Perfect competition

Define the term ‘perfect competition’

Individual Firms have no market power due to the amount of competition and hence are price takers

Explain the 4 characteristics of perfect competition.

• Many buyers of sellers: Due to the large number of market participants, sellers are price takers and so take the price determined by the market forces of supply and demand

• No barriers to entry and exit: Firms can enter and exit the market with relative ease, which increases the level of competition

• Homogenous products: Products are sold by competing firms are identical and and indistinguishable from eachover. This means that firms are unable to build brand loyalty given that there is no product differentiation which will enable them to stand out from their competitors. This suggests perfectly elastic demand, given that perfect substitutes exist.

• Perfect information

Draw a diagram illustrating a perfectly competitive market in the short-run

• A firm in competition does not have any market power, so it is unable to influence price and quantity

• This means that the firm acts as a price taker, and so takes the price determined by supply and demand at Qe.

• Assuming perfectly competitive firms pursue the objective of profit maximisation it will operate where MC=MR

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• At this point, given that AR>AC firms are making supernormal profits equal to the area (P1-C1) x Q1

Draw a diagram illustrating a perfectly competitive market in the long-run, making supernormal profits

• If firms in perfect competition make supernormal profits in the short-run, incumbent firms are attracted to the industry given that there is perfect competition about market conditions.

• This is because, incumbent firms are incentivised by the opportunity to make supernormal profits, and given that there are no barriers to entry firms can enter the industry with relative ease, increasing the degree of competition

• An increase in the no. of new entrants will increase supply from S1 to S2, putting downwards pressure on the industry price form P1 to P2 and an expansion in overall quantity from Q1 to Q2.

• Given that the individual firm is a price taker, it faces a perfectly elastic AR curve forcing them to sell at a lower price of P2, reducing the incentive to expand output and so output contracts from Q1 to Q2 as it now has a smaller share of the larger industry

• In the LR, at the profit maximisation level of output the firm is producing at the point where AC=AR and is only making normal profits (Break-Even)

Draw a diagram illustrating a perfectly competitive market in the long-run, making a loss

• If firms in perfect competition make a loss in the short-run, some firms may shut down assuming it is not making sufficient revenue to cover its variable costs

• Given that, in a perfectly competitive market there is no barriers to entry firms can exit the industry with relative ease

• An fall in the no. of new entrants will decrease supply from S1 to S2, putting upwards pressure on the industry price form P1 to P2 and a contraction in overall quantity from Q1 to Q2.

• Given that the individual firm is a price taker, it faces a perfectly elastic AR curve forcing them to sell at a higher price of P2, increasing the incentive to expand output and so output expands from Q1 to Q2 as it now has a larger share of the larger industry

• In the LR, at the profit maximisation level of output the firm is producing at the point where AC=AR and is only making normal profits (Break-Even)

Allocative efficency

In a perfectly competitive market, allocative efficiency is achieved given that P=MC. This means that recourses are being allocated in a way in which societal welfare is maximised. For consumers, this perfectly meets the value they place on a good or service which maximises their consumer surplus. Overall consumers are made better off as recourses are being allocated in a way that benefit them.

Productive Efficency

In a perfectly competitive market, productive efficiency is achieved given that the firm is operating at the lowest possible average cost where MC=AC. This means that there is full exploitation of firms economies of scale since a firm can produce the maximum output, with its inputs without any waste or inefficiencies.

X-Efficiency

In a perfectly competitive market, X-efficiency is achieved given that the firm costs lie on the AC curve, at the profit maximising level of output. This is because with high competition firms have the incentive to minimise costs as they are held fully accountable for making a loss as they may have to shut-down as a consequence. Therefore firm can produce the maximum output, with its inputs without any waste or inefficiencies.

Dynamic Efficiency

However, in evaluation although firms may be statically efficient a perfectly competitive market given the nature of competition meaning that they cannot deviate from these efficiencies it may be dynamically inefficient in the long run. Dynamically efficiency refers to when changing technology improves a firms productive potential over time or encourages product innovation. Given that firms in competition are unable to make SNP in the long run since it is competed away, it wont have the internal finance made available to them to invest in R&D and develop new technological products. This means that consumers wont be able to enjoy a variety of goods and services meaning that consumers may be worse off.

Alternatively, it wont have the internal finance made available to them to invest in R&D in order to improve its existing production process, such as increased use of automation which is the use of technology and machines to perform assembly line work. This means that, although the firm is operating at the lowest possible average cost this it is likely to stay this way as it wont be able to improve productivity and reduce cost’s in the production process, leading to stagnant business growth.