3.4.2 Perfect competition

PERFECT COMPETITION

• market where there’s high degree of competition

• few industries which fit this type of market structure

• e.g. may be agriculture but gov interferences may prevent it from being so

• assumptions made rarely hold and no market is completely perfectly competitive

PC CHARACTERISTICS

• mean that demand for firm’s goods is perfectly elastic, and prices are solely determined by interaction of demand and supply; the firms are price takers

• many buyer and sellers

• freedom of entry and exit from industry

• perfect knowledge

• homogenous goods

MANY BUYERS AND SELLERS

• means that one firm or customer won’t be able to influence market

• e.g. decision of one firm to double their output will have no effect

• if firm did manage to have an effect, this would mean the market was no longer perfectly competitive as there would be one large firm and other smaller firms, or one large buyer and other smaller buyers

FREEDOM OF ENTRY AND EXIT FROM INDUSTRY

• important as it means that when a business is making profits anyone can enter that market and start producing that product for themselves

• as a result, business are unable to make huge profits in long run and if they are making losses they are able to leave

• in long run, they make normal profits

PERFECT KNOWLEDGE

• enables firms to know when other firms are making profits which will attract them to join market

• all firms also have same costs as they can use same production techniques

• also means that any attempt to raise prices above level determined by market will lead to no sales, as customers will be aware they can buy the same good for a lower price

HOMOGENOUS GOODS

• important because it means if a firm raises it price above competitors’ no one will buy it and they won’t gain from lowering their price because they can sell all of your product at the same price as everyone else

PROFIT MAX EQULIBRIUM

• firms assumed to SR profit maximise- MC=MR

• SR- possible for firm to make a normal profit, a supernormal profit or a loss.

• LR- only normal profit for perfect comp

PROFIT MAX SR EQUILIBRIUM- DIAGRAM

• firm is a price taker- accepts industry price of P1

• firm produces an output of Q1

• yellow shaded rectangle shows area of SNP earned in SR

PROFIT MAX LR EQUILIBRIUM- DIAGRAM

• SNP made by existing firms means that new firms have an incentive to enter industry and no barriers allow them

• causes supply to increase- shown by right shift in supply from S to S1

• price level falls

• since firms are price takers- accept this new price

• SNP competed away, so firms only make normal profits

• new equilibrium at P=MC means firms produce at the new output of Q2 in the long run

ADVANTAGES OF PROFIT MAX

• LR- P=MC- allocative efficiency

• LR- produce at the bottom of AC curve- productive efficiency

DISADVANTAGES OF PROFIT MAX

• competition should keep costs and prices low- but firms unable to benefit from EoS so costs may be higher

• dynamic efficiency limited due to perfect info- means one firms’ invention will be adopted by another firm so investment will give the firm no competitive benefit