3.4.2 - Perfect Competition

Question 1

State 6 assumptions regarding perfect competition

Answer 1

1) Firms aim to maximise profits.
2) There are many participants (both buyers and sellers).
3) The product is homogeneous.
4) There are no barriers to entry to or exit from the market.
5) There is perfect knowledge of market conditions.
6) There are no externalities.

Question 2

Why is perfect competition ideal

Answer 2

• there is equality
• because if all its assumptions were fulfilled, and if all markets operated according to its precepts, the best allocation of resources would be ensured for society as a whole.

Question 3

What is the assumption regarding perfect knowledge in perfect competition

Answer 3

• It is assumed that all participants in the market have perfect information about trading conditions in the market and production methods.
• In particular, buyers always know the prices that firms are charging and details of the product, and thus can buy the good at the cheapest possible price.
• Firms that try to charge a price above the market price will get no takers. At the same time, traders are aware of the product quality.

Question 4

What is meant by no barrier to entry or exit

Answer 4

By this assumption, firms are able to join the market if they perceive it to be a profitable step, and they can exit from the market without hindrance. This assumption is important when it comes to considering the long-run equilibrium towards which the market will ten

Question 5

What is meant by homogeneous product?

Answer 5

• This assumption means that buyers of the good see all products in the market as being identical, and will not favour one firm’s product over another.
• If there were brand loyalty, such that one firm was more popular than others, then that firm would be able to charge a premium on its price.
• By ruling out this possibility the previous assumption is reinforced, and no individual seller is able to influence the selling price of the product.

Question 6

Why is it important that there are many participants in a perfect competition market structure

Answer 6

• that there are so many buyers and so many sellers that no individual trader is able to influence the market price. The market price is thus determined by the operation of the market.
• limited economies of scale meant minimum efficient scale is small relative to market demand then no firm is likely to become so large it will gain influence in the market

Question 7

What are the consequences of there being no barriers to entry

Answer 7

• anyone can enter a market and start making goods to make a profit:easy to enter and leave a market
• As a result, business are unable to make huge profits in the long run and if they are making losses they are able to leave. In the long run, they make normal profits.

Question 8

Diagram on p59 of CGP

Question 9

Why can’t firms operating in perfect competition make supernormal profits in the long run

Answer 9

• there is perfect knowledge in a marlet therefore producers recognise an incentive to enter the market (supernormal profits) and they act on it due to no barriers to entry, hence the industry supply increases, lowering industry price and because firms are price makers they must accept the new prices. This effect of new firms netering and price lowering continues until the incentive of supernormal profits disappears, i.e price is lowered to a point where P=AC therefore ony normal profits are earnt here.

Question 10

What is the implication if goods are homogenous

Answer 10

firms are price takers
- cannot set a price above the price set by industry as they lose their demand
- no point setting a price below the industry price because they make less profit, so they aren’t profit maximising as they should be

Question 11

What is the long run equilibrium

Answer 11

when normal profits are made

Question 12

How to draw diagrams

Answer 12

• industry on the left, firm on the right
• mc cuts ac at lowest point on ac

Question 13

Why can’t firms make subnormal profit (loss) in the long run?

Answer 13

• Price is below AC, so firms are mkaing loss
• firms are incentivised to leave the market and produce their opportunity cost instead
• no barriers to exit means firms can leave the maket with no extra cost, so as firms leavem industry supply falls (left shift) and price rises and this continues until no more incentive to leave ie. normal profits are being made now

Question 14

How does perfect competiton achieve allocative efficiency

Answer 14

In this market structure, P=MC at the long run when normal profits are made, therefore, yes allocative efficiency is achieved
- so resources follow consumer demand: consumers surplus is high, q is high, choice is high, price is low

Question 15

Does perfect competition achieve productive efficiency

Answer 15

• Yes in the LR equilibrium , the firm is operating at the lowest point of the cost curve wher MC=MR bc they profit maximise but this relies on assumption that there are no economies of scale
• otherwise small firms cannot earn economeis of scale therefore they aren’t on lowest point of AC curve

Question 16

iS THERE x EFFICIENCY?

Answer 16

Yes, they produce on their cost curve bc they are productively efficient and strong comp gives incentive to reduce waste and inefficiency

Question 17

Is there dynamic efficiency,

Answer 17

No - there is no supernormal profit in the long run to reinvest back into the company so consumers do not see brand new products over time, producers cannot lwoer costs due to newer tech over time
- also normal profitd means no reward for taking risks to invest

Question 18

Why are firms statically efficient

Answer 18

• if firms deviate away from the static efficiencies (AE, XE, PE) , they do not survive due to the intense competition
• So perfect competiton is statically but not dynamically efficient
• static efficiency doesn’t last forever bc etch and consumer tastes change

Question 19

two forms of x inefficiency

Answer 19

• using FOP wastefully
• paying to much for FOP

Question 20

Define perfect competition

Answer 20

where prices reflect complete mobility of resources and freedom of entry and exit, full access to information by all participants, homogeneous products, and the fact that no one buyer or seller, or group of buyers or
sellers, has any advantage over another.

Question 21

Define price taker

Answer 21

When a firm in a perfectly competitive market takes the ruling market price
as its demand curve – this contrasts with imperfect competition (such as monopoly or monopolistic competition) where businesses have price-setting power.

Question 22

Does Perfect competiton benefit from EOS?

Answer 22

many small firms producing relatively small amounts. Industries with high fixed costs would be particularly unsuitable to perfect competition