Pefect Competition

Question 1

Perfectly Competitive markets have certain Characteristics

Answer 1

1. Model of perfect competition = description of how a market would work if certain conditions were satisfied
2. Its theoretical - there are no real markets that work quite like this. But understanding how perfect competition works makes it easier to understand what’s going wrong with real-life markets when they have undesirable results.

Question 2

In a perfectly competitive market, the following conditions are satisfied

Answer 2

1. There’s an infinite number of suppliers and consumers.
   - Each of these suppliers is small enough that no single firm or consumer has any ‘market power’ (i.e. no firm can affect the market of their own).
   - Each firm is a ‘price taker’ - this means they have to buy or sell at the current market price.
2. Consumers have perfect information - i.e. perfect knowledge of all goods and prices in a market.
   - Every consumer decision is well-informed - consumers know how much every firm in the market charges for its products, as well as all the details about those products.
3. Producers have perfect information - i.e. perfect knowledge of the market and production methods.
   - No firm has any ‘secret’ low-cost production methods, and every firm knows the prices charged by every other firm.
4. Products are identical (homogeneous)
   - So consumers can always switch between products from different firms (i.e. all products are perfect substitutes)
5. There are no barriers to entry and no barriers to exit
   - New entrants can join the industry very easily. Existing firms can leave equally easily.
6. Firms are profit maximisers
   - All the decisions that a firm makes are geared towards maximising profit
   - This means that all firms will choose to produce at a level of output where MC = MR

Question 3

Perfect competition leads to Allocative Efficiency… usually

Answer 3

1. Conditions for a perfectly competitive market ensure that the rationing, signalling and incentive functions of the price mechanism work perfectly. In particular:
   - all firms are price takers (‘the market’ sets the price according to consumers’ preferences, rationing resources and signalling priorities),
   - consumers and producers have perfect knowledge of the market, and there are no barriers to entry or exit (so firms can recognise and act on incentives to change their output level or enter/ leave a market).
2. In perfect competition, a market’s demand curve = marginal utility (MU), because consumers’ demand reflects what that good is worth to them and that decreases as quantity increases due to the law of diminishing marginal utility
3. Also, a market’s supply curve = marginal cost (MC), because producers’ marginal costs increase as quantity increases due to the law of diminishing returns
4. Allocative efficiency occurs when a good’s price is equal to what consumers want to pay for it, and this happens in a perfectly competitive market because the price mechanism ensures that producers supply exactly what consumer’s demand. So, P = MC or P = MU
   * LOOK AT DIAGRAM ON PAGE 58*
5. Without perfect competition, a market can’t achieve allocative efficiency.

Question 4

Allocative efficiency and externalities

Answer 4

Perfectly competitive markets will achieve allocative efficiency, assuming that there are no externalities:

• Strictly speaking, allocative efficiency occurs when P =MSC (marginal social cost - i.e. including external costs to third parties).
• Perfect competition results in a long run equilibrium where P = MPC (marginal private cost - i.e. the cost the for the firm producting the product, ignoring external costs)
• But if there are negative externalities, say, then MPC < MSC - which means that P < MSC. This will mean thaat there’s allocative inefficiency, and that will => to overproduction and overconsumption.

Question 5

Perfect Competition means Supernormal Profits are Competed Away

Answer 5

1. In perfect competition, no firm will make supernormal profits in the long run.
2. This is because any short-term supernormal profits attract new firms to the market (since there are no barriers to entry). This means supernormal profits are ‘competed away’ in the long term - i.e. firms undercut each other until all firms make only normal profit.
3. These diagrams show how this equilibrium is maintained in the long run.
   - Suppose there’s high demand for a product across an industry as a whole, => a firm making supernormal profits, AS SEEN IN DIAGRAM PAGE 59
4. In a perfectly competitive market, those supernormal profits mean other firms will now have an incentive to enter the market. And since there are no barriers to entry, they can easily do this.
   - This results in a shift in the industry supply curve to the right LOOK AT DIAGRAM ON PAGE 59
   - meaning the market price falls until all excess profits have been competed away, and a new equilbrium is reached at P1 (with this firm supplying Q1)

Question 6

A firm will Leave a market if it’s Unable to make a profit in the Long Run

Answer 6

1. If the market price (AR) falls below a firm’s average unit-cost (AC), the firm is making less than normal profit (i.e. a loss).
2. There are no barriers to exit in a perfectly competitive market so in the long run the firm will just leave the market.
3. However, in the short run, there are two possibilities:
   - If the selling price (AR) is still above the firm’s average variable costs (AVC), then the firm may continue to trade temporarily.
   - If the selling price (AR) falls below the level of the firm’s average variable costs (AVC) then it will leave the market immediately.

