed that all participants in the market have perfect information about the trading conditions in the market.

Question 7

How is perfect knowledge advantageous to a buyer ?

Answer 7

In particular, buyers always know the prices that firms are charging, and thus can buy the good at the cheapest possible price

Question 8

How can perfect knowledge potentially be a disadvantage to a seller ?

Answer 8

Firms that try to charge a price above the market price will get no takers.

Question 9

Are there externalities in perfect competition ?

Answer 9

No there are no externalities, they are ruled out in order to explore the characteristics of the model

Question 10

Is the firm a price taker or a price maker in perfect competition ?

Answer 10

Firms are price takers, they have to accept whatever price is set in the market as a whole

Question 11

What is the demand (AR = MR) curve like for a price taker ?

Answer 11

Perfectly elastic demand curve

Horizontal line

Question 12

Where does a firm have to set output in order to maximise profits ?

Answer 12

MR = MC

Question 13

What should a firm do if price falls below short run average variable costs ?

Answer 13

They should leave the market as it will be better off just incurring its fixed costs

Question 14

Where is the industry equilibrium in the short run ?

Answer 14

Where SMC = Demand

Question 15

Where does a firms price have to be for supernormal profit to be made in the short run ?

Answer 15

It has to be greater than its average cost

Question 16

How is total profit worked out ?

Answer 16

Average revenue minus average costs equals profit per unit, so multiplying this by the quantity sold determines total profit.

Question 17

What is likely to happen to the market if firms are making supernormal profits ?

Answer 17

This will prove attractive to other firms which will seek to enter the market

This will continue happening for as long as firms are making supernormal profits

Question 18

Over time what will happen as more firms enter the market ?

Answer 18

The industry supply curve shifts to the right and the market price will fall

At some point the price will have fallen to such an extent that firms are no longer making supernormal profits and the market will then stabilise.