Perfect Competition
A2 Economics
Aims and Objectives
Aim:
• Understand perfectly competitive markets
Objectives:
• Explain the long run equilibrium of perfectly
competitive firms.
• Analyse the process of perfectly competitive
firms making losses.
• Evaluate the strategies of persistently loss making
firms.
Starter
• Draw a firm in perfect competition making supernormal
profit.
MC
Revenue &
Cost of X
ATC
£80
D=AR=MR=P
£60
0
10
Quantity Demanded and Supplied
• Draw the diagram to show Supernormal profit being eroded away
and explain.
The Firm
The Market
Price of
X
Revenue
& Cost
S
MC
S1
£80
£60
ATC
£80
D=AR=MR=P
£60
D=AR=MR=P1
D
0
0
Quantity Demanded and Supplied
8 10
Long Run Equilibrium: Normal Profit
The Firm
Revenue
& Cost
MC
ATC
D=AR=MR=P
P
0
Q
Quantity Demanded and Supplied
• The firm is in equilibrium in the long run, making normal profits where
ATC = AR.
• Equilibrium output at MC=MR is also where ATC is at its lowest point
(productive efficiency).
Long Run Equilibrium: Normal Profit
The Firm
Revenue
& Cost
MC
ATC
D=AR=MR=P
P
0
Q
Quantity Demanded and Supplied
• This point is also allocatively efficient – best allocation of resources to
meet demand.
• Firms in perfect comp. are likely to be statically efficient – both allocative
and productive efficiency.
Dynamic Efficiency
Definition:
• Efficiency over time – new products, techniques
and processes which increase economic growth.
• Essential for building supernormal profits.
• However, firms in perfect competition are
unlikely to be dynamically efficient as
supernormal profits cannot be maintained due to
free barriers to entry/perfect knowledge.
An Example of Perfect Competition? The
Internet Economy: Towards A Better Future
Is the internet
economy an
example of perfect
competition?
How many of the
assumptions apply
to this industry?
Firms Making Losses
The Firm
The Market
Price of
X
Revenue
& Cost
S
MC
ATC
S1
£80
£60
£82
£80
D=AR=MR=P1
£60
D=AR=MR=P
D
0
0
8
Quantity Demanded and Supplied
10
• At market price of £60 the firm is making losses as at output of 8 units ,
the ATC is £82 whereas the AR is only £60, therefore £22 losses are being
made per unit.
Firms Making Losses
The Firm
The Market
Price of
X
Revenue
& Cost
S1
MC
ATC
S
£80
£60
£82
£80
D=AR=MR=P1
£60
D=AR=MR=P
D
0
0
8
Quantity Demanded and Supplied
10
• Firm producing at MC=MR- meaning it is making the smallest loss
possible.
• If firms are making losses some will leave the industry (S – S1).
Firms Making Losses
The Firm
The Market
Price of
X
Revenue
& Cost
S1
MC
ATC
S
£80
£60
£82
£80
D=AR=MR=P1
£60
D=AR=MR=P
D
0
0
8
Quantity Demanded and Supplied
10
• This will lead to higher price of £80.
• Here the firm is making normal profit as ATC=AR (10 units)
• The firms market share has increased as firms have left the industry.
SPEED
DATING
Firms Entering and Leaving The Industry
The Firm
Revenue
& Cost
ATC
MC
TFC
£60
AVC
£50
D=AR=MR=P
£40
0
100
Quantity Demanded and Supplied
• Firm producing at MR=MC.
• TR = £5000, TC = £6000, Firm is making losses of £1000 per week!
Firms Entering and Leaving The Industry
Does the firm shut down immediately? Or close
down slowly?
• Depends on relationship between AVC and P.
• AVC = £4000, ATC = £6000, TFC = £2000.
• Firm faces TFC of £2000 which must be paid
whether the firm produces or not.
• At present running the firm = £1000 Loss
• Running firm paying £1000 towards TFC
Firms Entering and Leaving The Industry
• Shutting down immediately would result in
shareholders paying TFC immediately - £2000.
• Therefore if P is above AVC it pays the firm to
continue production to offset some part of its
fixed costs and close down slowly.
• If P falls below AVC there is no point in carrying
on and the firm should shut down immediately.
Worksheet
• Explain what level of output the firm will produce and why.
• What is the firms’ level of losses at this output level?
• You have been called in to advise the managing director as to whether
the firm should close immediately. Write a brief to explain the
costs/benefits of the firm’s options.