Perfect competition

Question 1

What are characteristics of perfect competition?

Answer 1

• Large number of buyers and sellers (firms)
• Homogenous (identical) products
• Perfect information
• No barriers to entry or exit
• Firms are price takers - they cannot influence the market price; demand to the firm is perfectly elastic (horizontal) and P=AR=MR
• Supernormal profit is competed away in the long run

Question 2

Show and explain perfect competition in the short run.

Answer 2

In perfect competition, the firm ‘takes’ the market price P. Assuming profit-maximisation, the firm will produce the output Q where MC=MR. At Q, AR is greater than AC, so profit per unit is AB. Total supernormal profit is the shaded area ABCP.

Question 3

When are there minimum losses in the short run for perfect competition?

Answer 3

If the firm faced higher costs, so AC>AR at the output where MC=MR, then the firm is making losses.
* The firm will shut down if its revenue does not cover its variable costs (if AR< AVC) in the short run.
* The firm will stay open in the short run if AR>AVC

Question 4

Show and explain perfect competition in the long run

Answer 4

In the long run, because there are no barriers to entry, new firms will join the market to gain some of the supernormal profit. This causes the market supply curve to shift right and the market price falls to P2. The firm now has to take the new lower price P2: the profit-maximising output falls to Q2, where the firm is making normal profit only.
All supernormal profit is competed away by the entrance of the new firms.
If the firm had been making losses in the short run, some firms would leave the market & market supply shifts left; the market price would rise until the long run equilibrium is restored

Question 5

Is there allocative efficiency (p=MC) in perfect competition?

Answer 5

firms are allocatively efficient in both the short and long run; as a price taker P=MR so when MC=MR, P=MC

Question 6

Is there productive efficiency (min LRAC) in perfect competition?

Answer 6

in the long run, the firm will produce wherethe long run AC curve is at its minimum, so firms are productively efficient

Question 7

Is there dynamic efficiency in perfect competition?

Answer 7

we assume firms make homogenous goods so there is little scope for innovation and differentiated to try to establish some market power. However, it is worth noting that in the real world, firms in competitive markets often are very entrepreneurial and innovative, but these markets may not fully meet the theoretical criteria for perfect competition