L14 - Perfect Competition Flashcards
What is the problem with the Original Supply and Demand Model?
- The original Supply and Demand curve showed the market quantity supplied and demanded
We now derive the supply curve from the technologies of the sellers - However they do not tell use the level of the prices or more qualitative aspects of the the market
- Therefore revisiting the model we will be looking at:
(a) positive aspects – how much is produced and at what price?
(b) normative aspects – are the positive aspects, in some sense, ‘good’?:
What is does Market Structure mean?
Market structure refers to the characteristics of a market that may affect the trades
- The characteristics we consider in this course are:
(a) - The number and size of sellers
(b) - The barriers to entry
(c) - The extent of product differentiation
(d) - The number and size of buyers
- Such characteristics may affect the nature of trades in the market
(output, price, and whether the outcome is ‘good’)
- For this topic, the markets are product markets: firms = sellers, individuals = buyers
What are some real world examples of Perfect Competition?
- ‘Perfect’ does not mean ‘best’ here (there are drawbacks)
- It refers to the underlying market structure, which is perfect for competition
It is at one extreme of the competition spectrum
-The assumptions are unrealistic and it’s difficult to think of real world examples.
So why study it?
(a) agricultural and financial markets are close to perfect competition
(b) use extremes as a foundation to build upon
What are the two rules for Profit Maximisation?
1 - Marginal Output Rule
2- Shutdown Rule
What is the Marginal Output Rule?
- If the firm does not shut down, then it should produce at the level where:
MR = MC
Why?
- Recall that when an extra unit is produced:
- the amount that TR (total revenue) increases by is MR
- the amount that TC (total cost) increases by is MC
If MR > MC, then producing an extra unit increases TR more than TC
- Thus, the firm’s profits increase (since π = TR – TC)
What is the Shutdown Rule?
- The firm should shut down if, for every level of output:
- (its price) p < AC (average economic cost)
- Otherwise it should produce according to the marginal output rule
- In the short-run: only one input varies, and only the expenditure on this factor is an
economic cost - p < AVC (average variable cost)
- In the long-run: all factors are variable, so expenditures on all factors are economic
costs - p < LRAC (long run average cost)
What are the Assumptions for topic 4 and 5?
A(1) –> BUYERS ARE PRICE TAKERS
- Each buyer takes price as given
- They believe that they can buy as much as they want at the going price without
having an effect on that price
- Reasonable assumption for most product markets, it may not hold in input markets
A(2) –> SELLERS AND sBUYERS HAVE COMPLETE INFORMATION
- Sellers are able to respond to incentives
- Buyers have the greatest chance to receive what they want from the market
- This is what we want when analysing perfect competition!
- This simplifies the analysis a lot!
- Holding this assumption constant for other market structures enable us to focus on
the effects of other changes
What are the Assumptions of Perfect Competition?
A(3) –> SELLERS ARE PRICE TAKERS
- Each seller believes its output choice will not affect the market price
- This has two parts to it:
(a) Sellers can sell as much as it wants, at a given price
(b) Sellers output choice will not trigger a reaction from rivals
A(4) –> ENTRY IS FREE
- A potential seller can enter the market in the long run without incurring costs that
an incumbent seller would not incur
- Entry is a long-run decision: all factors of production must be able to change
- Effectively, assumption implies:
(a) sellers are in the market if they have capital, and they can increase
their output by employing more labour
(b) a potential seller without any capital cannot produce using labour
alone (they have to have capital first)
What is the Appropriate market Structure under the Assumptions
A) - Size and Number of Sellers –> Many and small
- A change in seller’s output has little effect on price if it is small relative to total e.g. recall market price elasticity is: %ΔP= -(%ΔQ)/(E{m})
B) - Barriers to Entry –> Low
- Firms must be able to enter the market freely
C) - Product Sustainability –> Undifferentiated
- Buyers consider all products to be identical (homogeneous)
so they will buy the cheapest product
What is the Short-Run Equilibrium under Perfect Competition?
- There is an equilibrium in economic models when:
economic agents will not change their behaviour from the equilibrium - There is an equilibrium in a perfectly competitive market when:
(a) sellers produce as much as buyers want to purchase,
(b) buyers purchase as much as sellers choose to produce
This implies that:
(1) The market price is determined by market supply & demand
(2) A seller’s output is determined by seller-specific supply & demand
Therefore on the Seller’s Supply Curve:
- Price (p) is equal to Demand = Average Revenue (AR) = Marginal Revenue
- Equilibrium Production occurs at MR=MC
- where p ≥ AVC
What does the Seller’s Supply Curve look like?
- With Price (p) on the y-axis and Quantity Supplied q(p) on the x-axis
- With a flat horizontal line at Price level (p)
- With a positive X^2 like curve of AVC
- With a Positive X^2 like curve of MC which has a steeper gradient and lower turning point
What does the Short-Run Equilibrium look like as a Market Supply Curve?
This is for symmetrical firms that supply the same products
- With Price (p) on the y-axis and Quantity Supplied nq(p) on the x-axis
- If the market price is p so each firm supplies
q(p), then the market supply is nq(p)
- at various levels of p the market with supply varying levels of nq(p) which can be plot of the graph to form a line
- as the sellers supply curve follows the marginal cost curve - at the point the seller curve thus the MC cost is equal to the AVC curve there is a dotted line across the the y axis indicating no quantity will be supplied at a price below that below that point
- the supply curve is horizontal to the point where MC=AVC then is a diagonal vertical line
- the demand curve is a negative gradient line
- he market price is determined by the point
where supply and demand intersect
What does the Short-Run Equilibrium look like for a Market Supply Curve in a general case?
- In the general case where we have asymmetrical firms fell different products the market graph looks like the following:
- With Price (p) on the y-axis and Quantity Supplied Q(p) on the x-axis
- Supply is a positive gradient line and demand is a negative gradient line
- market price is determined by the point of intersection at quantity supplied being Q(p) where P = MC
Why in the Long-Run does the equilibrium changes for a Market Supply Curve?
(1) all factors are variable which has an impact on the seller’s costs
(2) other sellers can freely enter the market
In the Long-Run what is the third condition of equilibrium?
(a) sellers produce as much as buyers want to purchase
(b) buyers purchase as much as sellers choose to produce
(c) incumbent sellers will not leave the market
potential sellers will not enter the market
All of this implies that:
(1) Sellers make normal profit in the long-run (zero economic profit)
