Chp 13 perfect competition

What are the main characteristics of perfect competition?

Many buyers and sellers, price-taking firms, free entry and exit, perfect knowledge, homogeneous products, profit maximisation and perfectly mobile factors of production.

What does it mean when firms are price takers?

Individual firms cannot influence the market price because they have a very small market share. They must accept the price determined by industry demand and supply.

What are homogeneous goods?

Products that are identical, with no differences in quality or characteristics between different suppliers.

Why is there free entry and exit in perfect competition?

There are no significant barriers preventing firms from entering or leaving the market.

What is meant by perfect knowledge?

Buyers and sellers have complete information about prices, products and market conditions.

How is the market price determined under perfect competition?

Through the interaction of industry demand and supply.

Why is market power very limited in perfect competition?

There are many small firms, each with a very small market share, so no individual firm can influence the market price.

What happens to firms' profits when new firms enter a perfectly competitive market?

New firms increase market supply, lowering the market price and reducing existing firms' profits.

Can firms make supernormal profits in the short run?

Yes. Firms can earn supernormal profits if their revenue exceeds their total costs.

DIAGRAM How does a perfectly competitive firm maximise profit in the short run?

It produces Q1 where MC = MR, accepting the industry price P1. If AR exceeds AC, it earns supernormal profit.

What is the difference between normal and supernormal profit?

Normal profit is the minimum return needed to keep a firm in the industry. Supernormal profit is any profit above this level.

What is the long-run profit outcome in perfect competition?

Only normal profits are earned because free entry allows new firms to enter and compete away supernormal profits.

Why do supernormal profits attract new firms?

They indicate that the industry is profitable, creating an incentive for firms to enter because there are no barriers to entry.

What happens to industry supply when new firms enter?

Market supply increases, shifting the industry supply curve to the right.

DIAGRAM What happens to market price when new firms enter a perfectly competitive market?

The increase in market supply shifts supply to the right, reducing the equilibrium market price.

Why must existing firms accept the lower price?

They are price takers and cannot influence the market price, so they must accept the new industry price.

How are supernormal profits competed away in the long run?

New firms enter, increasing market supply and reducing price until existing firms only earn normal profit.

DIAGRAM What is the long-run equilibrium condition for a perfectly competitive firm?

MC = MR = AR = AC at the minimum point of the AC curve, meaning firms earn normal profit.

What does P = MC indicate?

Price equals marginal cost, which indicates allocative efficiency because the value consumers place on the last unit equals its cost of production.

What is allocative efficiency?

When resources are allocated to produce the goods and services consumers most value. It occurs where P = MC.

DIAGRAM Why is perfect competition allocatively efficient in the long run?

Firms produce where P = MC, so marginal benefit equals marginal cost and resources are allocated efficiently.

What is productive efficiency?

When a firm produces at the lowest possible average cost, at the minimum point of its AC curve.

Why is perfect competition productively efficient in the long run?

Firms produce at the minimum point of the AC curve, meaning they achieve the lowest possible average cost.

Are perfectly competitive firms allocatively efficient in the short run?

Not necessarily. Firms may produce where price does not equal marginal cost, so allocative efficiency is not guaranteed.

What is dynamic efficiency?

Improvements in production processes and products over time through innovation and investment.

Why might perfect competition have limited dynamic efficiency in the long run?

Firms only earn normal profits, leaving less retained profit available to fund research, development and innovation.

How might short-run supernormal profits improve dynamic efficiency?

Firms can reinvest supernormal profits into research, development and new technology, improving productivity and innovation.

Why might perfectly competitive firms experience limited economies of scale?

Individual firms are relatively small, so they may not produce enough output to benefit from large-scale production.

What is an advantage of perfect competition for consumers?

In the long run, competition results in lower prices and allocative efficiency, benefiting consumers.

Why might the perfect competition model have limited real-world relevance?

Its assumptions rarely exist in reality. Branding, product differentiation, advertising and externalities mean most markets are imperfectly competitive.