9.1 - Perfect Competition

Question 1

What are the characteristics of a perfectly competitive market?

Answer 1

The characteristics of a perfectly competitive market are: 1) many (infinite) buyers and sellers, 2) homogeneous (identical) goods and services, 3) no barriers to entry or exit, 4) perfect information/knowledge of market conditions, and 5) firms are profit maximizers and consumers are utility maximizers.

Question 2

How does the number of buyers and sellers affect a perfectly competitive market?

Answer 2

In a perfectly competitive market, there are many (infinite) buyers and sellers. This means that the concentration ratio is 0, and firms must compete with each other in order to survive in the marketplace.

Question 3

What is meant by homogenous goods and services in a perfectly competitive market?

Answer 3

In a perfectly competitive market, the goods and services produced are homogenous, or identical. This makes firms price takers, taking the price set by the market, as they have no influence in setting prices. If a firm raises its price, it will lose all its customers, and if it lowers its price, either all firms will follow suit, reducing revenue, or the firm will not cover its costs, leading to unsustainable losses.

Question 4

How do barriers to entry or exit affect a perfectly competitive market?

Answer 4

In a perfectly competitive market, there are no barriers to entry or exit for firms, meaning that entry and exit is completely costless. This implies that short-run supernormal or subnormal profit will not be sustained in the long run.

Question 5

What is perfect information/knowledge in a perfectly competitive market?

Answer 5

In a perfectly competitive market, there is perfect information/knowledge of market conditions for both consumers and producers. For consumers, they have perfect information over prices being charged, and producers have perfect information over costs and technology in the industry, as well as prices being charged.

Question 6

What is the goal of firms and consumers in a perfectly competitive market?

Answer 6

Firms are profit maximizers, producing where marginal cost equals marginal revenue at all times. Consumers are utility maximizers, consuming only up until price equals their marginal utility.

Question 7

Perfect Competition - Firm Behaviour, Short Run Supernormal Profit

Diagram

Answer 7

The market equilibrium price is at P1. Taking this price, firms will profit maximise where MC-MR producing Q2 units of output. At this level of production, AR>AC, thus the firm is making supernormal profits indicated by the shaded rectangle. Firms are attracted into the industry by the supernormal profits and with no barriers to entry, the supply curve shifts to the right from S1 to S2 thus the markert equilibrium price falls. This process continues from P1 to P2 until the demand (AR) curve, for an individual firm, is tangential to the AC curve, where normal profit is being made and the firm has returned to a long run stable equilibrium at 04.

Question 8

Perfect Competition - Firm Behaviour, Short Run Subnormal Profit (Loss)

Diagram

Answer 8

The market equilibrium price is at P1. Taking this price, firms will profit maximise where MC=M producing Q2 units of output. At this level of production, AR<AC, thus the firm is making subnormal profits (economic losses) indicated by the shaded rectangle. Firms who are not covering their average variable costs of production will shutdown and leave the industry to minimise their losses immediately given no barriers to exit, thus the supply curve shifts to the left from S1 to S2 increasing market equilibrium price. This process continues from P1 to P2 until the demand (AR) curve, for an individual firm, is tangential to the AC curve, where normal profit is being made and the firm has returned to a long run stable equilibrium at 04.

Question 9

Long Run Equiblibrium?

Answer 9

Long run equilibrium in perfectly competitive markets is defined by normal profit (AR=AC) and allocative efficiency, where P=MC at Q4

Question 10

How is allocative efficiency achieved in the long run in perfect competition?

Perfect Competition - Long Performance Pros

Answer 10

Allocative efficiency is achieved in the long run in perfect competition because firms produce where P=MC at the long run equilibrium point of production. This maximises the sum of both consumer and producer surplus, ensuring resources are allocated according to consumer demand and consumer choice is high while prices are low, thus maximising consumer surplus in the market.

Question 11

What is the benefit of being allocatively efficient for producers in perfect competition?

Perfect Competition - Long Performance Pros

Answer 11

Producers benefit from being allocatively efficient by getting ahead of rivals who are not meeting consumer wants and needs as well, thus increasing their market share. Over time, this can result in higher profits for the business. Perfectly competitive firms must be allocatively efficient, or they will lose market share to rivals who are doing so.

Question 12

How is productive efficiency achieved in the long run in perfect competition?

Perfect Competition - Long Performance Pros

Answer 12

Productive efficiency is achieved in the long run in perfect competition because perfectly competitive firms produce at the lowest point of the average cost curve, where MC=AC at the long run equilibrium point of production. This means all possible economies of scale are being exploited, leading to lower average costs, which can translate into lower prices for the consumer and higher levels of supernormal profit and market share for the producer over time.

