Week 9: Perfect Competition

Question 1

Firms in Perfectly Competitive Markets

Answer 1

Many firms
Each have negligible market share
Goods are homogenous and standard (all the same)
Free entry + exit in long run, no barriers to entry

Firms are known as price takers, as the overall market demand and supply conditions sets the price, and each firm must accept this price.

Question 2

Profit Maximisation in the Short Run

Answer 2

Marginal Revenue in Perfect Competition = Price,
( MR = P )

Marginal Cost = Change in TC / Q

The firm will increase output as long as each individual unit sold adds more to total revenue than total cost.
( When MR > MC)

Profit is maximised when MR = MC

Question 3

Short Run Profit Positions

Answer 3

Pure Economic Profit (P>ATC) = Where profit cuts Marginal Cost, Quantity cuts ATC, = ATC0.
Profit = (Price x ATC0) * Q

Normal Economic Profit ( P = ATC) = Where profit cuts MC, Quantity cuts ATC, ATC=1,
Profit = 0 as on same line
Not accounting profit, meaning it is making enough profit to make the firm ‘happy’

Economic Loss (PAVC) = Where profit cuts MC, quantity cuts ATC=2,
Profit = Negative, as it is below ATC
However will still run, as price is above AVC, meaning it can pay back some of it but not all of its costs

Shut Down ( P

Question 4

Profit Maximisation in the Long Run

Answer 4

All factors of production are variable
Free entry and exit
In the long run, firms earn 0 economic profit
As profits attract new entrants

Short run losses causes firms to leave, meaning supply decreases and price increases
On the graph,
Market demand increases, from d1-d2
This increases price to P2 and market output increases to Q2
Firms now earn positive economic profit
Attracts new firms, Supply increases to Q3 and shifts to S2,
Total market output has increased to Q2

Question 5

Productive efficiency

Answer 5

Output is produced with the least cost combination of resources
Firms in perfect competition always earn zero economic profits and operates at minimum ATC in the long run

Question 6

Allocative Efficiency

Answer 6

Firms are devoting exactly the amount of goods society wants them to devote
Price represents the marginal benefit consumers receive from the last unit
Firms produce up to the point where MR = MC

Question 7

Dynamic Efficiency

Answer 7

Highly competitive market, therefore technological advancements are important
Helps firms achieve productive efficiency and allocative efficiency

Question 8

Competition in Practice

Answer 8

Iron Ore industry
Easy to enter
Perfect competition
However all have different marginal and average costs

As demand decreases, some can not make a profit and shut down
They stop production but not quit the industry