3.4.2 Perfect competition

Question 1

What are the conditions for perfect competition?

Answer 1

• There is an infinite number of suppliers and consumers
• Producers and consumers have perfect information
• Products are homogenous (identical)
• There are no barriers to entry/exit
• Firms are profit maximisers

Question 2

[Conditions for perfect competition]

What does it mean if a firm is a profit maximiser?

Answer 2

All the decisions that a firm makes are geared towards maximising profit.

This means that all firms will choose to produce at a level of ourput where MC = MR.

Question 3

[Conditions for perfect competition]

What does it mean if there are no barriers to entry or exit?

Answer 3

• New entrants can join the industry very easily, and existing firms can leave equally easily.

Question 4

[Conditions for perfect competition]

What does it mean if products are homogenous?

Answer 4

This allows consumers to switch between products from different firms (i.e. all the products are perfect substitutes for each other).

Question 5

[Conditions for perfect competition]

What does it mean if producers and consumers have perfect information?

Answer 5

Consumers | Consumers know how much every firm in a market charges for its products, as well as details about those products.

Producers | Every firm knows the price charged by every other firm (no firm has lower-cost production method).

Question 6

[Conditions for perfect competition]

What does it mean if there is an infinite number of suppliers and consumers?

Answer 6

Each of the suppliers is small enough so that no firm has any market power.

Each firm is a price taker - meaning they have to buy/sell at the current market price.

Question 7

Is there allocative efficiency in perfect competition?

Answer 7

Yes - allocative efficiency occurs when a good’s price is equal to what consumers want to pay for it, and this happens in a perfectly competitive market because the price mechanism ensures that producers supply exactly what consumers demand.

AR (P) = MC

Question 8

Is there productive efficiency in perfect competition?

Answer 8

Yes - firms in a perfectly competitive market will be productively efficient because the long run output level is the lowest possible cost level (i.e. the bottom of the AC curve).

The firm is productively efficient as MC = AC at this level of output.

Question 9

Equilibrium level between MR and MC with perfect competition

Answer 9

• Output above this level (MC > MR) reduces profit, so firms wouldn’t produce it.
• Output below this level (MR > MC) would mean the firm would earn more revenue from extra output then it would spend in costs – so the firm would expand output as this would increase profit.

Question 10

Why are firms under perfect competition operating less productively efficient than a monopoly (where there is just one very big firm)?

Answer 10

• In a perfectly competitive firm, there’s an infinite number of firms.
• This means that each firm is very small, and so can’t take full advantage of economies of scale.
• If there are economies of scale, then an industry made up of an infinite number of very small firms may be less productively efficient than if there was one very big firm (i.e. a monopoly).

Question 11

Will dynamic efficiency happen in perfect competition?

Answer 11

No - firms in perfect competition can only earn normal profit, so there is no reward for taking risks. There is also no supernormal profit which can be reinvested in the firm.

Question 12

What might cause x-inefficiency?

Answer 12

• Using factors of production in a wasteful way (e.g. employment more people than necessary)
• Paying too much for factors of production (e.g. paying workers more than is needed or buying raw materials at higher prices than necessary)

Question 13

Will firms operating under perfect competition make supernormal profits?

Question 14

Will firms operating under perfect competition make supernormal profits?

Answer 14

No - because any short-term supernormal profits attract new firms to the market (because there are no barriers of entry). This means supernormal profits are ‘competed away’ in the long term - i.e. firms undercut each other until all firms make only normal profit.

Question 15

When will firms exit the market under perfect competition?

Answer 15

There are no barriers to exit in a perfectly competitive market so in the long run the firm will just leave the market.

In the short run:
- If the selling price (AR) is above a firm’s average variable costs (AVC), then the firm may continue to trade temporarily.
- If the selling price (AR) is below a firm’s average variable costs (AVC), then it will leave the market immediately.

Question 16

Do perfectly competitive markets only compete on price?

Answer 16

No - in practice, firms will usually compete in other ways, such as:
- Improved products
- Better quality of service
- Wider produce ranges
- Advertising and promotion
- Nicer packaging
- Wider product ranges
- Products that are easier to use

Question 17

Why might governments encourage competition?

Answer 17

• To improve productive efficiency.
• To encourage firms to set prices at a level that is fair to consumers.
• They hope that competition will encourage firms to innovate, leading to firms creating new products (increasing choice) and new production processes (increasing efficiency).

Question 18

Give examples of policies which a government could introduce to increase competition.

Answer 18

• Encourage new enterprises with advice and start-up subsidies.
• Increase consumer knowledge by ensuring that comparison information is available.
• Introduce more consumer choice and competition in the public sector. This might involve creating ‘internal markets’ in sectors such as health and schooling, for example.
• Privatise and deregulate large monopoly nationalised industries.
• Discourage mergers and takeovers which might excessively reduce the number of competing firms.
• Encourage more international competition – e.g. by joining the EU, countries enter into a multinational ‘single market’.

Question 19

Give an example of perfect competition

Answer 19

Fruit + veg

Question 20

Is there advertising in perfect competition?

Answer 20

There is no need for advertising in perfect competition because consumers already have perfect knowledge. In perfect competition, all products are identical so there’s no price differentiation.