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Perfect competition
This document discusses the model of perfect competition. It outlines the key assumptions of the model including homogeneous goods, many small buyers and sellers, perfect information, and free entry and exit. The document then examines the short-run and long-run equilibrium for firms under perfect competition and how price and output are determined. It also discusses how perfect competition leads to productive and allocative economic efficiency. While the assumptions of the perfect competition model are not fully met in reality, the model provides a benchmark for understanding different market structures and their impacts.
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Perfect competition
- 1. Perfect Competition Characteristicsof perfect competition Short and long run equilibrium Output and price under perfect competition Competition and economic efficiency The relevance of perfect competition
- 2. Assumptions Behind a Perfectly Competitive Market 1. The units of production are homogenous and therefore buyers have no preference for the goods of any particular seller. 2. There are an infinite number of buyers and sellers and therefore the behaviour of one does not influence the market price. 3. Buyers and sellers have a perfect knowledge of the market. 4. There are no barriers to movement within the industry. 5. Firms seek to maximise profit. 6. No externalities 7. That there are constant returns to scale. No Economies or diseconomies of scale.
- 3. Examples of Perfectly Competitive Markets? Close approximations: Foreign exchange dealing • Homogeneous product - US dollar or the Euro • Many buyers & sellers • Usually each trader is small relative to total market and has to take price as given • Sometimes, traders can move currency markets Agricultural markets • Pig farming, cattle • Market for apples, tomatoes
- 4. Price Taking Firms Competitive firms have little direct influence on the ruling market price Example of price-taking behaviour: Local farmers selling to large supermarkets When most firms in a market are price takers, there is only a small percentage difference in the prices of selected products within the market The law of one price may hold true – most of the existing firms sell at the prevailing price
- 5. Short-run price andoutput AR=MR Output MC MR=MC Maximum Profits Price Price P1 AC Q1 AC1 Output P1 MS MD
- 6. Showing short-run profits AR=MR Output MC Profits = (P1-AC1) x Q1 Price Price P1 AC Q1 AC1 Output P1 MS MD
- 7. A rise inmarket demand AR=MR Output MC Price Price P1 AC Q1 AC1 MD2 Output P1 MS MD P2 AR2=MR2 Q2 P2 New level of supernormal profits
- 8. What is aLong Run Equilibrium? The usual interpretation of a long run equilibrium is as follows: (1) The quantity of the product supplied in the market equals the quantity demanded by all consumers (2) Each firm in the market maximizes its profit, given the prevailing market price (3) Each firm in the market earns zero economic profit (i.e. normal profit) so there is no incentive for other firms to enter the market
- 9. Long-run equilibrium price AR=MR Output MC Price Price MS2 P1 AC Output Q2 P1 MS MD P2 AR2=MR2
- 10. The long-run equilibrium Output MC AC Price Price MS MS2 MD Output Q2 P2 AR2=MR2 In the long run equilibrium, normal profits are made i.e. price = average cost
- 11. Competition and Economic Efficiency Economic efficiency has several meanings: Productive efficiency • when output is produced at the lowest feasible average cost (either in the short run or the long run) Allocative efficiency • achieved when the price of output reflects the true marginal cost of production • (i.e. price=marginal cost)
- 12. Productive Efficiency Output Cost per unit AC1 AC2 AC3 LRAC Q1 Q2 Q3
- 13. Allocative Efficiency Market Supply Output Price Demand Consumer Surplus Producer Surplus P1 Q1
- 14. Allocative Inefficiency Market Supply Output Price Demand Consumer Surplus Producer Surplus P1 Q1 P2 Q2 Deadweight loss of welfare
- 15. Competition and Economic Efficiency Technological efficiency • where maximum output is produced from given inputs Dynamic Efficiency • Refers to the range of choice and quality of service • Also considers the pace of technological change and innovation in a market
- 16. Allocative efficiency Allocative efficiency achieved when it is impossible to make someone better off without making someone else worse off Also called Pareto Optimality No trades are left that would make one person better off without hurting someone else Occurs when price = marginal costs of production This occurs in the long-run under perfect competition
- 17. Importance of aCompetitive Environment The standard view is that competition drives an improvement in welfare and efficiency Competition forces under-performing firms out of the market and shifts market share to more efficient firms in the long-run Competition encourages firms to innovate and adopt best-practice techniques
- 18. How useful ismodel of perfect competition? Assumptions are not meant to reflect real world markets where most assumptions are not satisfied Pure competition is largely devoid of what most people would call real competitive behaviour by businesses! The model provides a theoretical benchmark against which we compare and contrast imperfectly competitive markets Consider perfect competition as a point of reference Useful when considering The effects of monopoly or other forms of imperfect competition The case for free international trade
- 19. Real world –imperfect competition! Some suppliers have a degree of control over market supply Some consumers have monopsony power against suppliers because they purchase a significant percentage of total demand Most markets have heterogeneous products due to product differentiation. Consumers nearly always have imperfect information and their preferences and choices can be influenced by the effects of persuasive marketing and advertising The real world is one in which negative and positive externalities from both production and consumption are numerous Finally there may be imperfect competition in related markets such as the market for essential raw materials, labour and capital goods.
Editor's Notes
- #3 Under perfect competition firms are assumed to be price takers.
- #6 A perfectly competitive industry is made up of a large number of small independent firms, each selling homogeneous (identical) products to a large number of buyers The firms demand curve is perfectly price elastic because any firm that raises it prices sees demand fall to zero as consumers, with perfect knowledge switch to other producers offering an identical product.
- #10 If most firms are making abnormal (supernormal) profits, this encourages the entry of new firms into the industry, causing an outward shift in market supply and forcing down the price. The increase in supply will eventually reduce the market price until price = long run average cost. At this point, each firm is making normal profit. There is no further incentive for movement of firms in and out of the industry and a long-run equilibrium has been established. This is shown in the next diagram.
- #12 Economic efficiency is achieved in the long run under perfect competition
- #13 Output Q3 represents the minimum efficient scale of production where long run average cost is at its lowest point – this is the output of productive efficiency in the long run. Efficiency usually occurs over a range of output rather than a unique level of production.
- #14 In both the short and long run in a competitive market, the equilibrium price is where market demand = market supply. At the ruling market price, consumer and producer surplus are maximised. No one can be made better off without making some other agent at least as worse off – i.e. the conditions are in place for a Pareto optimum allocation of resources.
- #15 If output is lower than the competitive market equilibrium and price is higher, then there is a fall in consumer surplus and a rise in producer surplus. But the net result is a deadweight loss of economic welfare
- #16 Economic efficiency is achieved in the long run under perfect competition