LS8 - Perfect Competition

Question 1

Perfect competition model

Answer 1

Allocates resources most efficiently and effectively, best allocation for society

Question 2

Perfect competition assumptions

Answer 2

Firms aim to maximise profits
Many participants (buyers and sellers)
Homogenous product (identical so no brand loyalty)
No barriers to entry or exit from the market
Perfect knowledge of market conditions
No externalities

Question 3

Perfect comp - profit maximising equilibrium in short run

Answer 3

• AR=MR=D line perfectly elastic as firms are price takers
• firm can make normal profit, supernormal profit or a loss

Supernormal profit:
- firms are profit maximisers so set high prices if high demand (MC=MR)
- but due to no barriers to entry/exit & perfect info, new firms enter market to earn same profits = increased supply (AR1 to AR2) so fall in price (P1 to P2) to normal profits

Loss:
- ATC above P1 so making loss
- some firms would leave industry as cant survive = decreased supply = increased prices (P1 to P2) to normal profit

e market equilibrium 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 market 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 firms has returned to a long run stable equilibrium at Q4

Question 4

Perfect comp - profit maximising equilibrium in long run

Answer 4

Only normal profits can be made in LR as perfect info (if prices change, consumers will know and demand will fall)
Firms produce at MC=MR, price level p1 (firms price takers so same as industry p)
AR=AC so no supernormal profits

Question 5

Perfect comp pros, cons and evaluation

Answer 5

PROS:

1. Allocative efficiency is achieved in S/R and L/R. Firms in perfect competition produce where P=MC at the l/r equilibrium. This is where demand= supply maximising the sum of both CS/ PS – key feature of a highly comp industry. At this point, resources are allocated according to consumer demand - consumers getting what they demand at exact quantity desire. Consumer choice is high & prices = low maximising CS in market. The quality of the product being sold is excellent too given the drive to meet the needs and wants of the consumer
   Producers benefit from being allocatively efficient getting ahead of rivals who are not meeting consumer wants and needs= increasing their MS. Overtime = higher profits for business. Perfectly competitive firms must be allocatively efficient otherwise they will lose market share to rivals who are doing so.
2. Productive efficiency is achieved in the long run. 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 as firms cannot increase output and lower their average costs any further. These lower average costs can translate into lower prices for the consumer increasing their consumer surplus
   Producer lower average costs- higher levels of supernormal profit over time and increases in market share if economies of scale benefits translate into lower prices than rivals. Perfectly competitive firms must be allocatively efficient otherwise they will lose market share to rivals who are doing so.

CONS:

Dynamic efficiency isn’t being achieve in l/r. Supernormal profits aren’t being made in long run restricting firms ability to reinvest back into business. Over times consumers don’t benefit with no tech advances of innovative new products reducing choice and also preventing price falls in the future
§ For produces the profit making potential reduces without R&D - new product launches which could’ve been patentable providing monopoly power. New products could’ve increase MS- crucial in comp industry. Technology could’ve allowed cost of productions to be reduced and that’s become more profitable overtime

PRODUCT HOMOGENEITY IS NOT IN THE BEST INTEREST OF CONSUMERS- prefer variety rather than having a large number of different sellers all producing same good/ service. Allocative efficiency - not actually maximise benefit of consumers

EVALUATION:

Static versus dynamic efficiency. Perfect competition deliver static efficiency; consumers benefits usually so do producers where market share can rise. However dynamic efficiency is a big loss along with product homogeneity. Consumers may be willing to lose some static efficiency benefits, instead paying slightly higher prices in return for differentiated goods and innovative product development overtime

The notion that firms are always dynamically inefficient and highly competitive industry is due to 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 such a fiercely competitive market. This
will be in the long-term interest of firms - element of monopoly power - can exploit to increase profit over time

IS IT REAL- Most firms have some degree of price setting power. Merely a theoretical idea based on a sequence of assumptions that rarely holds in the real world

Homogenous products- patents, control of intellectual property, ignored by perfectly competitive model

Rare for entry and exit in an industry to be cost less

Highly complex products- information gaps facing consumers- live in a world of complex products