Question 13

What is X efficiency, and how is it achieved in perfect competition?

Perfect Competition - Long Performance Pros

Answer 13

X efficiency is being achieved in perfect competition because perfectly competitive firms are producing on the average cost curve at the long run equilibrium output level. In this sense, firms are minimising their unit costs, implying there is no waste in production. For highly competitive firms, being X-efficient is crucial to charge the lowest prices for consumers, increasing their consumer surplus, and achieving higher levels of supernormal profit and market share over time. Perfectly competitive firms must be X-efficient, or they will lose market share to rivals who are doing so.

Question 14

Why is dynamic efficiency not achieved in the long run in perfect competition?

Perfect Competition - Long Performance Cons

Answer 14

Dynamic efficiency is not achieved in the long run in perfect competition because supernormal profits are not being made, restricting a firm’s ability to reinvest back into the business. This limits a firm’s R&D and new product launches, which could have provided monopoly power, increased market share, and reduced production costs through better technology, ultimately benefiting both consumers and producers.

Question 15

How does product homogeneity affect consumers in perfect competition?

Perfect Competition - Long Performance Cons

Answer 15

Product homogeneity, where a large number of different sellers produce the same good or service, is not in the best interests of consumers who prefer variety. Allocative efficiency might not actually maximise the benefit to consumers in this case.

Question 16

How does intense competition in perfect competition affect the quality of output?

Perfect Competition - Long Performance Cons

Answer 16

With such intense competition and a drive to reduce costs as much as possible to survive in the long term, the actual quality of output may not be as good as it could be. Cost savings may imply poorer customer service and less focus on quality perks that raise the cost of production but provide the consumer with greater satisfaction upon consumption.

Question 17

What is creative destruction, and how does it impact perfect competition?

Perfect Competition - Long Performance Cons

Answer 17

A perfectly competitive market can lead to creative destruction, where supernormal profits attract new and more efficient firms into the industry, driving out less efficient incumbent firms unable to compete. Whilst this may lead to increased unemployment, it benefits consumers by regularly reducing prices due to efficiency gains. In a market economy, losses and shutting down must be accepted as much as profits and success.

Question 18

evaluation: What are some drawbacks of static efficiency in perfect competition?

Perfect Competition - Long Performance Evaluation

Answer 18

While perfect competition delivers static efficiency, benefiting consumers and allowing producers to increase their market share, it also lacks dynamic efficiency and product differentiation. Consumers may be willing to sacrifice some static efficiency benefits in exchange for innovative product developments and differentiated goods, even if it means paying slightly higher prices.

Question 19

evaluation: Can firms in highly competitive industries be dynamically efficient?

Perfect Competition - Long Performance Evaluation

Answer 19

The notion that firms are always dynamically inefficient in highly competitive industries due to a lack of supernormal profit in the long run may not hold in reality. Firms may be forced to reinvest whatever profits they are making, even normal profits, to stay ahead of rivals and compete in a fiercely competitive market. This can also give firms an element of monopoly power that they can exploit to increase profits over time.

Question 20

evaluation: What is the limitation of the perfect competition model in the real world?

Perfect Competition - Long Performance Evaluation

Answer 20

The perfect competition model may be too unrealistic and not applicable in the real world as there are no perfect markets in reality. There are always some barriers to entry or exit, product differentiation, and some degree of market power. The model also assumes perfect information and rational decision-making, which may not hold in reality.

Question 21

Perfect Competition - The Shutdown Condition

Diagram

Answer 21

• Firms who are making enough revenue to cover their variable costs of production (AR>AVC) should continue producing in the short run even when losses are being made in perfect competition. This is because continuing in production will reduce total losses whereas shutting down would result in greater losses, thus moving factors of production to where they have better use is not yet the more beneficial option. By staying in production, other firms who are not covering their variable costs leave the industry, which will increase the market price allowing remaining firms to make at least normal profit or better, supernormal profits in the long run. In Figure 1, subnormal profits are being made at the profit maximising level of output, 01 as AR<AC, indicated by the shaded rectangle. As this firm is covering its variable costs, AR is greater than AVC, it should continue to produce in the industry. This is only true for a short period, as continual losses cannot be sustained in the long run. If losses persist, even firms who are covering their average variable costs will eventually leave the industry.
• Firms who are not making enough revenue to cover their variable costs of production (AR<AVC) will shutdown when losses are being made in perfect competition. This is because continuing in production will increase total losses whereas shutting down would result in lower losses, thus moving factors of production to where they have better use is a more beneficial option. In Figure 2, subnormal profits are being made at the profit maximising level of output, Q1 as AR<AC, indicated by the shaded rectangle. As this firm is not covering its variable costs, AR is also less than AVC, it should shutdown and leave the industry.