Chapter 4: Perfect competition

Question 1

List the key characteristics of a perfectly competitive market?

Answer 1

1. Atomistic firms, not large enough to influence supply or price
2. Product homogeneity
3. Firms are price takers
4. Little to no barriers to entry
5. P=MC
6. Perfect information

Question 2

Why is P always equal to MC in a perfectly competitive market?

Answer 2

Because MR is constant and since MR=MC and P=MR, transitively, P=MC

Question 3

What determines whether a shift in a curve leads to a price or output effect?

Answer 3

Elasticity of the other curve i.e if supply shifts and demand is highly elastic, quantity is expected to change more than price, resulting in an output effect. This however depends also on the elasticity of supply.

Question 4

What happens in the LR in a perfectly competitive market?

Answer 4

All firms make normal profits due to the relative ease of exit and entry.

Question 5

Why might a PC market be considered inefficient?

Answer 5

From a dynamic point of view, there is no incentive to attempt to generate an economic profit since rents cannot be extracted from a profitable product due to zero barriers to entry.

Question 6

What is observed empirically?

Answer 6

Monopolistic competition seems to be the more realistic model.

For example:
Some firms have lower marginal costs, allowing for P>MC and the sustenance of economic profit.
Product differentiation can also lead to a divergence in P
Markups do exist since P>MC

Question 7

How does trade create surplus?

Answer 7

Consumers paying less than they might have been willing to pay

Question 8

Describe the fundamental theorem

Answer 8

Allocative efficiency corresponds to maximum surplus