Perfect Competition

Question 1

Characteristics of Perfect Competition

Answer 1

Perfectly Competitive Market:
- Many buyers & sellers
- Price takers
- Free entry to & exit the market
- Perfect Knowledge
- Homogeneous goods
- Firms are short run profit maximisers
- Factors of production are perfectly mobile

• Profits likely to be lower as each firm has small market share
• If firms make a profit, new firms will enter the market, due to low barriers to entry, to attain profit
• New firms will increase supply lowering avg. price
• Incumbent firms’ profits will be competed away

Question 2

Profit Maximising Equilibrium in SR

Answer 2

• SR, firms make supernormal profits. LR, profits are competed away, only normal profits are made
• Diagram shows SR equilibrium for a perfectly competitive market
• Firm is price taker, accepts industry price P1
• In SR, firm produces at output Q1
• Yellow shaded rectangle shows the area
  of supernormal profits
• It is assumed that firms are SR profit maximisers

Question 3

Profit Maximising Equilibrium in LR

Answer 3

• Diagram shows LR equilibrium for a perfectly competitive market
• Supernormal profits made by existing firms means that new firms have incentive to enter the industry
• Since there are no barriers to entry, new firms are able to enter the industry
• Causes market supply to increase, shown by S to S1
• Price level falls, since firms are price takers, they accept this new, lower price
• In LR, competitive pressure ensures equilibrium is established
• Supernormal profits have been competed away, so firms only make normal profits in the long run.
• New equilibrium at P=MC means firms produce at the new output of Q2 in LR

Question 4

Adv. & Disadv. of a Perfectly Competitive Market

Answer 4

Advantages:
- In LR, allocative efficiency is achieved, P =MC
- Productive efficiency, firms produce at the bottom of AC curve
- Supernormal profits produced in SR might increase dynamic efficiency through investment

Disadvantages:
- In LR, dynamic efficiency limited due to lack of
supernormal profits
- Few/no EoS since firms are small
- Unrealistic model, in reality, branding, product differentiation, adverts & positive & negative externalities, mean that competition is imperfect