Perfect Competition

Question 1

What is perfect competition? Name features.

Answer 1

Perfect competition is a market structure where there are many firms and competitive prices.
1. Many small firms.
2. Freedom of entry and exit; this will require low sunk costs.
3. All firms produce an identical or homogenous product.
4. All firms are price takers; therefore a firm’s demand curve is perfectly elastic.
5. There is perfect information and knowledge for both
consumers and producers.

Question 2

Explain the LRPC diagram

Answer 2

The diagram on the right shows the industry supply and demand; this sets the market price of P1.
•Firms are price takers;
their demand curve is perfectly elastic.
•Firms will maximise profits, where MR=MC (Q1).
•At this level of output Q1, firms make normal profits (AR=AC).

Question 3

Efficiency in PC

Answer 3

1. Allocative efficiency. This is because the long run equilibrium (Q1) occurs where P = MC.
2. Productive efficiency. This is because firms produce at the lowest point on the SRAC.
3. X-efficient. Competition between firms will act as a spur to increase efficiency and make sure firms use the best combination of inputs.
4. Resources will not be wasted through advertising, because products are homogenous.

Question 4

Explain the SRPC diagram

Answer 4

firm and industry

Question 5

Impact of higher demand in PC

Answer 5

•If there is an increase in market demand (D2), there will be an increase in the market price to P2.
•Therefore,the individual demand curve, and hence AR,
will shift upwards.
•Firms will now maximise profits at Q2 (where MR=MC).
•This will cause firms to temporarily make supernormal profits (AR -AC) × Q2.
•However, there is perfect information, so other firms will know this market has supernormal profits.
•There are no barriers to entry, so this will encourage newfirms into the market, until normal profits are made and prices fall back to P1.

Question 6

Impact of higher costs in pc

Answer 6

• If firms had a rise in AC, they would start to make a loss.
• But, if firms make a loss, they will close down, causing the market price to rise until the industry is profitable again.
• Therefore, in the long run, firms in perfect competition will make normal profits (AR=AC).

Question 7

Disadvantages of PC

Answer 7

1. No scope for economies of scale. This is because there are many small firms producing relatively small amounts. Industries with high fixed costs would be particularly unsuitable to perfect competition.
2. Undifferentiated products. These can be boring, giving little choice to consumers.
3. Limited investment. Lack of supernormal profit will make investment in R&D unlikely; this would be important in an industry such as pharmaceuticals.
4. Limited incentives. With perfect knowledge, there is no incentive to develop new technologies, because it w
   ould be shared with other companies.
5. Externalities. If there are externalities in production or consumption, there is likely to be market failure without government intervention.

Question 8

How does the internet affect PC?

Answer 8

It is easier to check prices
The internet has helped to reduce the costs of entering an industry
Many firms are producing similar goods