3.4.2 Perfect Competition

Question 1

Assumptions of perfect competition model?

Answer 1

• Firms aim to max profits
• Many participants (buyers and sellers)
• Product is homogenous (no brand loyalty)
• No barriers to entry or exit from the market
• Perfect knowledge of market conditions
• No externalities

Question 2

Many participants?

Answer 2

• So many buyers and sellers such that no individual trader is able to influence the market price

Sellers: limited EoS

Question 3

Homogenous product?

Answer 3

• Buyers see all goods in market as identical
• No brand loyalty so no individual seller able to influence market price

Question 4

Perfect knowledge?

Answer 4

• Buyers always know prices and can buy good at cheapest possible price (firms that charge above market price get no takers)
• Traders aware of product quality

Question 5

Shape of demand/AR curve in perfect competition in the short run?

Answer 5

• Perfectly elastic, firms are price takers and have to accept whatever price is set in the market

Question 6

Why are firms price takers under perfect competition?

Answer 6

• Buyers won’t buy at higher price due to perfect knowledge
• No incentive for firms to lower price because they can sell as much output as they want at the market price

Question 7

Why does short-run MC curve represent short-run demand curve?

Answer 7

• If market price was to change, firm would react by changing output, but choosing to supply at MR=MC
• The Q firm would supply at any given price

Only when SMC is above SAVC (shut-down point)

Question 8

Industry supply curve?

Answer 8

Σ SMC curves

Question 9

What happens in SR when firms make supernormal profit?

Answer 9

• Freedom of entry = attractive to other firms = firms enter market = industry supply curve shifts to the right = fall in market price = return to normal profit

If prices fell even further, some firms would exit the market and process would go into reverse