LS8 - Perfect Competition

Question 1

What are the assumptions of perfect competition?

Answer 1

1. Firms aim to maximise profits (setting price where MR=MC)
2. There are many participants (both buyers and sellers)
3. Product is homogenous
4. There are NO barriers to entry or exit from the market
5. There is perfect knowledge of market conditions
6. There are no externalities

Question 2

Describe how firms profit maximise in perfect competition

Answer 2

Firms act in their own self-interest and set a price similar to competition as this allows them to maximise profits

Question 3

Why are there many participants in a perfect market?

Answer 3

• perfect knowledge and competition prevents economies of scale
• Market price is determined by the operation of the market. Therefore there are limited economies of scale and no singular firm can grow large enough to have any influence in the market

Question 4

Why is a homogenous product a characteristic of perfect competition?

Answer 4

• all products are identical so consumers will not prefer one firm’s over another
• lack of brand loyalty prevents firms from charging a premium on their product.
  This helps to reinforce the fact that no firms have the power to influence the selling process of the product

Question 5

How do the lack of barriers to entry or exit contribute to perfect competition?

Answer 5

• when existing firms in the industry are making supernormal profit, new firms can join without hindrance
• when existing firms in the industry are making losses, they can exit with ease
• this is important when considering the long-run equilibrium towards which the market tends to

Question 6

Explain how perfect knowledge contributes to perfect competition

Answer 6

• all participants have perfect knowledge about trading conditions
• buyers always know where to buy the good at the cheapest possible price (firms charging above the market price will make no sales)
• traders are aware of product quality

Question 7

Explain how a lack of externalities contributes to perfect competition

Answer 7

Prevents the attainment of allocative efficiency

Question 8

In perfect competition how does the market return to equilibrium when firms are making supernormal profit?

Answer 8

• perfect knowledge means firms are aware that firms within an industry are making supernormal profit
• there are no barriers to entry (the homogenous nature of the product further encourages entry)
• therefore firms will enter the industry causing the industry supply curve to shift RIGHT
• the market price FALLS
• it continues to FALL until firms are making normal profit
• firms set marginal revenue equal to marginal cost to maximise profit and make normal profit

Question 9

In perfect competition how does the market return to equilibrium when firms are making losses?

Answer 9

• there are no barriers to exit
• therefore firms will exit the industry
• The industry supply curve shifts LEFT
• the market price rises
• it continues to rise until firms are making normal profit

Question 10

Define productive efficiency. Is it achieved by a market in perfect competition?

Answer 10

• this is when a firm operates at the minimum point of its long-run average cost curve.
• in the short run this is not necessarily achieved as firms need not operate at minimum average cost
• in the long run this is achieved in the long run equilibrium position

Question 11

Define allocative efficiency. Is it achieved by firms in perfect competition?

Answer 11

• when price is set equal to marginal cost
• as firms can only make normal profits in the long run allocative efficiency is achieved in BOTH the long and short run.

Question 12

What are the criticisms and uses of the perfect competition model in economic theory

Answer 12

This model is often criticized as an unrealistic theoretical ideal based on assumptions that seldom reflect real-world markets. However, some agricultural markets may approach this ideal, such as a study showing nearly perfect elasticity for sweetcorn (-31), dismissing the model as useless overlooks its value.

It serves as a benchmark for comparing alternative market structures and allows for economic analysis by relaxing its assumptions, such as product differentiation or incomplete information. Thus, despite few markets fully embodying perfect competition, the model remains useful in economic theory and analysis of market structures.