5.3

• What are the characteristics of perfect competition?

  • large number of buyers and sellers
  • Perfect market information
  • Ability to buy and sell as much as they want at the ruling market price
  • Unable to influence the ruling market price
  • No barriers to entry or exit
  • Uniform (homogenous) product
• perfect competition does not exist in real life
• How is price determined in perfectly competitive market?

  By interaction of supply and demand
• why are profits likely to be lower in a competitive market than a market wth only a few large firms?

  each firm in a competitive market has a very small market share. therefore, market power is very small. if firms make abnormal profit. new firms will enter the market, due to low barriers to entry. new firms will increase supply, which lowers the average price. existing firms’ profits will be competed away
• what profits can be made in the short and long run in perfectly competitive markets?

  • short run: supernormal profits
  • long run: normal profits (profits competed away)
• advantages of a perfectly competitive market

  • lower price in the long run. P=MC so there is allocative efficiency
  • since firms firms produce at the bottom of the AC curve, there is productive efficiency
  • supernormal profits produced in the short run might increase dynamic efficiency through investment
• disadvantages of a perfectly competitive market

  • in the long run, dynamic efficiency might be limited due to the lack of supernormal profits
  • since firms are small, there are few or no economies of scale
  • assumptions of the model rarely apply in real life. in real life branding, product differentiation, adverts and positive and negative externalities mean that competition is imperfect
• What does it mean when firms are ’price takers’?

  Firms must accept the market price because they are too small to influence it due to high competition and identical products
• in the short run, can firms in perfect competition make supernormal profits?

  yes, if average revenue > average total cost, firms make abnormal profit
• what happens to supernormal profits in the long run in perfect competition?

  new firms enter due to no barriers, increasing supply -> price falls -> profits are competed away -> firms make normal profits only
• what is normal profit?

  the minimum level of profit needed to keep a firm in the market - when total revenue equals total costs including opportunity cost
• why is allocative efficiency achieved in perfect competition?

  because P=MC in long run equilibrium - resources are allocated to produce what consumers want at the right quantity
• why is productive efficiency achieved in perfect competition (in the long run)?

  firms produce at the lowest point on their average cost curve: MC=AC, meaning output is produced at minimum cost
• what is dynamic efficiency and is it likely in perfect competition?

  dynamic efficiency = innovation/improvements over time. unlikely in perfect completion due to no supernormal profits to fund R&D
• give a real-life examples that partially resembles perfect completion

  local fruit/vegetable markets - many small sellers, low barriers, similar products - though not perfect due to product branding and imperfect information
• productive efficiency definition

  for the economy as a whole occurs when it is impossible to produce more of one good without producing less of another. for a firm it occurs when the average total cost of production is minimised
• allocative efficiency definition

  occurs when it is impossible to improve overall economic welfare by reallocating between markets. in the whole economy, price must equal marginal cost (P=MC) in every market
• allocative inefficiency

  occurs when P>MC, too little of a good is produced and consumed, and when P<MC, when too much of a good is produced and consumed