3.4.2 Perfect Competition Flashcards
What are the assumptions of a perfectly competitive market?
- Homogenous (identical) products (they are all perfect substitutes) – there is no product differentiation at all
- All firms have access to the same quality factors of production
- Large number of buyers & sellers and all sellers act independently (i.e. no price collusion)
- Free (costless) entry into and exit from the market i.e. no barriers to entry or exit
- Perfect knowledge / information for buyers and sellers
- Profit maximisation is assumed as the key objective of firms – and consumers are assumed to be utility
maximisers when making their purchasing decisions - If there are many firms producing identical products, and consumers can easily switch from one firm to
another, then firms will be price-takers in equilibrium. They will have to accept the prevailing market price.
What are examples of perfect competition?
Explain profit maximisation in perfect competition in the short run with cost/rev diagrams
- The market price is set by the interaction of market supply and demand
- Each individual firm is a price taker in a perfectly competitive market
- The ruling market price becomes the AR and MR curve for the firm
- Average revenue equals marginal revenue at every level of output
- We assume that the aim of each firm is to find a profit-maximising output
How can firms also make losses in the short run in perfect compeitition? Explain with a diagram
Firms can also make losses in the short run in perfect competition – this will happen if the ruling market price is less than the average cost for a particular firm. This causes firms to leave the industry, raising the market price.
Explain when a firm can consider shutting down production using chains of analysis
How do firms in perfect competition make normal profits in the long run?
- If most firms are making abnormal (supernormal) profits in the short run, this encourages the entry of new
firms into the industry driven into the market by the profit motive - This will cause an outward shift in market supply forcing down the ruling market price
- The increase in market supply will eventually reduce the ruling market price until price = long run average
cost - At this point, each firm in the industry is making normal profit where price (AR) = average cost
- Other things remaining the same, there is no further incentive for movement of firms in and out of the industry and a long-run equilibrium is established where price = average cost at output where MR=MC
What does normal profit in the long run in perfect competition look like?
Where is the long run equilibrium in perfect competition and how does it look like?
- In long run equilibrium, all firms are making normal profits (P=AC)
- Normal profits where AR=AC – i.e. just enough profits to keep resources in their current use
How does subnormal profits affect the adjustment to market equilibrium in the long run? Show that in a diagram
Firms making sub-normal profits are likely to leave the industry. This causes an inward shift of market supply which then leads to a rise in the market equilibrium price. In the long run the net exit of firms will allow the remaining firms to earn normal profits where price = AC.
Is perfect competition allocatively efficient?
In both the short and the long run, price is equal to marginal cost (P=MC) and thus allocative efficiency is achieved.
Is perfect competition productively efficient?
Productive efficiency occurs when the equilibrium profit maximising output is supplied at minimum average cost. This is attained in the long run for a competitive market. Output is at lowest point of AC. If a firm is producing at the lowestpoint of their lowest average cost curve this also means that the firm must be X efficient
Is perfect competition dynamically efficient?
We assume that a perfectly competitive market produces homogenous products – in other words, there is little scope for innovation designed to make products differentiated from each other and allow one or more suppliers to establish monopoly power. Furthermore, the lack of any supernormal profit suggests that firms will not have the funds available to reinvest. Therefore firms in perfect competition are unlikely to be dynamically efficient.
Why are competitive markets good for economic efficiency?
- Lower prices because of many competing firms. The cross-price elasticity of demand for one product will be
high suggesting that consumers are prepared to switch their demand to the most competitively priced
products in the marketplace. - Low barriers to entry – the entry of new firms provides competition and ensures prices are kept low
- Lower total profits and profit margins than in monopoly
- Greater entrepreneurial activity. For competition to be improved and sustained there needs to be a genuine
desire on behalf of entrepreneurs to innovate and to invent to drive markets - Competition will ensure that firms move towards productive efficiency and avoid X inefficiency
- The threat of competition should lead to a faster rate of technological diffusion, as firms have to be responsive
to the changing needs of consumers. This is known as dynamic efficiency.
Evaluate the assumptions of the perfect competition model?
- Most firms have some amount of price-setting power – they are price makers not price takers!
- Dominance in real world markets of differentiated / branded products
- Highly complex products, there always information gaps facing consumers
- Impossible to avoid search costs even with the spread of digital/web technology
- Patents, control of intellectual property, control of key inputs are all ignored by the perfect competition model
- Rare for entry and exit in an industry to be costless
- The model of perfect competition also assumes that there are no externalities (positive or negative); in reality,
there are often 3rd party effects of every market
What are pros of perfect competition?
- Consumers are not exploited by firms, in terms of high prices
- Equality – products are the same regardless of where they are bought, so all consumers are able to buy the
same product - No ‘wasted’ costs in terms of advertising etc.
