Types Of Markets - Perfect Competition

Question 1

Define perfect competition

Answer 1

This is a theoretical market form that does not exist in practice. It shows what a market would look like if competition was at its maximum and is based on 5 assumptions.

Question 2

What are the 5 assumptions about perfect competition?

Answer 2

1. There are lots of small firms in the market
2. All firms produce an identical product
3. All firms are trying to profit maximise
4. There is complete freedom of exit and entry to the market
5. Consumers and businesses have perfect knowledge of what is going on in the market

Question 3

What is the significance of there being lots of small firms in the market? (Perfect competition)

Answer 3

This means that consumers have lots of choice and no individual firm will have any control over the market

Question 4

What is a homogenous product?

Answer 4

This is where all firms produce an identical product. This means the only thing that consumers would be interested in is price.

Question 5

What point will a firm produce up to when trying to profit maximise?

Answer 5

Where MC = MR

Question 6

What is perfect knowledge?

Answer 6

When all consumers know each product is the same and the price each firm is charging

Question 7

What follows from the 5 assumptions of perfect competition?

Answer 7

It follows from these assumptions that all firms will be forced to charge the same price, they will be price takers from the market as a whole and they face a horizontal, perfectly price elastic demand curve for their product. (MR = P)

Question 8

What level of profit can a business in perfect competition earn in the short run?

Answer 8

In the short run depending upon the relationship between their revenues and their costs, they can earn any level of profit

Question 9

What level of profit can firms in perfect competition earn in the long run?

Answer 9

In the long run, because of freedom of entry and exit, firms will only be able to earn normal profits and be forced to charge the lowest prices. Therefore, produce their produce at the lowest possible average total cost until there is no incentive to enter or exit the market, as firms are making normal profit.

Question 10

What are the effects of changes in demand on a perfectly competitive market?

Answer 10

The effects of a change in demand on perfect competition will be to change the output of the market, but in the long run it should have no impact on the price.

Question 11

Advantages of perfect competition (3)

Answer 11

1- Consumers will only pay exactly how much it costs businesses to produce that last unit (features allocative efficiency where MC = P)

2-They will achieve productive efficiency (q = lowest point on the ATC curve) - because the market is so competitive all firms will be forced to produce at the minimum point of the ATC curve

3-Because all firms are price takers, consumers have all control - consumer sovereignty

Question 12

Disadvantages of perfect competition (4)

Answer 12

1 - In practice, consumers don’t get any real choice in terms of what they buy - all products are exactly the same

2-Firms will be too small to benefit form economies of scale

3 - Very unlikely to feature dynamic efficiency (constantly improving products) . This is because a) they may hit be able to afford it only making normal profit and b) they have little incentive to improve their product because they gain no advantage - every rival would do exactly the same

4- not a very realistic theory because in practice firms will try to produce a slightly different product