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Chapter 8 Perfect Competition © Edco 2012. Positive Economics Assumptions/Characteristics of Perfect Competition There are many buyers in the market. There are many competitive sellers in the market. Each firm is a price taker, i.e. it accepts the price as it is set on the market, and each firm supplies such a small fraction of the market that it cannot influence the market price. The goods are homogenous. © Edco 2012. Positive Economics Assumptions/Characteristics of Perfect Competition (Continued) There is freedom of entry to and exit from the industry/there are no barriers to entry or exit within the industry. Perfect knowledge exists as to prices and profits. Each firm seeks to maximise profits (where MC = MR). No collusion exists on the market. Firms face a perfectly elastic supply of factors of production. © Edco 2012. Positive Economics Why Don’t Firms in Perfect Competition Engage in Advertising? Homogenous goods Increased cost and no additional revenue Benefits the entire industry Perfectly elastic demand © Edco 2012. Positive Economics Perfect Competition: The Short Run Average revenue is equal to marginal revenue, which is the same as price. This is the horizontal, perfectly elastic demand curve of a firm in perfect competition. A company will produce the quantity where MC = MR because at this stage, the company covers its variable cost and is making extra profits (supernormal profit). This happens because AR is greater than AC. © Edco 2012. Positive Economics Perfect Competition: The Short Run (Continued) The SNP earned in the short run will attract new firms to enter the market. As more firms enter the industry, the market supply curve will shift to the right. Market price will fall from P1 to P2, eliminating SNP to a point where only normal profit is being earned. © Edco 2012. Positive Economics Perfect Competition: The Long Run There will be sufficient time for new firms to enter or leave the market. New firms will be attracted because of supernormal profits. Existing firms will leave if normal profits are not being earned. © Edco 2012. Positive Economics Perfect Competition: The Long Run (Continued) Eventually there will be the right number of firms in the industry with each firm in equilibrium where AC = AR. The AR curve will be tangent to the AC curve, indicating that all costs are covered and only normal profit is being earned. © Edco 2012. Positive Economics Supply Curves in Perfect Competition A profit-maximising firm will supply output where MC = MR and MC is increasing at a faster rate than MR. The short run supply curve of a firm in perfect competition is that part of the MC curve which lies above the lowest point of the average variable cost curve. © Edco 2012. Positive Economics Supply Curves in Perfect Competition (Continued) The long run supply curve of a perfectly competitive firm is that portion of its marginal cost curve which lies above the lowest point of its average cost curve. In the long run, marginal cost is equal to price (MC = P). This is unique to perfect competition only. © Edco 2012. Positive Economics Benefits of Perfect Competition Produces at point of lowest cost Minimum prices No advertising Efficiency is encouraged © Edco 2012. Positive Economics Disadvantages of Perfect Competition No scope for economies of scale Little choice for consumers No research and development No incentive to develop new technology © Edco 2012. Positive Economics Summary Short run Long run Produces where MC = MR Produces where MC = MR Must cover AVC Must cover all costs, i.e. AC SNP may be earned (AR > AC) Normal profit earned (AR = AC) Produces where MC = MR = AC = AR © Edco 2012. Positive Economics