Perfect competition
Learning Objectives
At the end of this chapter you will be able to
Explain the assumptions of perfect competition
Distinguish between the demand curve for the industry
and for the firm in perfect competition (pc)
Explain how the firm maximises profit in pc
Explain and illustrate short run profit and loss situations
in perfect competition
Explain and illustrate the long-run equilibrium in pc
Explain and illustrate the movement from short run to
long run in pc
Define and illustrate productive efficiency
Define and illustrate allocative efficiency
Explain and illustrate productive and allocative efficiency
in the short run and long run in pc
• mjmfoodie Video see You Tube
(http://www.youtube.com/watch?v=61GCo
galzVc)
Perfectly competitive markets
We can look at the market as a spectrum
At one end we have perfect competition where there is a
large number of small firms
These are price takers (a firm that has to accept the price
dictated by the market)
At the other end is the natural monopoly where the
industry comprises of one firm only
This is a price maker (it decides the price)
Perfectly competitive markets
Firms operating under conditions of competition have to
remain price competitive and will try to improve the quality
of their product/service to stay ahead of their competitors
Perfect competition is an extreme form of competition
and is based on the following assumptions
Large number of buyers and sellers – this is to
ensure the product is sold and the firm is a price taker
No one is large enough to affect the market price
Buyers and seller have perfect information on product
and prices
Homogeneous products (all the same)
Freedom of entrance and exit – cost free to move in
and out.
Firms will make normal profit in the long run
All firms have equal access to technological
improvements – firms are unlikely to engage in R&D
Factors of production are perfectly mobile – they can
undertake any types of work in any location
Perfectly competitive markets
Many, if not all, of these assumptions are unrealistic
The model is good because it serves as a benchmark to
compare other market structures
Economists use this as the model that shows how
competition creates an efficient market
While perfect competition may not be possible some
competition is welcome
The diagrams below show the perfectly competitive firm
and the market (industry)
Perfectly competitive markets
The firm has to sell its product at £5 (it is a price taker)
If it sells above this price consumers will go elsewhere
If it sells below this price all the consumers will come to
this firm but they will not be able to service all of their
needs and it will not be maximising its returns
We saw before that the demand curve is perfectly elastic
and D=AR=MR=P (they are all £5)
The diagram of the industry shows that both consumer
and producer surplus are maximised – the market is
allocatively efficient
How many does the firm produce?
We saw before that the profit maximising firm will chose
its output level using the relationship between marginal
revenue and marginal cost
Profit maximising output is where MR = MC
At this point the firm will make £800 revenue
Notice that we label our y axis Revenue and Cost
Short run profits and the industry response
To work out how much profit the firm is making we have to
work out the total costs (profit = total revenue – total costs)
To do this we need to add the average total cost curve (ATC)
as per the diagram below
Don’t forget that the MC curve cuts the ATC curve at its
lowest point
We can see that when the output is 10 the firm’s costs will be
£60 which means the total costs will be 60 x10 = 600
Profit = Revenue – total costs; 800 – 600 = £200
We include normal profit in total costs so this £200 is
abnormal profit
Short run profits and the industry response
A firm in the perfectly competitive market is a price taker
That means it has to accept the market price
If it increases the price customers will go elsewhere
If it decreases the price it will not be able to serve all of the
customers and they will be dissatisfied and leave
Whenever the price is above the red line (where the MC cuts
the ATC at its lowest point) the firm will make abnormal profits
This can only happen in the short run (we will find out why in a
minute)
Time for you to do some work!!
Complete P111 Q 1 (10 marks)
20 minutes to complete
With the help of a diagram, explain
how it is impossible for a firm in
perfect competition to earn
abnormal profits in the long run
Short run profits and the industry response
If there are abnormal profits other firms will be attracted
to the market (there are no barrier to entry)
This will shift the supply curve to the right and the price
will fall to 60
This means that MR has changed
The output of the firm will have to fall to 8 at the new
profit maximising point (MC=MR)
At this point revenue and costs are equal
Short run profits and the industry response
This does not mean the firm is making zero profit – it
means the firm is making normal profits
In a perfectly competitive market when there is abnormal
profit in the short run firms keep entering the market until
the abnormal profits are competed away and only normal
profits are available
This is the long run equilibrium position for firms in
perfect competition; average total costs equals average
revenue
Time for you to do some work!!
Complete P111 Q 2 (10 marks)
Productive efficiency
Firm’s are said to be
productively efficient if
they produce at the lowest
possible unit cost
(average cost)
As we have seen, firms
in a perfectly competitive
market operate at this
point in the long-run
If a firm is producing at
this level they are
combining their resources
as efficiently as possible
and resources are not
being wasted by inefficient
use
MC = AC
Allocative efficiency
This is sometimes also
called the socially optimum
level of output
This happens when
suppliers are producing the
optimal mix of goods and
services required by
consumers
Price reflects the value that
consumers place on a good
and is shown on the demand
curve (average revenue)
Marginal cost reflects the
cost to society of all the
resources using in producing
an extra unit of a good
including the normal profit
that firms require to stay in
business
Allocative efficiency
If the price were higher than
the marginal cost consumers
would value the good more than
it cost to make it
If both sets of stakeholders are
to meet at the optimal mix then
output would expand until price
equalled mc
If the marginal cost were to be
greater than price society would
be using more resources to
produce the goods than value it
gives to consumers and output
would fall
So allocative efficiency occurs
when marginal cost (the cost of
producing one more unit) equals
average revenue (the price
received for a unit)
The allocative efficient level of
output is where MC= AR
MC = AR
In the long run the perfectly
competitive firm is allocatively
efficient
Time for you to do some work!!
Q 2 P111 (10 marks) – to hand in this lesson
Complete Q3 P111 – to hand in after lesson 2mrw
Complete essay Q 1 (a) and (b) - to hand in after
lesson 2mrw