3.4.2 Perfect competition

What is perfect competition?

• A market where there is a high degree of competition - closest example is agriculture, but in reality, no market is perfectly competitive

• PED of goods are infinite, as they are perfectly elastic

• In recent years, the internet has also made some markets close to perfectly competitive - increased price transparency, lower barriers to entry, increased homogeneous goods, etc.

Characteristics of perfect competition

1. Many buyers and sellers

• This means that no one firm or customer can influence the market

2. Any one firm has insignificant market share

• So many firms that firm concentration ratio is so small and insignificant

3. No barriers to entry or exit

• Therefore, when a firm is making profits anyone can enter the market to make the same product, or when a firm is making a loss they can stop production and just leave

4. Perfect knowledge/information

• If a firm is making profits, other firms will know and will attract them to join the market - this competes away any profits

• All firms also have the same costs, as production techniques are the same - any new technology will be copied

• If a firm tries to raise prices above market price, consumers will be aware and switch producers and still buy the same good for a lower price, leading to no sales

5. Homogeneous goods

• All firms sell the exact same product (e.g. tomatoes, eggs) - therefore, if a firm raises their price, consumers will buy the same good from elsewhere for a lower price

• Therefore, firms in perfect competition are ultimately price takers

Short run profit maximisation (supernormal profits)

• Firms look to short run profit maximise, so will produce at MC=MR - therefore, they can make supernormal profits in the short run (AR>AC)

Short run profit maximisation (loss)

• When short run profit maximising (MR=MC), firms can also make an economic loss (AR<AC)

Long run profit maximisation (supernormal to normal profits)

• In the long run, firms in perfect competition can only make normal profits - due to perfect knowledge and no barriers to entry, new firms are encourage to join the market due to supernormal profits

• This increases supply from S1 to S2 in the industry, leading to fall in price from P1 to P2, producing at P/AR=AC (productive and allocative efficiency)

Long run profit maximisation (loss to normal profits)

• In the long run, firms making a loss will just leave the industry due to low barriers to entry - this decreases supply from S1 to S2, increasing prices from P1 to P2, as firms can increase prices due to less competition, producing at P/AR=AC (productive and allocative efficiency)

Efficiencies in perfect competition

• Always productively efficient (MC=AC) and allocative efficient (P=MC) in the long run

• Has X-efficiencies, as competition keeps costs low, hence prices are low - however, firms do not benefit from economies of scale, which means costs are higher than they could be

• However, no dynamic efficiency in the long run due to no supernormal profits for research and development, lack of financing - any new inventions will also be adopted by other firms (may be some dynamic efficiency in the short run, but usually unsuccessful)