Perfect competition Flashcards
What are the conditions for perfect competition
- Many buyers and sellers
- Firms are selling homogenous goods so they are price takers
- No barriers to entry or exit
- Perfect information so consumers know about prices and quality and producers know about prices, technology and costs
- Firms are profit maximisers (MC=MR)
What is the long run equilibrium for a firm in perfect competition
Normal profit, any other type of profit is a short run equilibrium
How can we draw the diagram for the whole market in perfect competition
- Price against quantity graph
- Draw supply and demand and mark the equilibrium price P1
- This is where the firm gets the price from as they are price takers so draw a dotted line across to the firm diagram
How can we draw the diagram for the specific firm in perfect competition
- (Price/costs/revenue) against (quantity) graph
- At P1 (the market price) draw a horizonal line which is AR = MR = D1
- Draw a smiley face AC curve (due to law of diminishing returns)
- Draw the MC curve which cuts AC at the minimum point
How can you show short run supernormal profits on a perfect competition diagram
- Draw AC to be below AR
- Firm is profit maximiser so produces where MC = MR at quantity Q2
- Vertical distance between AR and AC at Q2 is the unit supernormal profit
- x by Q2 to get area of total supernormal profit
Explain the process by which short run supernormal profits are eroded
- Firms will see the supernormal profit and want to enter the market due to the profit incentive
- It is easy for new firms to enter the market as there are no barriers to entry and there is perfect information of market conditions
- Supply in market will continually rise causing price to fall until the difference between AR (price) and AC is 0 i.e. normal profit at which point firms have no incentive to enter the market anymore
What is the easiest way to show the erosion of supernormal profits in the long run on a diagram
- Start by drawing the long run price P2 ( line showing AR2 = MR2 = D2) on the diagram of the firm
- This is at the minimum point of the AC curve as the difference between AR and AC needs to be 0 at MC=MR and MC cuts AC at the minimum point i.e. price is falling
- Draw a dotted line back across to market diagram to mark on P2 as this price came from the market
- Draw the shifted out supply curve accordingly so it now cuts demand at price P2 and quantity Q3
- Draw Q4 on the firm diagram to mark the new MC = MR which occurs at the minimum point of the AC curve where AR=AC so the firm makes normal profits
How can you show short run subnormal profits on a perfect competition diagram
- Draw AC to be above AR
- Firm is profit maximiser so produces where MC = MR at quantity Q2
- Vertical distance between AC and AR at Q2 is the unit subnormal profit i.e. unit loss
- x by Q2 to get area of total subnormal profit i.e. total loss
Explain the process by which short run subnormal profits are eroded
- Firms will see the subnormal profit and want to leave the market and produce their opportunity cost instead where they can make profits
- It is easy for firms to leave the market as there are no barriers to exit
- Supply in market will continually fall causing price to rise until the difference between AC and AR (price) is 0 i.e. normal profit at which point firms have no incentive to leave the market anymore
What is the easiest way to show the erosion of subnormal profits in the long run on a diagram
- Start by drawing the long run price P2 ( line showing AR2 = MR2 = D2) on the diagram of the firm
- This is at the minimum point of the AC curve as the difference between AR and AC needs to be 0 at MC=MR and MC cuts AC at the minimum point i.e. price is rising
- Draw a dotted line back across to market diagram to mark on P2 as this price came from the market
- Draw the shifted in supply curve accordingly so it now cuts demand at price P2 and quantity Q3
- Draw Q4 on the firm diagram to mark the new MC = MR which occurs at the minimum point of the AC curve where AR=AC so the firm makes normal profits
How efficient is a firm in perfect competition in the long run
Static efficiency:
- Allocatively efficient as P = MC
- Productively efficient as min point of AC curve
- X efficient as producing on the AC curve
Dynamic efficiency:
- Not dynamically efficient as no LR supernormal profits
What determines whether a firm in perfect competition will leave the market or stay if subnormal profits are being made
Leave and produce opportunity cost if they are unable to cover their average variable costs
Why is the shutdown condition based on whether the firm can meet its variable costs
- If firm shuts down, TR = 0 and TVC = 0 but still has to pay fixed costs so loss = TFC
- If firm continues, their loss = TFC + TVC - TR
They should shutdown if TFC<TFC+TVC-TR as they can minimise the lost, so if TR<TVC
They should continue if TFC>TR-TFC-TVC so if TR>TVC
If TR=TVC, it doesn’t matter but they may continue to satisfy loyal customers and workers
What does a firm who continues in the loss making market aim for
- That other firms who can’t meet their variable costs will leave, causing long run equilibrium of normal profit or maybe even supernormal profits in the short run
- However, if losses keep persisting, they will have to leave eventually so not shutting down is only for a short while
What is the expression for the shutdown condition
Consider shutting down if AR = AVC
How can you show a firm that is making subnormal profit but shouldn’t shutdown on a diagram
- Draw AR = MR = D
- Draw AVC below AR
- Draw AC above AR (loss)
AC should be slightly above AVC and tending towards AVC (as AFC tends towards 0) - Draw area of subnormal profit
- Explain how AR > AVC so don’t shutdown yet
How can you show a firm that is making subnormal profit but should shutdown on a diagram
- Draw AR = MR = D
- Draw AVC above AR
- Draw AC above AR (loss)
AC should be slightly above AVC and tending towards AVC (as AFC tends towards 0) - Draw area of subnormal profit
- Explain how AR < AVC so shutdown
