Competitive Markets and Efficiency

Question 1

What are the properties of a perfectly competitive market?

Answer 1

• Many buyers and sellers
• homogenous goods
• each firm has no market power/is a price taker
• demand for each individual firm is perfectly elastic
• buyers have perfect information

Question 2

Why are perfectly competitive markets productively efficient?

Answer 2

Will produce at bottom of AC curve when making normal profits which is the long term equilibrium.

Question 3

Why are perfectly competitive markets allocatively efficient?

Answer 3

• Because they produce where P = MC. This means the marginal benefit placed by consumers (price) is the same as the marginal cost of producing one more unit.
• If produce less: MB > MC, so consumers value extra units more than it costs to produce them.
• If produce more: MC > MB so the true cost of producing more is greater than the benefit to consumers.
• Total (consumer and producer surplus) is maximised.

Question 4

How does perfect competition reach long term equilibrium?
Provide an example.

Answer 4

• In short term, a firm may be making supernormal profits.
• As a result, profit incentive may cause firms to enter the market due to no barrier of entry
• This shifts the supply of the whole market to the right, increasing output and reducing price.
• The perfectly elastic demand curve of the firm goes down to the new market price, reducing profits until normal profits are made.
• Example: Ice Cream trucks during a hot summer.