Question 7

Perfect competition leads to Productive Efficiency - card 1

Answer 7

1. Productive efficiency is about ensuring the costs of production are as low as they can be. This will mean that prices to consumers can be low as well.
2. In perfect competition, productive efficiency comes about as a direct result of all firms trying to maximise profits.
3. At the long run equilibrium of perfect competition, a firm will produce a quantity of goods such that:
   marginal revenue (MR = marginal costs (MC)
   - Output above this level (MC>MR) reduces profit, so firms wouldn’t produce it.
   - Output below this level (i.e. MR>MC) would mean the firm would earn more revenue from extra output than it would spend in costs - so the firm would expand output as this would increase profit.
   LOOK AT DIAGRAM PAGE 60

Question 8

Perfect Competition leads to productive efficiency - card 2

Answer 8

4. Its no accident that in a perfectly competitive market, this long run output level is at the bottom of the average-cost (AC) curve - i.e. at the lowest possible cost level. In other words, firms in a perfectly competitive market will be productively efficient.
5. Having to compete gives firms a strong incentive to reduce waste and inefficiency. In other words, firms need to keep their level of ‘x-inefficiency’ as low as possible - if they don’t, they may be forced to leave the market.
   - X-efficiency measures how successfully a firm keeps its costs down. X-inefficiency (or ‘organisational slack’) means that production costs could be reduced at that level of production. X-inefficiency can be caused by either
   a) using factors of production in a wasteful way (e.g. by employing more ppl than necessary) or
   b) paying too much for factors of production (e.g. paying workers more than is needed or buying raw materials at higher prices than necessary).
6. But perfectly competitive markets only achieve productive efficiency if you assume that there are no economies of scale in the industry.
   - In a perfectly competitive market, there’s an infinite number of firms
   - This means that each firm is very small, and so can’t take full advantage of economies of scale.
   - If there are economies of scale, then an industry made up of an infinite number of very small firms may be less productively efficient than if there was one very big firm (i.e. a monopoly) as seen on p.60

Question 9

Perfect competition Doesn’t lead to Dynamic Efficiency

Answer 9

1. Dynamic efficiency is about improving efficiency in the long term, so it refers to the willingness and eagerness to
   a) carry out research and development to improve existing products or develop new ones
   b) to invest in new technology or training to improve the production process and reduce production costs.
2. However, these strategies involve a considerable amount of investment and therefore risk, so they will only take place if there is adequate reward.
3. Firms in a perfectly competitive market earn only normal profit, so there’s no reward for taking risks. This means dynamic efficiency will not be achieved.
4. However, as long as a market is towards the ‘perfect-competition end’ of the spectrum shown (as seen on p.61), then firms can achieve a degree of dynamic efficiency without becoming too allocatively and productively inefficient. This is why firms do achieve some degree of dynamic efficiency - in real life, no market is perfectly competitive.

Question 10

Perfect competition does lead to Static Efficiency

Answer 10

1. If allocative and productive efficiency are achieved at any particular point in time, this = static efficiency. But static efficiency can’t last forever, since technology and consumer tastes change. E.g. the methods used to make cars in the 1920s might have been allocatively and productively efficient at the time, but they’d be hopelessly out of date now.
2. To remain allocatively and productively efficient, car makers would have needed to invest in new production technology and design new models at some point

Question 11

In Real Life there’s a ‘Spectrum’ of different market structures

Answer 11

1. In a perfectly competitive market, all the goods produced are identical, so the only way for firms to compete is on price. Only can compete with rivals by selling their products at lower prices.
2. In practice, firms usually compete in other ways than on price - e.g., they might use:
   - Improved products
   - Advertising and promotion
   - Better quality of service
   - Nicer Packaging
   - Wider product ranges
   - Products that are easier to use
3. In the real world, markets fall somewhere on a ‘spectrum’ of different market structures.
   LOOK AT DIAGRAM ON PAGE 61
4. At one extreme are ‘perfectly competitive markets’, and at the other are ‘pure monopolies’ (where there’s no competition at all). Real-life markets lie somewhere between these extremes.
5. The closer an actual market matches the description of a perfectly competitive market, the more likely it is to behave in the same way.

Question 12

Governments often try to Encourage Competition in markets

Answer 12

1. Perfectly competitive markets => efficient in the long run outcomes in theory (e.g. the long run equilibrium is allocatively and productively efficient, and firms are forced to become x-efficient).
2. By encouraging competition, govts hope to achieve these same kinds of efficiencies in real life. E.g, governments want to make sure firms:
   i) Are forced to produce efficiently, reducing costs where possible,
   ii) set prices at a level that’s fair to consumers,
3. They also hope competition will encourage firms to innovate, leading firms to create both new products (giving more choice for consumers) and new production processes (allowing firms to reduce their costs further).

Question 13

There are various policies a govt can introduce to increase competition in the economy:

Answer 13

1. Encourage new entreprises and advice and start-up subsidies.
2. Increase consumer knowledge by ensuring that comparison information is avaliable.
3. Introduce more consumer choice and competition in the public sector. This might involve creating ‘internal markets’ in sectors such as health and schooling, e.g.
4. Privatise and deregulate large monopolistic nationalised industries.
5. Discourage mergers and takeovers which might excessively reduce the number of competing firms.
6. Encourage more international competition - e.g. by joining the EU, countries enter into a multinational ‘single market’