3.4.2 perfect competition

Question 1

what is a perfectly competitive market?

Answer 1

A theoretical market where there is a high degree of competition. No market can be completely perfectly competitive.

Question 2

What are the characteristics of perfect competition?

Answer 2

• many buyers and sellers, none of them are large enough to influence price = firms are price takers
• no barriers to entry and exit
• buyers and sellers have perfect knowledge of prices
• products are homogenous

Question 3

What does the demand curve look like for perfect competition?

Answer 3

Perfectly elastic demand curve due to firms being price takers

Question 4

What objective does a perfectly competitive firm follow?

Answer 4

They are profit maximisers, produce at MC = MR.

Question 5

What profits are made for perfectly competitive firms in the short run?

Answer 5

Supernormal profits are made in the short run

Question 6

Explain long run profit maximisation for perfectly competitive firms?

Answer 6

Most firms make supernormal profits in the short run which encourages entry of new firms. This causes an outward shift in market supply forcing down price. Reduces the market price until it is equal to LRAC. Each firm makes normal profit where AC = AR. There is no further incentive for firms to move in and out of the industry, long run equilibrium is established where P = AC where MR = MC.

Question 7

Explain short run profit maximisation for perfectly competitive firms

Answer 7

Market price is set by interaction of market supply and demand. Each individual firm is a price taker. Ruling market price becomes the MR and AR curve for firms in the industry. AR = MR at every output level. Each firm aims to find a profit maximising output.

Question 8

What is efficiency like in perfect competition?

Answer 8

• they are productively efficient as they produce where MC = AC, the lowest point of the AC curve
• they are allocatively efficient as they produce where P = MC.
• not dynamically efficient as there is no scope for innovation due to homogenous products

Question 9

Why is perfect competition good for economic efficiency?

Answer 9

• lower prices due to high competition. XED is high because consumers are willing to switch demand to cheapest products
• low barriers to entry, ensures competition and low prices
• lower total profits than monopolies
• greater entrepreneurial activity = improved competition due to innovation
• competition ensures firms move towards productive efficiency

Question 10

Evaluation of the perfect competition model

Answer 10

• most firms have some price setting power, they are price makers rather than takers
• in real world markets, there is dominance from differentiated and branded products
• highly complex products, there are always information gaps facing consumers
• impossible to avoid search costs
• patents, control of property, control of inputs are all ignored by the model
• rare for entry and exit to be completely costless