Perfect Competition Flashcards
Describe the 6 characteristics of a Perfect Competition Market Structure
- There are no barriers to entry
- All goods in the industry are homogenous (all products are the same)
- There is a very large number of firms
- All producers and consumers have perfect knowledge (meaning that they know of all the qualities, prices, and availabilities of each respective good)
- Firms can enter and leave the industry freely (free market)
- Firms are profit maximisers (so firms will produce were MC = MR)
Why is the demand curve for a firm of a firm in a perfectly competitive market structure horizontal
Given that all products are homogenous and that there is perfect knowledge, all firms are price takers (cannot influence price) and demand is perfectly elasticity
(there is no market power in this market structure)
Given that firms are price takers, D=AR=MR=P, and the Demand curve is perfectly elastic. Firms cannot lower or increase price without dire consequences (making a loss or decrease profit)
Give 3 examples of some industries are close to having perfect competition
- Wheat businesses in the EU
- All farms are small relative to size of EU, so one firm changing output will have no real impact on the market
- Wheat is wheat, basically can’t be told apart (product would be homogenous) - Frita Market
- would have very low barriers to entry as preparation of frita doesn’t require much skill or FOP’s
- would have many firms because there are thousands of Zambia’s who sell frita’s by the side of the road everyday
- products would be homogenous as ingredients for basic frita are always the same - Tomatoes Market by the side of the road
- would have very low barriers to entry as growing tomatoes doesn’t require much skill or FOP’s
- would have many firms because there are thousands of Zambia’s who sell tomatoes by the side of the road everyday
- tomatoes are a homogenous arigicultural product
Describe the diagram of an Industry in a Perfectly Competitive Market
Industries in perfect competition will face normal supply and demand curves, meaning law of demand and law of supply would still apply.
Where is the Profit maximising level of output?
where MR = MC
Note: MC always intersect AC at the minimum point
Describe when FOP’s are variable and when Perfectly Competitive firms can leave the market
The short run refers to a period when inputs are fixed.
As long as producers in a industry have fixed inputs, no one can enter or leave the market. Firms can only make a choice on how much quantity of output to produce.
To leave or enter an industry, all inputs must be variable which can happen in the long run
State 2. reasons why is it worth studying Perfect Competition
- very useful because it serves as a benchmark to compare other market structures. It provides a number of insights into competitive markets and how they function
- Economists use this as the model that shows how competition creates an efficient market (allocative and productive efficiency)
Explain what it means to say a firm are making abnormal profit in the short run
A Firm in the industry making abnormal profits in the short run, meaning that they cover their total costs, including opportunity costs.
Explain what it means to say a firm in the Industry is making a loss
Firms in industry are making losses in the short run (they are not covering their total costs, or the opportunity costs.)
Why can firms only make normal profit in the long run?
If firms are making either Short Run Abnormal Profit or Short Run Losses, other firms begin to react and the situation starts to change until an equilibrium point is reached in the long run.
If a firm makes abnormal profit
new firms would be attracted to the market and would join in the hope of also earning abnormal profit. As more firms join, the increase in supply (shift S1 downward to S2) would have the effect of lowering the price but as price falls, abnormal profits also fall. Thus, the price in the market continue to fall until it equals to the minimum AC - resulting - all firms earn normal profit in the end
Suppose firms were making a loss
With all inputs variable, many firms will be incentives to leave the industry and switch production. This causes a decrease in supply (shift S1 upward to S2) causing prices to rise. This continues until the price is equal to AC. The result– remaining firms in the industry earn normal profit
Explain what needs to take place for a firm to break even in the Short run
Average costs must equal average revenue, an occurrence that would cause a firm to make normal profit
(Revenue earned is equal to total economic costs spent )
Why can allocative efficiency be achieved in perfect competition?
Given that all firms make normal profit in the long, where Price = Marginal cost correlates to MB=MC, the point of allocative efficiency is referred to as the socially optimum level of output as the extra benefit to society of getting one more unit of the good (MSB) is equal to the extra cost to society of producing one more unit of the good (MSC).
State 3 Advantages of Perfect Competition
Explain each with reference to an example
Advantages
- Allocative Efficiency is attainable
- firms in this market structure have no market power, thus, in the long run
market outcomes can lead to the best possible allocation of resources based on a mix of what consumers want and need (desirable from the viewpoint of society) - Productive Efficiency is attainable
- Firm’s are said to be productively efficient if they produce at the lowest possible unit cost (lowest point on the average cost curve)
- If a firm is making abnormal profit in short run perfect competition, they will not be producing at the most efficient level.
- However, all firms in a perfectly competitive market operate at this point in the long-run
- Thus, the market is efficient as there is less wastage of the world’s resources due to inefficient resource allocation - Leads to lower prices for consumers
- competition not only creates efficient market outcomes but also makes firms responsive to consumer needs and wants and more inclined to lower prices (e.g In the long run of perfect competition, no firm can achieve abnormal profit, thus, all firms sell at relatively low prices to compete which benefits consumers)
State 3 Limitations of Perfect Competition
Explain each with reference to an example
- Hinges on unrealistic assumptions
- Many, if not all, of these assumptions regarding the characteristics of a perfectly competitive market are unrealistic
2) Lack of product variety
– all products are identical (consumers prefer product variety)
some may even argue the need for product variety justifies a market having inefficient market outcomes (welfare loss)
3) No incentive for Research & development
- - lack of ability to pursue abnormal profit, in the long run, means firms cannot achieve economies of scale and don’t have capacity or incentive to pursue research & development (market consequently will always be stagnat)
4) Firms cannot achieve economies of scale
Draw the diagram and describe a firm making abnormal profit in the short run and why they will eventually only be able to make normal profit in the long run (Example with reference to an example)
At the equilibrium price P1 at Q1 were S intersects D, there is a balance between forces of supply and demand in the market which is unlikely to change without external change. The equilibrium price P1 corresponds to the price received by a firm in perfect competition as well as the AR, MR and D curve. When Average cost is less than average revenue (unit profit) or a firm is making abnormal profit shown by the vertical distance between AR & AC at Qmax on the diagram. However, this isn’t going to last in the long run because this abnormal profit is going to attract new firms into the market who will be able to enter the market due to no barriers to entry and perfect information of market conditions. As the enter the market, this will increase supply from S1 to S2, putting a downward pressure on price cause it fall until their is no more incentive for new firms to enter the market shown by the drop from P1 to P2, corresponding to a fall in price price received by firm and a decrease in the AR, MR, and D from AR1=MR1= D to AR2=MR2=D at the lower output level Q2. Abnormal profits cease in the long run as all firms can only make normal profit due to the fall in the market price
