Perfect Competition

Question 1

What are the characteristics of a competitive market?

Answer 1

Many buyers

Many sellers

Product is homogenous

Consumers have perfect information

Firms are price takers

Firms seek to maximise profits

Firms can freely enter and exit the market

Long run economic profits are set to zero

Question 2

What is a representative firm?

Answer 2

Because all firms are the same, we can use one graph to represent all firms in the market

Question 3

How do firms in a perfectly competitive market calculate profits?

Answer 3

Profits are found by: Profit = TR-TC

Rewrite this expression by dividing and multiplying the right-hand side by Q

Profits = (TR/Q - TC/Q) *Q

Given that TR/Q is average revenue which is equal to the price for a firm in perfect competition, we can rewrite this as:

Profits = (P – ATC) *Q

Question 4

Graph positive economic profits for a firm

Answer 4

Question 5

Graph negative economic profits for a firm

Answer 5

Question 6

Can a perfectly competitive firm have long run economic profits or losses?

Answer 6

Positive economic profits lead to more firms entering the market in the hope of achieving further profits

This increases market supply, decreasing market price

Price will fall until profits are once again equal to zero

Negative economic profits lead to firms exiting the market in the hope of avoiding a loss

This decreases market supply, increasing the market price

Price will rise until profits are once again equal to zero

Question 7

Explain why in perfect competition, the long-run supply curve is perfectly elastic

Answer 7

Firms are always producing where MR = MC

In long-run perfect competition, firms must produce where MR = MC = ATC, so that the firm may have zero economic profits

This means that any shock to the demand for a product will be met by a change in supply that returns the market to equilibrium price

In summary, the long run supply curve is perfectly elastic