Perfect Competition Flashcards
(11 cards)
What is perfect competition?
A market structure in which a very large number of firms compete to sell a homogeneous product
What are the 5 assumptions of the perfect competition model?
- There is a large number of small firms, each acting independently and unable to influence the price
- All firms sell a homogeneous (or identical) product
- There is free entry and exit
- There is perfect information, so that all firms and consumers have all necessary information on price and output to make decisions
- Ensures consumers do not pay above market price
& firms price products at same price
- Ensures consumers do not pay above market price
- There is perfect resource mobility
What is the nature of the demand curve for a firm in perfect competition?
The demand curve for the firm is perfectly elastic, meaning a small change in price will lead to a large change in quantity
- If firm raises price above market price it will not sell any output as buyers will buy the product elsewhere for the market price
- the firm has no incentive to reduce price as it can sell all its quantity at the market-determined price
What is the relation between D and MR of a firm in perfect competition?
D = P = MR = AR in a perfectly competitive firm. This is because firms are price takers, meaning price is constant.
Why can a firm make profit/loss in the short run in perfect competition?
In the short run, at least one factor of production is fixed. For a firm to be able to leave the industry (if making losses) or firms to enter the industry (if firms are making profits), then all factors of production must be variable.
What is the break-even price of a firm in perfect competition?
The break-even price is the price at which the firm makes normal profit.
P = minimum ATC (revenue/unit = cost/unit)
What is the shut down price of a firm in perfect competition?
If a loss-making firm stops production in the short-run it will still have to pay for fixed costs and thus will make a loss equal to fixed costs. Thus, only if a firm is producing at minimum AVC (when loss = fixed costs) should the firm shut-down. For a price below minimum AVC, loss > fixed costs. For a price above minimum AVC, loss < fixed costs, and so firm should continue producing.
Why do profit-making firms in perfect competition earn normal profit in the long run?
In the long run, all the firm’s resources are variable. This means that there is free entry and exit. Thus, if economic profits are being earned, firms will be attracted and will enter the market. This will cause the supply to increase and thus the price to fall.
Why do loss-making firms in perfect competition earn normal profit in the long run?
In the long run, all the firm’s resources are variable. This means that there is free entry and exit. Thus, if losses are being made, firms will wish to minimize their losses by shutting down and leaving the market. This will cause the market price to increase, meaning those firms who were making losses earlier but did not shut down will now earn normal profit.
Why do some firms shut down sooner than others in perfect competition?
Normal profit covers implicit costs (varied across firms) as well as explicit costs. Therefore, although firms might face identical explicit costs, some will shut down sooner due to their different levels of implicit costs. This is why some firms exit the industry while others do not.
What causes firms to start earning economic profits or losses again? What causes a shift from long-term equilibrium?
- Changes in Demand
- If demand increases => price increases => firms will make profit
- if demand decreases => price decreases => firms will make loss - Changes in technology or resource prices
- improvement in technology or fall in resource prices => lower costs => firms will make profit
- increase in resource prices => higher costs => firms will make loss
