Perfect Competition

Question 1

Characteristics of Perfect Competition

Answer 1

• Unlimited number of buyers and sellers in the market (many firms)
• No barriers to entry or exit in the market (free entry)
• Homogenous goods
• Price takers (firm as price taker)
• Perfect knowledge
• Perfect mobility

Imagine: Two identical goods in two identical shops. One cannot put the price up or they won’t sell.

Question 2

Short run

Answer 2

The short run is a period too short for new firms to enter the market.

Question 3

Marginal revenue

Answer 3

the addition to revenue from selling an additional unit of output

Question 4

Average revenue

Answer 4

revenue earned per unit of output

Question 5

Marginal cost

Answer 5

the addition to cost from producing an additional unit of output

Question 6

Average cost

Answer 6

cost per unit of output

Question 7

What happens to the market in the long run?

Answer 7

• The long run is a period long enough for new firms to enter (or exit) into the market.
• If potential firms see that profit is being earned they will attempt to enter the market.
• If firms are making a loss, they will exit the market.

Question 8

Profit

Answer 8

Profit maximising condition: MR = MC.

MC< MR = cost of producing the last unit is less than the revenue from selling it –> continue to produce until Q where MR = MC.

MC > MR = cost of producing the last unit is greater than the revenue from selling it –> reduce output until Q where MR = MC.

Question 9

Profit in Short Run

Answer 9

Abnormal profit - As new firms enter the market, increased competition drives prices down. Prices will keep falling until firms reach the break-even point, where total revenue = total cost.

Loss - When firms making a loss leave the market, the reduced in competition raises prices. Prices will continue to rise until firms reach the break-even point, where total revenue = total cost.

Question 10

Profit in Long Run

Answer 10

However, firms in perfect competition are only able to earn supernormal profit in the short run.

Therefore, in long run, all firms operate at break-even point

Question 11

Efficiency

Answer 11

Short run - it is allocatively efficient, but not productively efficient.

Long run - it is both allocatively and productively efficient

Question 12

Allocative/Economic efficiency

Answer 12

When firms allocate resources into the production of goods desired by consumers. It occurs when price equals marginal cost.

AR = P = MC

Question 13

Abnormal Profit Diagram

Answer 13

Question 14

Loss Driagram

Answer 14

Question 15

Perfect Competition Diagram

Answer 15

Question 16

Long Run Diagram

Answer 16

Question 17

Shape of the demand curve in Perfect Competition

Answer 17

• Perfectly Elastic - any price change causes consumers to switch sellers

Question 18

Why is the demand curve elastic?

Answer 18

• In a perfectly competitive market, firms are price takers and must accept the market price.
• Goods are homogenous, so consumers can easily switch between sellers.
• If one seller charges even slightly more, consumers will buy from the cheaper seller. Thus, all sellers charge the same price, at the break-even point.