9.1 Signposting

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

Perfect Competition - Long Run Performance Pros

Answer 2

• Allocative efficiency is achieved in the long run
• Productive efficiency is achieved in the long run
• X efficiency is being achieved

Question 3

Perfect Competition - Long Run Performance Cons

Answer 3

• Dynamic efficiency is not being achieved in the long run
• Product homogeneity is not in the best interests of consumers who prefer variety rather than having a large number of different sellers all producing the same good or service
• 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
• A perfectly competitive market can lead to creative destruction which creates unemployment (this is a weak argument though as the benefits of creative destruction far outweigh the costs)

Question 4

Perfect Competition - Long Run Performance Evaluation

Answer 4

• 1) Static vs Dynamic efficiency. Perfect competition delivers static efficiency; consumers benefit hugely
  as a result as do producers whère market share can rise. However dynamic inefficiency is a big loss along
  with product homogeneity case could be made that consumers may be willing to lose some static
  efficiency benefits, instead paying slightly higher prices in return for differentiated goods and innovative
  product developments over time.
• 2) 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.

Question 5

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

Diagram

Answer 5

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 6

Perfect Competition - The Shutdown Condition

Diagram

Answer 6

• 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.