Transcript Perfect competition

Quick Quiz
• On 2 separate diagrams
• For a firm facing a downward sloping
demand curve:
• Illustrate normal profit
• Illustrate abnormal profit
Market Structures
Perfect
Competition
Monopolistic
Competition
Oligopoly
Monopoly
The theory of the firm examines how prices and
output vary under these different market
structures
Perfect Competition is based upon a number
of assumptions
•
•
•
•
•
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Many buyers and many sellers
Firms are ‘price takers’ (perfectly elastic D curve)
No barriers to entry or exit
Homogeneous products
Perfect information
Perfect factor mobility
• If these conditions exist, the market system can produce
an optimal allocation of scarce resources
What markets have features of perfect
competition?
• When perfect competition exists, resources are allocated
through price signals
• Fierce competition ensures that costs are minimised and that
resources are used sparingly (firms will produce at their lowest
average total cost hence will be productively efficient)
• Inefficient firms will be driven out of the market; only those
with the lowest costs will survive
• Prices will be pushed downwards
• It ensures that consumer sovereignty prevails – firms become
price takers
• Normal profit is made in the long- run (normal profit is the
minimum level of profit required to keep the factors of
production in their current use in the long run)
• Note: Despite the lack of real- world examples, the model plays
a very important part in economic analysis and policy.
• Many economists would argue that achieving perfect competition
(or moving towards it) would bring a number of advantages and is
therefore used as a standard to judge the shortcomings of real
world industries and can help form policies towards industries.
Possible short-run profit and
loss situations in perfect
competition
Recall...
• The output level for a firm with a
perfectly inelastic demand curve using
MC and D=AR=MR
•Remember
•MC=MR determines quantity
•AC determines cost per unit and
AR is the price per unit
MC
£
s/r
abnormal
profits in
perfect
competition
AC
D= AR= MR
P
C
q
Output
s/r loss in perfect
competition
•Remember
•MC=MR determines quantity
•AC determines cost per unit and
AR is the price per unit
MC
AC
£
C
D= AR= MR
P
q
Quantity
The movement from shortrun to long- run in perfect
competition
• If firms are making either short- run
abnormal profits or short- run losses,
other firms react and the situation
starts to change until an equilibrium
point is reached in the long run
If abnormal profits are being
made in the short- run...
• New firms enter the market (due to
assumptions) attracted by the abnormal
profit
• Industry supply curve shifts to the
right so the market price falls
• As firms are price takers, their D
curves shift downwards until any
abnormal profit has been ‘competed
away’
Short- run abnormal profits to long- run normal profits
£
£
S
S1
MC
D= AR= MR
P
P
C
P1= C1
P1
AC
D1= AR1= MR1
D
Quantity
q1 q
Quantity
If subnormal profits are being
made in the short- run…
• When AC>AR
• Can occur if demand falls or costs rise
• Some firms will leave the industry, some will
remain
• Recall the shut down price…
• Those who are receiving a price equal to or
above their AVC will remain open, those who are
not will shut down
• Note: It is usually assumed that firms have
identical cost curves, however this is not very
realistic…
Marginal Firms
• Those with the highest costs
• The firms who are first to leave an
industry when subnormal profit is being
made and the last to enter when
supernormal profits are made
Activity
• Illustrate the movement from shortrun loss to long run normal profits in
perfect competition
Short- Run loss to long- run normal profits
£
AC
£
S1
S
MC
C
P1
D= AR= MR
P=C1
D1= AR1= MR1
P
P
D
Quantity
q q1
Quantity
Long- run equilibrium in perfect competition
£
£
S
MC
D= AR= MR
P
P
AC
D
Quantity
q
Quantity
• In theory, perfect competition produces
a long- run equilibrium where all firms
earn only normal profits and produce at
minimum cost
Productive Efficiency in
Perfect Competition
• A firm is productively efficient if it
produces at it lowest possible average
cost (the lowest point on its lowest
possible AC curve)
• As MC always cuts AC at its lowest we
can say that where MC=AC is the
productively efficient output level
Allocative Efficiency in
Perfect Competition
• Socially optimum level of output
• When there is no excess supply or
demand
• What is demanded is being produced
• Note. Does not necessarily mean that there is
a ‘fair’/ equal distribution of income.
• Allocative Efficiency occurs where
MC= AR
i.e. The cost of producing an extra unit is
equal to the value placed on a unit
• P reflects the value consumers place on
a good shown by D (AR) curve.
• MC reflects the cost to society of all
the resources used in producing an
extra unit of the good, incl. the normal
profit.
• Recall: Assumption of perfect information
The Firm’s Supply Curve under PC
• Firms are profit maximisers so output is
set where MC=MR
• As MR=AR (i.e. Price) in PC, the
individual firm will adjust their output
so that P=MC
• s/r MC curve above AVC curve
• l/r MC curve above AC curve
LR S Curve= MC above AC
SR S Curve= MC above AVC
MC
£
P
AC
AR= MR
P1
AR1= MR1
P2
AR2= MR2
P3
AVC
Q3Q2Q1 Q
AR3= MR3
Quantity
When there is perfect competition…
• Fierce competition ensures that costs are minimised
and that resources are used sparingly
• Inefficient firms will be driven out of the market;
only those with the lowest costs will survive
• Prices will be pushed downwards
• It ensures that consumer sovereignty prevails – firms
become price takers
Activities on Perfect
Competition
• WS7
• Data Response