perfect competition

• what are the conditions of perfect competition?

  many buyers and sellers

  no barriers to entry

  buyers and sellers have perfect knowledge of prices

  homogenous products
• why are there many buyers and sellers in perfect competition?

  due to the number of market participants sellers are price takers
• what are price takers?

  firms that have no market power are unable to influence the price - they take the "going price" offered by the market.
• what does no barriers to entry and exit mean?

  firms can start-up or leave the industry with relative ease which increases the level of competition
• what do buyers and sellers having perfect knowledge of prices mean?

  this assumption presupposes perfect information e.g if one seller lowers their price then all buyers will know about it
• what do homogenous products mean?

  The products are homogenous: this means firms are unable to build brand loyalty as perfect substitutes exist and any price changes will result in losing customers
• why do governments encourage more competition in their economy?

  There is little market failure in perfectly competitive industries
• firms in perfect competition have a ___ market power, ___ market share and a ___ industry concentration ratio?

  low
• what does this graph show about an individual firm in perfect competition ?

  • In order to maximise profit, firms in perfect competition produce up to the level of output where marginal cost = marginal revenue (MC=MR)
  • The firm does not have any market power so it is unable to influence the price and quantity
  • The firm is a price taker due to the large number of sellers
  • The firm's selling price is the same as the market price, P1 = MR = AR = Demand

  
• what type of profit do firms make in the short run?

  • A seller may gain a competitive advantage for a short period of time, which allows them to make abnormal profit
• what does this graph show about a firm in perfect competition making abnormal profit?

  • The marginal cost curve (MC) is the supply curve of the firm
  • The firms is producing at the profit maximisation level of output, where MC=MR (Q1)
  • At this point, AR (P1) > AC (C1)
  • The firm is making abnormal profit  = (P1-C1) x Q1
  • this is in the short run

  
• what happens when firms make abnormal profit in the short run?

  new firms are attracted to the industry

  • They are incentivised by the opportunity to make abnormal profit
  • There are no barriers to entry
  • It is easy to join the industry
• describe what happens when firms make abnormal profit in the short run?

  firm initially produces at profit maximisation level of output, MC=MR (Q1)

  • At Q1, AR (P1) > AC (P2) so firm makes abnormal profit
  • Incentivised by profit, new firms join the industry so supply increases from S1→S2
  • Overall quantity in the industry increases from Q1→Q2
  • The industry price falls from P1→P2
• describe how profits go from abnormal to normal in the long run

  • Incentivised by profit, new firms join the industry and supply increases from S1→S2
  • Overall quantity in the industry increases from Q1→Q2
  • The industry price falls from P1→P2
  • The firm hast to now sell its products at the industry price of P2
  • The output of the firm falls from Q1→Q2 as it now has a smaller market share of the larger industry
  • At the profit maximisation level of output (MC=MR) the firm is now producing at the point where AR= AC
  • The firm is making normal profit
  • firms making a loss leave the industry
• when are firms in perfect competition allowed to make losses?

  short run
• how do losses happen in the short run?

  • Periods of intense competition can cause prices to fall below the average costs
  • New firms may enter the industry. This results in the market share being divided up between more competitors and some individual firms may start making a loss
• what does this graph show about a loss making firm in perfect competition?

  The firms are producing at the profit maximisation level of output, where MC=MR (Q1)

  • At this level of output, the AR (P1) < AC (C1)
  • The firm's loss is equivalent to (P1-C1)xQ1

  
• what is the short run shut down point ?

  AR=AVC
• what rule determines which firms shut down in perfect competition?

  • The shut down rule will determine which firms shut down
  • There are no barriers to exit, so it is easy to leave the industry
• how does the graph show a loss making firm in the short run?

  • The firm is initially producing at the profit maximisation level of output, where MC=MR (Q1)
  • At this level of output, the AR (P1) < AC (C1) and the firm is making a loss
  • Some firms leave the industry, and supply decreases from S1→S2
  • Overall quantity in the industry falls from Q1→Q2
  • The industry price increases from P1→P2

  
• how does the graph show a loss making firm in the long run?

  • Some firms leave the industry, and supply decreases from S1→S2
  • Overall quantity in the industry falls from Q1→Q2
  • The industry price increases from P1→P2
  • The firm now has to sell its products at the industry price of P2
  • The output of the firm increases from Q1→Q2 as it now has a larger market share of the smaller industry
  • At the profit maximisation level of output (MC=MR) the firm is now producing at the point where AR= AC
  • The firm is making normal profit

  
• what is allocative effiency?

  average revenue = marginal cost (AR = MC)

  • At this point, resources are allocated in such a way that consumers & producers get the maximum possible benefit
  • No one can be made better off without making someone else worse off
  • There is no excess demand or supply
• what is productive effiency?

  marginal cost = average cost (MC=AC) lowest point on the AC curve

  • At this point average costs are minimised
  • There is no wastage of scarce resources & a high level of factor productivity
• what does this graph show about efficiency in perfect competition?

  • The firm produces at the profit maximisation level of output where MC=MR (Y)
  • The firm is productively efficient as MC=AC at this level of output
  • The firm is allocatively efficient as AR (P)=MC

  
• what type of market structure is perfect competition?

  theoretical
• Compared to a perfectly competitive market, free markets have no?

  efficient allocation of resources.

  • Firms may not aim to be allocatively and productively efficient. They may focus on short-term gains instead
• what is a privatisation example of where huge inefficiencies rose?

  • Following the privatisation of the water industry in the UK in 1989, huge inefficiencies arose
  • Under private ownership, the main objective of these water companies was to earn short-term profits
  • Dividends increased for shareholders of water companies
• what did the privatisation of the water industry lead to?

   significant underinvestment in infrastructure and maintenance of water supply systems 

  • This led to productive inefficiency, as deferred maintenance led to the deterioration of infrastructure over time. This caused inefficiencies such as leaks, bursts, and service disruptions
  • It also led to allocative inefficiency as the best interest for consumers and society's welfare declined with fall in water quality and service
• it can be strongly argued that higher effiencies would be achieved under?

  government ownership