3.4 - Perfect competition

Question 1

Characteristics of perfect competition

Answer 1

1) Large Number of Sellers/firms:

2) Homogeneous Products

3) Perfect Information:

4) Free Entry and Exit to market (no bariers to entry/exit):

5) Price Takers

6) Zero Long-Run Economic/supernormal Profit

7) Perfect Mobility of Resources

8) Non-Collusive Behavior:

Question 2

Profit maximising equilibrium - perfect competition

Answer 2

• Firms are assumed to short run profit maximise and so the firm will produce at MC=MR.
• In the short run, it is possible for the firms operating in perfect competition to make a loss or a supernormal profit
• However, in the long run, these firms will only make normal profit .
• This can be seen on the diagram.
• In the short run, firms are making the supernormal profit of the shaded area.
• Prices are set
  by the market at P1, where S1=D1.
• As a result, the firm faces the demand curve of
  AR1=MR1 and produce where MC=MR1 at Q1 goods.
• However, since there is perfect information and no barriers entry, the fact they are making supernormal profits will acts as an incentive to other firms to enter the market.
• This will increase supply from S1 to S2 and lead to a fall in price from P1 to P2.
• The firm now has the demand curve AR2=MR2 and produces where
  MC=MR2 at Q2.
• This is also where AR2=AC and so they are making normal profits.
• If the firm was making a loss, firms would leave the industry and this would decrease supply,
  pushing prices up and reverting to the long run equilibrium. (normal profit)

Question 3

Why are perfect competition firms Price takers?

Answer 3

• Due to firms in perfect competition selling homogenous goods, there are many substitutes for consumers
• This means that the demand curve/Average revenue is perfectly elastic
• So, the demand is highly sensitive to a change in price
• This means that the firms do not have market power and must sell at the market price.

Question 4

Efficiency in perfect competition

Answer 4

● Perfect competition in the long is productively efficient, since they produce where MC=AC.
They are also allocative efficient since they produce where P=MC. Thus, they are
static efficient.

● However, they are not dynamic efficient . Firms don’t make supernormal profits in the long run and no single firm will earn enough profit for research and development. Also small firms struggle to receive finance. The existence
of perfect information also means one firms’ invention will be adopted by another firm
and so the investment will give the firm no competitive benefit. Governments tend to
have to do all the research.

● Competition should keep costs, and therefore prices, low. However, firms will be
unable to benefit from economies of scale and this may mean costs are higher than they otherwise could be.