Chapter 13 - Market Structure: Perfect Competition Flashcards
What is market structure?
The market environment within which firms operate.
What is the summary of perfect competition?
At one extreme is perfect competition, which is the main topic of this chapter. This is a market in which each individual firm is a price taker. This means that no individual firm is large enough to be able to influence the price, which is set by the market as a whole.
This situation would arise where there are many firms operating in a market, producing a product that is much the same whichever firm produces it. You might think of a market for a particular sort of vegetable, for example. One cauliflower is very much like another, and it would not be possible for a particular cauliflower-grower to set a premium price for its product.
Such markets are also typified by freedom of entry and exit. In other words, it is relatively easy for new firms to enter the market, or for existing firms to leave it to produce something else. The market price in such a market will be driven down to that at which the typical firm in the market just makes enough profit to stay in business. If firms make more than this, other firms will be attracted in, and therefore supernormal profits will be competed away. If some firms in the market do not make sufficient profit to want to remain in the market, they will exit, allowing price to drift up until again the typical firm just makes enough to stay in business.
What is the summary of monopoly?
At the other extreme of the spectrum of market structures is monopoly. This is a market where there is only one firm in operation. Such a firm has some influence over price, and can choose a combination of price and output in order to maximise its profits. The monopolist is not entirely free to set any price that it wants, as it must remain aware of the demand curve for its product. Nonetheless, it has the freedom to choose a point along its demand curve.
What is the summary of monopolistic competition?
Between the two extreme forms of market structure are many intermediate situations in which firms may have some influence over their selling price, but still have to take account of the fact that there are other firms in the market. One such market is known as monopolistic competition. This is a market in which there are many firms operating, each producing similar but not identical products, so that there is some scope for influencing price, perhaps because of brand loyalty. However, firms in such a market are likely to be relatively small. Such firms may find it profitable to make sure that their own product is differentiated from other goods, and may advertise in order to convince potential customers that this is the case. For example, small-scale local restaurants may offer different styles of cooking.
What is the summary of oligopoly?
Another intermediate form of market structure is oligopoly, which literally means ‘few sellers’. This is a market in which there are just a few firms that dominate the market. Each firm will take decisions in
close awareness of how other firms in the market may react to their actions. In some cases, the firms may try to collude - to work together in order to behave as if they were
a monopolist - therefore making higher profits. In other cases, they may be intense rivals, which will tend to result in supernormal profits being competed away. The question of whether firms in an oligopoly collude or compete has a substantial impact on how the overall market performs in terms of resource allocation, and whether consumers will be disadvantaged as a result of the actions of the firms in the market.
What is a ‘barrier to entry’?
A characteristic of a market that prevents new firms from readily joining the market
How can a barrier to entry and exit be enforced?
If a firm holds a patent on a particular good,
this means that no other firm is permitted by law to produce the product, and the patent-holding firm therefore has a monopoly. The firm may then be able to set price such as to make supernormal profits without fear of rival firms competing away those profits. On the other hand, if there are no barriers to entry in a market, and if the existing firms set price to make supernormal profits, new firms will join the market, and the increase in market supply will push price down until no supernormal profits are being made.
Firms may also face barriers to exit - a situation in which leaving a market may cause the firm to incur high costs. For example, there may be significant sunk costs that cannot be recovered if a firm leaves its market. Such costs may arise because a firm has invested in specific capital goods that cannot be used for alternative purposes, or it may have contracts with suppliers that cannot be broken.
What is the definition of perfect competition?
A form of market structure that produces allocative and productive efficiency in long run equilibrium.
What are the assumptions of perfect competition?
- Firms aims to maximise profits
- There are many participants, none of which is large enough to influence price
- The product is homogenous
- There are no barriers to entry or exit from the market
- There is perfect knowledge of market conditions
How does perfect knowledge work in perfect competition?
It is assumed that all participants in the market have perfect information about trading conditions in the market. In particular, buyers always know the prices that firms are charging, and can therefore buy the good at the cheapest possible price. Firms that try to charge a price above the market price will get no takers. At the same time, traders are aware of the product quality.
What does a price taker mean?
A firm must accept whatever price is set in the market as a whole.
If a firm is a price taker, what would the demand curve look like?
It would be a perfectly elastic demand curve, so a horizontal line.
When would a firm exit the market in PC?
If the price falls below short-run average variable cost, the firm’s best decision will be to exit from the market, as it will be better off just incurring its fixed costs. So the firm’s short-run supply (SRS) curve is the SMC curve above the point where it cuts SAVC (at its minimum point).
How does industry equilibrium in the short run work?
If you add up the supply curves of each firm operating in the market, the result is the industry supply curve. The price will then adjust to P1 at the intersection of demand and supply. The firms in the industry between them will supply Q1 output, and the market will be in equilibrium.
