2.11 (3) Market Power in Perfect Competition

Market power

• Ability of a firm to influence and control the conditions in a specific market

• Significant impact on price, output, and other market variables

Why is market power low in perfect competition?

• Many firms compete and sell identical products

• No single firm can influence price

• Firms have low market share and low concentration ratios

• High competition reduces market failure and improves efficiency

How do firms maximise profit in perfect competition?

• Firms maximise profit where:

  MC=MR

• Firms are price takers because there are many sellers

• Firms have no market power and cannot influence price

• Selling price equals market price:

  P=MR=AR=D

Diagrammatic Representation of Perfect Competition

What happens to profits in perfect competition in the short run and long run?

• In the short run, firms may make:

  • abnormal profit

  • losses

• In the long run, firms return to normal profit due to free entry and exit of firms in the market

Why do firms move from abnormal profit in the short run to normal profit in the long run in perfect competition?

• Abnormal profits attract new firms into the industry

• Firms are incentivised by the opportunity to earn supernormal profit

• There are low/no barriers to entry

• Increased competition reduces profits back to normal profit in the long run

Diagram Moving from Abnormal Profit in the Short-run to Normal Profit in the Long-run

Diagram analysis — Short-run abnormal profit in perfect competition

• The firm initially profit maximises where:

  MC=MR

  → at output Q1

• At this level of output:

  AR(P1)>AC

  → so the firm earns abnormal/supernormal profit

• The firm is incentivised by profit and new firms are attracted into the industry

Diagram Analysis — Entry of new firms in perfect competition

• New firms entering increase market supply:

  S1→S2

• Industry output increases:

  Q1→Q2

• Market price falls:

  P1→P2

• As a price taker, the firm must now sell at the lower industry price P2

• The firm’s output and market share fall:

  Q1→Q2

Diagram Analysis — Long-run equilibrium in perfect competition

• The firm still profit maximises where:

  MC=MR

• The firm is now producing where:

  AR=AC

• Abnormal profit has been eliminated

• The firm earns normal profit in the long run

• Firms making losses leave the industry, while abnormal profits attract new entrants until only normal profit remains

Losses in Perfect Competition in the Short-run

Firms in perfect competition are able to make losses in the short-run

Diagram Losses in Perfect Competition in the Short-run

Diagram Analysis in Perfect Competition in the Short-run

• The firms are producing at the profit maximisation level of output where MC=MR (Q₁)

  • At this level of output, the AR (P₁) < AC (C₁)

  • The firm's loss is equivalent to (P1-C1) X Q1

Moving from Loss in the Short-run to Normal Profit in the Long-run

• If firms in perfect competition make losses in the short-run, some will shut down

  • The shut down rule will determine which firms shut down

  • There are no barriers to exit, so it is easy to leave the industry

Diagram Moving from Loss in the Short-run to Normal Profit in the Long-run

Diagram Analysis — Short-run losses in perfect competition

• The firm initially profit maximises where:

  MC=MR

  → at output Q1Q1​

• At this level of output:

  AR(P1)<AC(C1)

  → so the firm is making a loss

• Losses cause some firms to leave the industry

Diagram Analysis — Firms leaving the industry in perfect competition

• Firms leaving reduce market supply:

  S1→S2

• Industry output falls:

  Q1→Q2

• Market price rises:

  P1→P2

• As a price taker, the firm must now sell at the higher industry price P2

• The firm’s output and market share increase:

  Q1→Q2

Diagram Analysis — Long-run equilibrium after losses in perfect competition

• The firm still profit maximises where:

  MC=MR

• The firm is now producing where:

  AR=AC

• Losses have been eliminated

• The firm earns normal profit in the long run

• Firms making losses leave the industry, while supernormal profits attract new entrants until only normal profit remains

Alocative efficiency

• Occurs at the level of output where average revenue = marginal cost (AR = MC)

  • At this point, resources are allocated in such a way that consumers & producers get the maximum possible benefit

  • No one can be made better off without making someone else worse off

  • There is no excess demand or supply

Productive efficiency

• Occurs at the level of output where marginal cost = average cost (MC=AC)

  • At this point average costs are minimised

  • There is no wastage of scarce resources & a high level of factor productivity
     

Diagram Efficiency in Perfect Competition

Diagram Analysis - Efficiency in Perfect Competition

• The firm produces at the profit maximisation level of output where MC=MR (Y)

• The firm is productively efficient as MC=AC at this level of output

• The firm is allocatively efficient as AR (P)=MC