Perfect Competition Flashcards
Explain the characteristics of firms in a perfectly competitive market structure and their implications on how firms behave.
1) Number of producers: Large number of small firms relative to market size. Large numbers of buyers and sellers results in each firm having no significant share of the total market output. As a result, each firm has an insignificant share of the market and can act independently of the other.
2) Extent of barriers to entry and exit: Financial, technical or government-imposed barriers are absent. Low start-up costs allow potential entrants to enter. Each firm has an insignificant share of the market and can act independently in deciding its own output level
3) Nature of good: Homogeneous
Products of rivals are perfect substitutes and there is no rivalry among firms in advertising and quality differences. Buyers will not have preferences and sellers have no advantage over one another
4) Perfect knowledge
Rivals have complete information about production costs of rivals, prices, available production technology. Buyers have complete information about sellers’ price, quality and availability of products
5) Market power: Price taker due to the homogeneity of product, insignificant market share and perfect knowledge, each firm must sell at the price determined by market demand and supply as consumers will not purchase from a firm that sells its goods at a higher price than the prevailing PE.
Explain why a perfectly competitive firm has a perfectly price elastic demand curve.
In a perfect market structure, firms are price takers and have no incentive to increase or reduce prices hence demand is perfectly price elastic and the demand curve is a horizontal straight line which is also equal to the price of the good (determined by supply and demand of the market), average revenue and marginal revenue regardless of output level because the sale of each and every additional unit adds the exact same amount to the total revenue.
Distinguish between a perfectly competitive firm’s and industry’s demand curve.
The market demand curve slopes downward, while the perfectly competitive firm’s demand curve is a horizontal line equal to the equilibrium price of the entire market. The horizontal demand curve indicates that the elasticity of demand for the good is perfectly elastic.
Explain the output decisions of a PC firm.
The PC firm produces at the profit maximising equilibrium where the firm has no tendency to change its price and output decisions. Although it cannot determine its own price, it has the ability to decide on its output level that maximises total profit which is where MC = MR and MC must be rising. This is because when MC is decreasing, an incremental unit of production adds more to the firm’s revenue than to the firm’s total costs. The firm will be more profitable if it increases production. When MC is increasing, an incremental unit of production adds more to the firm’s costs than it does to its revenue. The firm will minimise its losses/maximise profits by stopping production.
Explain long-run equilibrium of a perfectly competitive firm and its industry in terms of:
• Adjustment from short run supernormal profit to long run equilibrium
• Adjustment from short run subnormal profit to long run equilibrium
Supernormal to normal:
A PC firm can only make a maximum of normal profits in the long run because there are no barriers to entry or exit, hence any firm that sees that there are supernormal profits to be gained in the industry has the ability to enter and compete in that industry in the long run. In the short run, the presence of supernormal profits attracts new firms to enter the market. The increase in the number of firms leads to an increase in quantity supplied at every price in the market. Market supply increases (The market supply curve shifts to the right), leading to a surplus at the original market price. This causes the equilibrium market price to fall. As PC firms are price-takers, they now have to sell at a lower price, eroding their supernormal profits. Eventually, when the market supply curve has shifted to the right, with a resultant fall in market equilibrium price to the new equilibrium price, the supernormal profits of the firms will be completely eroded and the firms remaining will only be making normal profits at their new and lower profit-maximising output where MC = MR and MC is rising. (Overall market quantity increases but each firm would have reduced its own quantity.)
Subnormal to normal:
When PC firms experience subnormal profits in the short run, they expect the subnormal profits to persists and will decide to shut down and leave the market in the long run (facilitated by the lack of barriers to exit). This leads to a fall in the quantity supplied of output in the market at every price level, hence market supply falls, causing a shortage at the initial equilibrium price. Price adjustment process. Eventually, the losses of the PC firms who survived will be reduced and they will make normal profits.
Evaluate the merits and demerits of perfect competition using the following criteria: productive efficiency, allocative efficiency, dynamic efficiency, consumer surplus, choice and equity.
A PC firm is a price-taker hence its demand is perfectly price elastic and Price = AR = MR. At the profit-maximising output level where MR = MC and MC is rising, P = MC and firm is allocatively efficient.
Only firms in PC attain productive efficiency as they operate at its MES, its lowest LRAC since it is a price taker and has to be as cost-efficient as possible in order to maximise profits and not leave the industry in the long rrun.
PC firms tend to spread opportunities and wealth more widely and evenly. Without BTEs, the profits are spread amongst many small firms, leading to equity. In addition, consumer surplus is maximised when P=MC.
The PC firm does not have the ability or the incentive to be dynamically efficient relative to the MPC or oligopoly due to the assumption of perfect information, long-run normal profits and assumption of homogeneous products.
PC do not provide consumers with choices in terms of product given that the goods are homogeneous. Instead, there is a choice of many producers. The PC market also reacts to consumer demand responsively and changes in demand will lead to changes in eqm price with a resultant allocation of resources to meet the consumers’ wants, leading to consumer sovereignty.
