3.4.2 - Perfect Competition

Question 1

What Is Perfect Competition?

Answer 1

Individual firms have no market power due to the amount of competition, and so are unable to influence the price.

Question 2

What Are The Characteristics Of Perfect Competition?
(6 Points)

Answer 2

~ Many buyers and sellers.

~ Homogenous goods are being sold.

~ Firms are price takers from the market.

~ No barriers to entry or exit, no costs involved.

~ Perfect information of market conditions, between buyers and sellers.

~ Firms are profit maximisers, producing where MC = MR.

Question 3

Why Is SNP A SR Equilibrium & Not A LR Equilibrium?
(2 Points)

Answer 3

~ The SNP attracts new firms into the market.

~ They can enter with ease, as there is no barriers to entry and there is perfect information of market conditions.

Question 4

Draw The Graph For SNP In The SR & Explain It
(8 Points)

Answer 4

Diagram Steps:
~ AC < AR.

~ Firms produce where MC = MR, profit max position.

~ Compare AR and AC, to find the SNP.

~ Long run position is where MC = AC, so draw new AR curve and quantities.

Theory:
~ When new firms enter supply shifts to the right, and the price falls.

~ This keeps happening until there is no more incentive to enter the market.

~ Until all the SNP goes, causing normal profit (AR = AC)to be left at the end in the LR.

~ Which is why SNP doesn’t last in the LR.

Question 5

Why Is Subnormal Profit A SR Equilibrium & Not A LR Equilibrium?
(3 Points)

Answer 5

~ Firms will be incentivised to leave the market as they are making a loss, and to produce their opportunity cost instead.

~ They can leave the market, as there are no barriers to exit.

~ Not all firms leave, this is because of the shut condition in perfect competition.

Question 6

Draw The Graph For Subnormal Profit In The SR & Explain It
(8 Points)

Answer 6

Diagram Steps:
~ Loss is going to be made, so AC > AR.

~ Firms produce where MC = MR, profit max position.

~ Compare AC and AC, to find the subnormal profit and the SR position.

~ Long run position is where MC = AC , so draw new AR curve and quantities.

Theory:
~ As firms leave the market, supply shifts left and price rises.

~ This keeps happening until there is no more incentive to leave the market.

~ Until all the subnormal profit goes, causing normal profit (AR = AC) to be left at the end in the LR.

~ Which is why subnormal profit doesn’t last in the LR.

Question 7

Why Don’t All Firms Leave When There A Losses Being Made, During The Subnormal Profit SR Equilibrium?

Answer 7

All down to the shut down condition in perfect competition.

Question 8

Describe What Happens If A Firm Chooses To Shut Down, In A Loss Making Industry
(3 Points)

Answer 8

~ No revenue would be coming in.

~ Firm would still have to cover its fixed costs or production.

~ Shutting down would depend on the losses of continuing production.

Question 9

Describe What Happens If A Firm Chooses To Continue Producing, In A Loss Making Industry
(3 Points)

Answer 9

~ They would have revenue coming in.

~ Firm would still have to cover its total costs or production.

~ Shutting down would depend on the losses of continuing production.

Question 10

What Is The Shutdown Condition?
(2 Points)

Answer 10

~ AR = AVC, at this point firms should consider shutting down.

~ If AR < AVC, firm should definitely shut down.

Question 11

Draw The Graph For A Firm Making A Loss, But Covering Its AVC & Explain It
(8 Points)

Answer 11

Diagram Steps:
~ Draw revenue curves.

~ AC > AR, as the firm is making a loss.

~ Draw AVC below AR, and AC above AR and AVC.

~ Firms produce where MC = MR.

~ Draw cost line, to form subnormal profit.

Theory:
~ Firm isn’t going to shut down, as they are covering the AVC.

~ AR > AVC, so firm can cover costs, even though they are making a loss.

~ Firms should let other firms leave the market, and reap the benefits.

Question 12

Draw The Graph For A Firm Making A Loss, But Isn’t Covering Its AVC & Explain It
(8 Points)

Answer 12

Diagram Steps:
~ Draw revenue curves.

~ AC > AR, as the firm is making a loss.

~ Draw AVC above AR, and AC above AR and AVC.

~ Firms produce where MC = MR.

~ Draw cost line, to form subnormal profit.

Theory:
~ Firm is going to shut down, as they aren’t covering their AVC.

~ AVC > AR, so firm cannot cover costs.

~ Loss cannot be sustained, firm should leave industry and move FOPs elsewhere.

Question 13

What Efficiencies Are Being Achieved In Perfect Competition?
(3 Points)

Answer 13

~ AE.

~ PE.

~ XE.

Question 14

Describe How Allocative Efficiency Is Achieved In Perfect Competition
(4 Points)

Answer 14

~ P = MC, so AE is being achieved.

~ Resources are perfectly following consumer demand.

~ Prices are low, CS is high, choice and quantity are high.

~ Consumers benefit heavily.

Question 15

Describe How Productive Efficiency Is Achieved In Perfect Competition
(2 Points)

Answer 15

~ Firms are operating at the lowest point on the AC curve.

~ Full exploitation of EOS in the market.

Question 16

Describe How X-Efficiency Is Achieved In Perfect Competition
(2 Points)

Answer 16

~ Firms are producing on their AC curve.

~ They are minimising waste and costs.

Question 17

What Efficiencies Are Not Being Achieved In Perfect Competition?

Answer 17

DE.

Question 18

Describe How Dynamic Efficiency Is Not Being Achieved In Perfect Competition
(3 Points)

Answer 18

~ No SNP in the LR.

~ Don’t have the profit in the LR, to reinvest back into the firm.

~ Can affect consumers, due to less innovation, e.t.c.