Perfect Competition

Question 1

What is a perfectly competitive market and what are it’s key features(5)?

Answer 1

It is a market that is highly competitive.

Key features:

1) There are a (very) large number of buyers&sellers in the market
2) None of the sellers are large enough to influence the price. They are “price takers”
3) There is freedom of entry & exit from the industry
4) Buyers & sellers have perfect knowledge
5) All firms produce a homogeneous product (ie. exactly the same from all producers). This means that firms can only compete using price.

This kind of market doesn’t really exist, but commodity markets are very close.

Question 2

What do the revenue costs look like in perfect competition and why?

Answer 2

All firms are price takers, so they all sell at “market price” (which is established by the price mechanism, S&D diagram from unit 1). They can sell as much as they like at this price, so they’d never sell below it.
Because each firm is so small an increase in output has only an infinitesimally small effect on market supply and so no effect on the market price.

Therefore for each firm:
1. Demand is perfectly elastic
2. TR = P*Q; AR=TR/Q=P
3. If AR is constant, this can only occur when MR is constant 
=> D=AR=MR(=P)

The D/AR/MR curve is horizontal

Question 3

What is the profit maximizing quantity in perfect competition?

Answer 3

TR&TC Diagram:
MR is the gradient of TR, and as it is constant and positive, TR is a straight line sloping upwards from the origin. Profit maximising is where the gap between TR and TC is the greatest (or the gradient of TR equals the gradient of TC)

Normal Diagram:
As Profit=TR-TC, the Total Profit curve is an upside down parabola.
Mπ(gradient of Tπ)=MR-MC, therefore πmax is at MR=MC.

Question 4

What does the short run equilibrium look like in perfect competition?

Answer 4

Diagram: Perfect Competition
AC - crosses MC below D/MR/AR
Supernormal Profit is being made:
Total π = AπQ = (AR(P)-AC)Q

Question 5

What does the long run equilibrium look like in perfect competition?

Answer 5

The opportunity to get abnormal profits attracts new firms to the market. As new firms enter the market, the market supply slowly rises, pushing down the market price (S&D diagram with increasing supply, thus price falls). Thus in the LR firms face a failing D/AR/MR curve. This process continues until the incentive to enter the market disappears, or no abnormal profit is made.

ONLY NORMAL PROFIT
=> Equilibrium at: AC=MC=MR/AR/D

Question 6

When does the firm leave a perfectly competitive market?

Answer 6

In the LR a firm will leave the market if it is making a loss, i.e. AC is above AR=MC=MR (Loss = (AC-AR)*Q)

However in the SR a firm may continue to produce even if ACAVC we say (AR)P-AVC is a contribution and thus reduces losses. So firms can make less of a loss by staying open, until their contracts (FC’s, rent, electricity) run out.

Question 7

What is productive efficiency?

Answer 7

Productive efficiency - where a firm makes the most efficient use of its inputs, or where costs per unit/AC are at their lowest.
MC=AC

Question 8

What is allocative efficiency?

Answer 8

Allocative efficiency - where resources are used to produce a bundle of goods which satisfies consumers preferences and maximises their welfare, so producing exactly what consumers want and in the correct quality, or S=D in every market.
MC=AR

Question 9

What is dynamic efficiency?

Answer 9

Dynamic efficiency - where resources are allocated efficiently over time, implies improved (cheaper) production methods or the development of new products.

Question 10

How efficient is a perfectly competitive market?

Answer 10

In SR:
Allocatively efficient

In LR:
Both Allocatively and Productively efficient