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

Shape of the demand curve in perfect competition

Answer 2

• 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 change the same price, just at the break-even point.
• The demand curve is perfectly elastic, meaning any price change causes consumers to switch sellers.

Question 3

short run

Answer 3

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

Question 4

Marginal revenue

Answer 4

the addition to revenue from selling an additional unit of output.

Question 5

Average revenue

Answer 5

revenue earned per unit of output

Question 6

Marginal cost

Answer 6

the addition to cost from producing an additional unit of output

Question 7

average cost

Answer 7

cost per unit of output

Question 8

Cost and revenue curves in the long run

Answer 8

• the long run is period of time 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 9

Profit maximisation

Answer 9

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 10

Profit in the short run

Answer 10

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

Question 11

Profit in the long run

Answer 11

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 12

Efficiency

Answer 12

Short run - it is allocatively efficient, but not productively efficient
Long run - it is both allocatively and productively efficient

Question 13

Allocative/Economic efficiency

Answer 13

when firms allocate resources into the production of goods desired by consumers. it occurs when price equals marginal cost.
AR = P = MC

Question 14

Abnormal profit diagram

Question 15

Loss diagram

Question 16

Perfect competition diagram

Question 17

Long run diagram

Question 18

Shape of the demand curve in perfect competition (2 diagrams)