5.3 Perfect Competition

Question 1

What are the characteristics of perfect competition?

Acronym-Many Sellers Need Perfect Help For Fighting

Answer 1

• A perfectly competitive market has the following characteristics:

o Many buyers and sellers
o Sellers are price takers
o No barriers to entry and exit
o Perfect knowledge
o Homogeneous goods
o Firms are short run profit maximisers
o Factors of production are perfectly mobile

Question 2

How is price determined in a perfectly competitive market?

Answer 2

• by the interaction of demand and supply.

Question 3

What will profits look like in a perfectly competitive market?

Answer 3

• Profits are likely to be lower than a market with only a few large firms.
  -This is because each firm in a competitive market has a very small market share.
  -Therefore, their market power is very small.
• If the firms make a profit, new firms will enter the market, due to low barriers to entry, because the market seems profitable.
  -The new firms will increase supply in the market, which lowers the average price.
  -This means that the existing firms’ profits will be competed away.

Question 4

Profit maximising equilibrium in the short run

Answer 4

• In the short run, firms can make supernormal profits.

Question 5

Draw a diagram to illustrate the short run equilibrium for a perfectly competitive market and explain the diagram

Answer 5

• The firm is a price taker, and it accepts the industry price of P1.
• In the short run, the firm produces an output of Q1
• The yellow shaded rectangle shows the area of supernormal profits earned in the short run.
• It is assumed that firms are short run profit maximisers.

Question 6

Profit maximising equilibrium in long run

Answer 6

• In the long run where profits are competed away, only normal profits are made.

Question 7

Draw a diagram to illustrate the long run equilibrium for a perfectly competitive market.
Explain what the diagram is showing

Answer 7

• The diagram below shows the long run equilibrium for a perfectly competitive
  market.
• The supernormal profits made by existing firms means that new firms have
  an incentive to enter the industry (market seems profitable)
• Since there are no barriers to entry in a perfectly competitive market, new firms are able to enter the industry.
• This causes the supply in the market to increase, as shown by the shift in the supply curve from S to S1.
• The price level in the market falls as a consequence. Since firms are price takers, they must accept this new, lower price.
• In the long run, competitive pressure ensures equilibrium is established.
• The supernormal profits have been competed away, so firms only make normal profits in the long run.
• The new equilibrium at P=MC means firms produce at the new output of Q2 in the long run.

Question 8

What is the shutdown condition for firms in a PCM?

Answer 8

AR=AVC

Question 9

What is the break even condition for firms in a PCM?

Answer 9

AR=AC

Question 10

What are the advantages of a perfectly competitive market?

Answer 10

• In the long run, there is a lower price. P =MC, so there is allocative efficiency.
• Since firms produce at the bottom of the AC curve, there is productive efficiency.
• The supernormal profits produced in the short run might increase dynamic efficiency through investment.

Question 11

What are the disadvantages of a perfectly competitive market?

Answer 11

• In the long run, dynamic efficiency might be limited due to the lack of supernormal profits.
• Since firms are small, there are few or no economies of scale.
• The assumptions of the model rarely apply in real life. In reality, branding, product differentiation, adverts and positive and negative externalities, mean that competition is imperfect.