How does perfect competition work in the short run?
However, now the firm’s average revenue (which is equal to price) is greater than its average cost. The firm is therefore making supernormal profits at this price. (Remember that ‘normal profits’ are included in average cost.) Indeed, the amount of total supernormal profits being made is shown as the shaded area on the diagram.
This is where the assumption about freedom of entry becomes important. If firms in this market are making profits above opportunity cost, the market is generating more profits than other markets in the economy. This will prove attractive to other firms, which will seek to enter the market - and the assumption that there are no barriers to prevent them from doing so.
This process of entry will continue for as long as firms are making supernormal profits. However, as more firms join the market, the position of the industry supply curve, which is the sum of the supply curves of an ever-larger number of individual firms, will be affected. As the industry supply curve shifts to the right, the market price will fall. At some point the price will have fallen to such an extent that firms are no longer making supernormal profits, and the market will then stabilise.
If the price were to fall even further, some firms would choose to exit from the market, and the process would go into reverse. Therefore price can be expected to stabilise such that the typical firm in the industry is just making normal profits.
Another situation may be that a firm also tries to maximise profits by setting MC = MR, but finds that its average cost exceeds the price. It makes losses shown by the shaded area, and in the long run will choose to leave the market. As this and other firms exit from the market, the market supply curve shifts to the left, and the equilibrium price will drift upwards until firms are again making normal profits.
How does PC work in the long run?
It is shown in the situation for a typical firm and for the industry as a whole once long-run equilibrium has been reached and firms no longer have any incentive to enter or to exit the market. The market is in equilibrium, with demand equal to supply at the going price. The typical firm sets marginal revenue equal to marginal costs to maximise profits, and just makes normal profits.
What does the industry long-run supply (LRS) curve show?
Under perfect competition, the curve that, for the typical firm in the industry, is horizontal at the minimum point of the long-run average cost curve.
How does different cost conditions affect LRS?
If firms are not identical, but face different cost conditions, then the LRS may slope upwards. This could happen because some firms face a more favourable environment than others. Perhaps their location confers some advantage because they are closer to the market, or to some raw material. This would then allow some firms to survive for longer if the market price falls. In this case, as price falls, the least efficient firms would exit from the market until the marginal firm just makes normal profits. Notice this also suggests that the most efficient firms in the market are able to make some supernormal profits even in long-run equilibrium, and it is only the marginal firm that just breaks even.
How is allocative efficiency enforced in PC?
For an individual market, allocative efficiency is achieved when price is set equal to marginal cost. In perfect competition, the process by which supernormal profits are competed away through the entry of new firms into the market ensures that price is equal to marginal cost when the market is in long run equilibrium. So allocative efficiency is achieved. Indeed, firms set price equal to marginal cost even in the short run, so allocative efficiency is a feature of perfect competition in both the short run and the long run.
How is productive efficiency enforced in PC?
For an individual market, productive efficiency is reached when a firm operates at the minimum point of its long-run average cost curve. Under perfect competition, this is indeed a feature of the long-run equilibrium position. So productive efficiency is achieved in the long run - but not in the short run, when a firm is not necessarily operating at minimum average cost.
What is the evaluation of PC?
A criticism sometimes levelled at the model of perfect competition is that it is merely theoretical ideal, based on a sequence of assumptions that rarely holds in the real world. Perhaps you have some sympathy with that view.
It could be argued that the model does hold for some agricultural markets. One study in the USA estimated that the price elasticity of demand for an individual farmer producing sweetcorn was -31,353, which is pretty close to perfect elasticity.
However, to argue that the model is useless because it is unrealistic is to miss a very important point. By allowing a glimpse of what the ideal market would look like, at least in terms of resource allocation, the model provides a measure against which alternative market structures can be compared. Furthermore, economic analysis can be used to investigate the effects of relaxing the assumptions of the model, which can be another valuable exercise. For example, it is possible to examine how the market is affected if firms can differentiate their products, or if traders in the market are acting with incomplete information. The impact of the internet on how markets work is also significant in this respect, as information is becoming much more accessible than ever before.
So, although there may be relatively few markets that display all the characteristics of perfect competition, that does not destroy the usefulness of the model in economic theory. It will continue to be a reference point when examining alternative models of market structure.
Why may PC not be the best market structure?
Some writers, such as Nobel prize winner Friedrich von Hayek, have disputed the idea that perfect competition is the best form of market structure. Hayek argued that supernormal profits can be seen as the basis for investment by firms in new technologies, research and development (R&D) and innovation. If supernormal profits are always competed away, as happens under perfect competition, such activity will not take place. Similarly, Joseph Schumpeter argued that only in monopoly or oligopoly markets can firms afford to undertake R&D. Under this sort of argument, it is not quite so clear that perfect competition is the most desirable market structure.
