Market Structures and Perfect Comp

Question 1

Conditions for firms in perfect comp

Answer 1

• Lots of firms all with very small market share, no individual firm has enough market power to influence the market.
• The products firms are selling are perfectly homogenous, there are no ways to differentiate their products from competitors and consumers are indifferent between which producer they buy from. Branding is non-existent or has no impact on consumer prefference.
• Firms are price takers, facing perfectly elastic AR curves and having no influence over market price.
• There is perfect information between sellers and between buyers and sellers, this means firms cant take advantage of asymmetrical information and consumers are always aware of the prices all firms are charging.
• There are no patents or other protection afforded to incumbent firms and there are no entry/exit barriers allowing firms to freely enter and exit this market at will.
• We assume that all agents act rationally, consumers look to maximise utility and producer act to maximise therir profit.

Question 2

Some examples of the market

Answer 2

• Certain commodities markets
• Foreign exchange markets

Question 3

Perfect comp diagram

Answer 3

Firms take its selling price from the market equalibrium. All fimrs will sell at this same price (due to homogenous prodcuts, zero branding and limited market share. It will be the prevailing price where profits are eroded to normal levels. AR=ATC at profit maximising quantity of Qpm.

Question 4

Perfect comp in the short run vs the long run

Answer 4

There can be a short run movement away from this equalibirium following changes in the overall market. These are resolved through further adjustments and thus the diagram for perfect comp shows the long run equalibirum of the market.

Question 5

What happens if there is a increase in market demand

Answer 5

• The market is orgininally at equalibirum where the market supply S1 intersects the market demand D1, this results in a market clearing price of P1 and a equalibirum quantity of Q1.
• Firms are price takers due to the large number of firms in the market and the inability to product differentiate, this means that each firm takes the market price at P1, resulting in a perfectly elastic AR curve for each firm.
• Assuming the firm is rational, they will operate at profit max and produce at MC=MR, due to the highly competitive nature of the market firms will make normal profits.
• If there is a shock to the market resulting in a increase in the demand curve, the demand curve shift from D1 to D2. There is a resultant extension in supply and a new market equalibrium at P2 and Q2.
• Price taking firms will therefore raise their prices and take the new high makret price, this leads their AR curve to shift upwards. As MR also shifts with AR the Profit maximising kevel has changed. Individual firms how are generating supernormal profits as AR is greater than AC at QPM2.
• New supernormal profit incentivises firms to enter this market, lack of entry and exit barriers make this possibe. Inflow of new firms into the market although increases market supply from S1 to S2, firms are price takers and the AR falls along with supernormal profits to normal profits.
• This results in a stable, long run equalibrium for firms in perfectly competitive markets.

Question 6

What happens if there is a decrease in market demand

Answer 6

• If there is a decrease in the market demand curve from D1 to D2, resulting in a contraction in market supply, a new market equalibirum forms at Q2 and P2.
• Price takers lower their prices to this new, lower market price, this lead to their AR curve shifting downwards. As MR has alos shifted with AR, the PM level has now changed to a lower equalibirum Q. The result of this is firms now generate subnormal profits
• This incentives some exisitng firms to leave the market, made possible by lack of exit barriers. This results in a decrease in market supply, and the equalibrium is pushed back upwards to the previous price level, this results in the AR curve shifting upwards, profit max returning to the original position and subnormal profits being eroded away to normal profits again.
• This results in a stable long run equalibrium in prefectly competitive markets where MC=MR=AR=AC.

Question 7

Allocative efficiency in perfect Comp.

Answer 7

AR=MC

In a perfect comp market, in the short run the market could not be allocative efficient, but in the long run they will always operate at a allocative efficient equalibrium of AR=MC.

Question 8

Productive efficiency

Answer 8

This is using the fewest resources per unit of output and at ATC=MC

In perfect Comp firms wil be productive efficient in the long term as they can only make normal profits, this means they have to minimise costs as much as possible to remain in the market. In the S.R firms might deviate from MC=ATC as profits can be supernormal.

Question 9

X efficiency

Answer 9

Competition between firms will act as a spur to increase efficiency, in perfect comp this is likely to occur.

Question 10

Dynamic Efficiency

Answer 10

Lack of supernormal profit may make investment in R&D unlikely. This is important in an industry such as pharmaceuticals which require significant investment. Because there is a lack of investment, the firms may become static – there is no improvement in productivity and no reduction in costs over time; this makes them dynamically inefficient.