Topic 7: Perfect Competition

Question 1

What are the causes of competition in supply?

Answer 1

1. Number of firms in the market
   * the more firms there are, generally speaking the more competitive they are (competing for consumers’ business)
2. The similarity of the product being produced

• if firms are producing a very similar (sometimes identical) product, then the demand for each firm’s product is likely to be highly elastic (large number of close substitutes)
• this will impact on the price the firm is able to charge consumers

3.Ease of entry and exit in the market

• if it is easy for a firm to set up in an industry, the more competitive it is likely to be i.e. if existing firms are making high profits, it is easy for new firms to enter, which increases supply and lowers the price (and ultimately profits)
• important in relation to resource allocation and prices charged/economic profit

Question 2

What is the general effect of a greater degree of competition on a market?

Answer 2

1. the lower the equilibrium price
2. greater the equilibrium quantity
3. more efficient the allocation of resources

Question 3

What is the difference between economics and businesses?

Answer 3

• economists are pro-competition, because it results in lower prices to consumers, and greater efficiency (in the use of resources)
• business is concerned with maximising profits. Often, the less competition they have, the higher the price they can charge, and the greater will be their profits.

Question 4

What are the main characteristics and assumptions in a perfectly competitive market?

Answer 4

1. There are many firms (and consumers)
   * each has a negligible fraction of total market share and hence less influence on market
2. The firms produce a homogeneous (standardised) product
   * perfect substitutes removing ‘product/consumer’ loyalty
3. There is free entry and exit in the long run
   * no barriers such as patents, copyrights etc

Assumptions

• on the supply side, firms seek to maximise economic profit
• on the demand side, consumers aim to maximise utility.

Question 5

Describe firm’s short run position in terms of total revenue and costs?

Answer 5

• firms will produce at the level of output where the gap between TR and TC is largest (Q0)
• slope of TR = ΔTR/ ΔQ = MR
• slope of TC = ΔTC/ ΔQ = MC
• whenever TR>TC, economic profit is made (red shaded area)
• where profit is maximised, the slopes of TR and TC are equal at this point, profit maximisation for a firm will occur where MR = MC

Question 6

How do firms maximise revenue in the short run?

Answer 6

• MR*: the extra revenue received from selling one more unit of output. In perfect competition this is equal to price (MR = P)
• MC*: change in TC/TVC divided by change in Q
• the firm will ↑ output as long as each additional unit sold adds more to total revenue than to total cost. That is, as long as MR is greater than MC
• golden rule of profit maximisation: a firm should produce where MR = MC in order to maximise profits

Question 7

Describe the four short run positions of firms

Answer 7

Pure economic profit (P > ATC)

• P0 = MR
• maximum economic profit where MC = P0, ATC = ATC0
• profit = (P0 – ATC0) x Q0

Normal (0) economic profits (P = ATC)

• P1 = MR
• per unit profit = (P1 – ATC1) x Q1 = 0, as MC = P1 = ATC = ATC1
• does NOT mean that the firm is making no accounting profit. Recall, these costs include opportunity costs, which includes the return that the owners could have been making elsewhere. Therefore, zero economic profit means that the firm is earning just enough profit here to ‘keep them happy’

Economic (quasi) loss (P < ATC but > AVC)

• P2 = MR
• when MC = P2, ATC = ATC2, ARC2 > P2
• profit = (P2 – ATC2) x Q2 = < 0
• firm will continue to produce (in the short run), even though it is making a loss as price is still > AVC. i.e. its revenues cover its variable costs, and make some contribution to covering its fixed (sunk) costs.

Shut down (P < AVC)

• P3 = MR
• rather than produce at Q3, the firm will opt to shut down as the loss they make on producing Q3 units is > the loss they would make if they shut down and incurred NO variable costs (i.e. only have to pay their fixed costs) = TFC
• therefore, loss is smaller if they shut down, firms then wait till P>AVC to start producing again

Question 8

how can a firm’s supply curve be derived?

Answer 8

• where P = Pmin., firms are indifferent to producing Qmin, and shutting down (if price falls below this they will definitely shut down)
• Qmin = minimum amount the firm will produce in the short run. As prices rise above Pmin, the firm is willing to supply the quantity that corresponds to where P=MC
• Therefore, the firm’s supply curve is its MC curve above minimum AVC
• market supply curve = sum of individual supply/MC curves

Drawing a firm’s supply curve with data

1. Draw P = MR = AR
2. Draw MC curve
3. Work out if MC is <, > or = P
4. Mark out Q accordingly
5. Draw vertical line through Q (all values occur on this line)
6. Mark out ATC, AVC values on this line
7. Draw ATC and AVC curves (AC, AVC at MC at their minimum)

Question 9

Describe profit maximisation in the long run

Answer 9

• all factors of production are variable;
• there is free entry and exit.
• firms in a perfectly competitive market will earn zero economic profits
• e.g. positive economic π attracts new entrants
  
  • this ↑ market supply (market supply curve = sum of individual firms’ supply curves)
  • price ↓, economic profits decrease, firms cease to enter when normal economic π’s are made
• e.g. short run losses will cause some firms to exit the industry
  
  • as firms exit, the supply curve shifts left
  • price will ↑ until normal profits are being made

Question 10

Describe perfect competition in terms of surpluses

Answer 10

• benchmark against which we compare other market structures
• maximises consumer and producer surplus (and therefore total surplus)
• firms produce up to the point where the cost of the last (marginal) unit produced is equal to price (P=MC), producer surplus (PS) thus maximised
• consumers consume up to the point where the marginal benefit they receive from that good is also equal to its price (MB = P), consumer surplus (CS) thus maximised

Question 11

how efficient is perfect competition?

Answer 11

1. Productive efficiency

• output is produced with the least-cost combination of resources
• in the long run, this is achieved where LAC is at its minimum, Price = MC = LACmin
• firms in perfect competition always earn zero economic profits and operate at minimum ATC in the long run so perfect competition has productive efficiency.

1. Allocative efficiency
   * firms produce output that is most highly valued by consumers. We know this because:
2. Price represents the marginal benefit consumers receive from the last unit
3. Firms produce up to the point where the price is equal to the marginal cost of the last unit

• therefore, the marginal benefit received by consumers is equal to the marginal cost of producing that unit. Price = MB = MC
• firms are devoting exactly the amount of resources to this good that society wants them to devote.

1. Dynamic efficiency

• due to the highly competitive nature of this market, technological innovation can be very important;
• improvements in technology over time can:

(a) help firms achieve productive efficiency (output at the minimum possible cost)
(b) achieve allocative efficiency (as it allows firms to meet the changing tastes and preferences of consumers).
* however, there are arguments that sometimes firms in perfect competition may be too small to invest heavily in research & development.

Question 12

Describe the iron ore industry in terms of competition

Answer 12

• although not an exact replication of perfect competition, the iron ore industry certainly has many of its characteristics that make it a good one to examine in this context:
  
  • global market (lots of firms/mines from many countries, many consumers)
  • fairly homogenous product
  • entry and exit is relatively easy
• price of iron ore, having risen significantly since the mid-2000s, has been just as spectacularly falling since 2011, the main driver of this has been seen as the fall in demand from China for this raw material, as their demand for steel has fallen
  
  • as the market price rose, new mines started producing iron ore, and existing mines increased their production levels (increase in market demand, leading to a higher price, and increases in the quantity being supplied)
  • as demand for iron ore falls, so too does the global price
• this has led to some mines closing, while others are increasing production, this is due to marginal and hence average prices
• LRAC = only variable costs, so if P<lrac>
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