L14: Perfect Competition

Microeconomics Overview

  • Course: ECA002

  • Topic: Perfect Competition

  • Lecturer: Luke Garrod

Aims of Market Structure Lectures

  • Before Christmas: Analyzed buyer and seller behavior in markets.

  • Now: Integrating both sides with previous supply & demand analysis.

  • Purpose of revisiting:

    • Positive aspects: production levels and pricing.

    • Normative aspects: assessing goodness of these outcomes.

  • Market Structure Definition:

    • It encompasses characteristics affecting trades, including:

      • Number and size of sellers.

      • Barriers to entry.

      • Product differentiation.

      • Number and size of buyers.

Quick Exercise

  • Compare markets for bottled mineral water and cola:

    • Number and size of sellers.

    • Barriers to entry.

    • Product differentiation.

    • Number and size of buyers.

Aims of the Lecture

  • Focus: Perfect Competition

  • "Perfect" indicates market conditions, not quality.

  • Assumptions: Often unrealistic, hard to find real-world examples.

  • Importance of study:

    • Insight into agricultural and financial markets.

    • Extremes help form foundational understanding.

    • Investigate output production and pricing in perfect competition.

Lecture Outline

  1. Two rules for profit maximization (review Topic 3).

  2. Fundamental assumptions.

  3. Appropriate market structure.

  4. Short-run equilibrium.

  5. Long-run equilibrium.

  • Reading Material: Lipsey & Chrystal, chapter 6.

Reminders: Profit Maximization Rules

1. Marginal Output Rule

  • If firm continues production:

    • Condition: MR = MC (marginal revenue equals marginal cost).

    • Reasoning: Producing an extra unit is beneficial if MR > MC, increasing total revenue and profit.

2. Shutdown Rule

  • Firm should shut down if:

    • For any output level: p < AC (average cost).

    • Short-Run Condition: p < AVC (average variable cost).

    • Long-Run Condition: p < LRAC (long-run average cost).

Assumptions of Perfect Competition

A(1) Buyers are Price Takers

  • Buyers accept market prices without influence.

A(2) Complete Information

  • Sellers respond to market incentives.

  • Buyers have optimal purchasing opportunities.

A(3) Sellers are Price Takers

  • Sellers perceive their output does not affect market price.

    • Selling as much as desired at a given price.

    • Output choices do not provoke rival responses.

A(4) Free Market Entry

  • Potential sellers can enter without existing costs, thus:

    • Long-run entries involve changes in all production factors.

    • Entry supports market competition with no capital barriers.

Market Structure Characteristics

  • Size and Number of Sellers: Many small sellers influence price minimally.

  • Barriers to Entry: Low; firms must enter freely.

  • Product Substitutability: Homogeneous products lead to price competition.

Short-Run Equilibrium Under Perfect Competition

  • Definition: Equilibrium occurs when:

    • Sellers produce exactly what buyers wish to purchase.

    • Established through market supply and demand.

    • Market price is set where supply and demand curves intersect.

Seller's Supply Curve and Market Supply Curve

  • Equilibrium Price (p): Establishes output levels by employing marginal output and shutdown rules.

  • Market Supply: Derived from total outputs of numerous symmetric sellers.

General Case of Short-Run Equilibrium

  • Market interactions dictate equilibrium as price adjusts to changes in demand and supply.

Long-Run Equilibrium in Perfect Competition

  1. Long-run adjustments allow for freely adjusted production costs.

  2. Conditions ensuring equilibrium:

    • Sellers continue selling based on market demand.

    • Zero economic profits at equilibrium as sellers neither enter nor exit.

Long-Run Equilibrium Characteristics

  • Prices equate average costs at their minimum, indicating:

    • Normal profits realized as firms stabilize.

Lecture Summary

  • Short-Run Dynamics: Price reflects production costs; firms can yield supernormal profit.

  • Long-Run Dynamics: Price equals average cost, supporting only normal profits.

  • Learning Objectives:

    • State assumptions of perfect competition.

    • Describe market structure relevant to these assumptions.

    • Derive short- and long-run equilibrium graphically.