3.4.2 perfect competition

what is perfect competition

a market structure in which individual firms have no market power due to the amount of competition and are unable to influence the price

characteristics of perfect competition

• lots of buyers and sellers

• no barriers to entry and exit

• perfect information

• goods are homogenous

what are sellers in perfect competition market

price takers as lots of market participants

price takers

firms that have no market power and are unable to influence price so have to sell at current market price

barriers to entry

conditions that make it difficult or expensive for a firm to enter a market to compete with the existing suppliers

homogenous

products sold by competing firms are identical and indistinguishable from eachother

why is it bad products are homogenous in perfect competition

this means firms are unable to build brand loyalty as perfect substitutes exist and any price changes will result in losing all customers.

demand in perfect competition

perfectly price elastic

what industries have perfect competition

no market is perfectly competitive but agriculture may be

objective of perfect competition

to profit maximise so produce up to level of output where MC=MR

what is firms selling price

same as market price p1 = MR =AR =Demand

diagram showing how firm in perfect compertion has to accept market price

short run of perfect competition

firms can make supernormal profit or losses

lonf run of perfect competition

always return to long run equilibirium where they make normal profit

why dont any firms make supernormal profit in long run of perfect competition

because any short term supernormal profits attract new firms to the market since no barriers of entry so supernormal profits are competed away in the long term

perfect competition diagram in short run

• firms total revenue is TR = Q x P (the total area of red and grey triangles)

• firms total costs are TC = Q x C (the are of the gret rectangle since c is firms average cost at this level of output)

• subtract tc from tr to find firms profit

• here tr > TC so firm is currently making supernormal profit (area of red rectangle)

perfect competition diagram in long run

• in perfectly competitive market those supernormal profits mean other firms will have icnentive to enter market

• results in shift of industry supply curve to the right

• meaning market price falls until all excess profits have been competed away and a new long run equilibrium is reachd at price p1

what happens if in long run firms dont make profit

• if market price (AR) falla below firms AC firm is making less than normal profit

• no barriers to exit in perfectly competitibe market so in long run firm will just leave market

what happens in short run if firm doesnt make profit

• if selling price(AR) is still above the firms average variable costs then the firm may continue to trade temporarily

• if the selling price(AR) falls below the level of the firms average variable costs the it will leave market immediately

efficiency of perfect competition

• productively efficient

• allocatve efficient

• static efficient

• not dynamic efficient

why does perfect competition lead to allocative efficiency

• in perfect competition markets demand curve = marginal utility because consumers’ demand reflects what that good is worth to them and that decreases as quantity increases due to law of diminshing marginal utility

• markets supply curve = marginal costs because producers marginal costs increase as quantity increase due to law of diminishing returns

• allocative efficiency occurs when a goods price is equal to what consumers want to pay and this happens as price mechanism ensure producers supply exaclty what consumers demand

when can perfect competition not be allocative efficient

• achieve it assuming no externalities

• strictly speaking it occurs when P =MSC

• it results in long run equilibrium where P=MPC

• but if thre are negatuve externalities MPC<MSC so P<MSC so allocative inefficient as leads to overproduction and overconsumption

why does perfect competition lead to productive efficiency

• it comes about as direct result of firms trying to maximise profits

• at long run equilibrium firm will produce quantity of goods such that MR=MC

• output above this level (MC>MR)reduces profits so firms wouldnt produce

• output below this level (MR>MC) would mean firms would earn more revenue form extra output than would spend in costs so expand output

• in long run output level is at bottom of AC curve

when can perfect competition only be productive efficieny

• if assume no economies of scale in industry

• there are infinite number of firms so each firms is very small so cant take advantage of eos

• if there are eos then an industry made up of an infinite number of very small firms may be less productively efficient than if there was one very big firm

why doesnt perfect competition lead to dynamic efficieny

no single firm will have enough for research and devlopment and small firms struggle to receive finance,the existence of perfect information also means one firms invention willl be adopted by another firms and so investment will give firm no competitive benefit

why is perfect competition static eficeinty

as allocaive and productive efficiency are achieved nu cant last forveer as techinology and consumer tastes change