Students should be able to:
Understand the assumptions of perfect competition and be able to explain the behaviour of firms in this market structure.
Understand the significance of firms as price-takers in perfectly competitive markets. An understanding of the meaning of shut-down point is required. The impact of entry into and exit from the industry should be considered.
2. Perfect Competition
Topic 3.3.9
Students should be able to:
• Understand the assumptions of perfect competition and be
able to explain the behaviour of firms in this market
structure.
• Understand the significance of firms as price-takers in
perfectly competitive markets. An understanding of the
meaning of shut-down point is required. The impact of entry
into and exit from the industry should be considered.
3. What is Perfect Competition?
• Perfect competition describes a market structure
whose assumptions are strong and therefore
unlikely to exist in most real-world markets
• We can however take some useful insights from
studying a world of perfect competition and then
comparing and contrasting with “real world”
imperfectly competitive markets and industries
• Economists have become more interested in pure
competition because of the rapid growth of e-
commerce as a means of buying and selling goods
and services. And also the popularity of online
auctions as a device for allocating scarce resources
4. • Homogenous Products (all perfect substitutes)
• All firms have access to factors of production
• Large number of buyers & sellers
• Free entry and exit to/from the market
• Perfectly elastic demand curve
• Perfect knowledge / information
• Profit maximization assumed as key objective
What is Perfect Competition?
5. Price,
Cost
Output
Price,
Cost
Output
Market Supply and
Demand
Revenues, Costs and Profits for a
Competitive Firm
D
S
AC
MC
Price and Output in Perfect Competition
When drawing perfect competition diagrams, remember to make a
distinction between the market and a representative individual firm
11. Adjustment to Long Run Equilibrium
• If most firms are making abnormal (economic) profits in
the short run, this encourages the entry of new firms into
the industry driven into the market by the profit motive
• This will cause an outward shift in market supply forcing
down the ruling market price
• The increase in market supply will eventually reduce the
price until price = long run average cost
• At this point, each firm in the industry is making normal
profit where price (AR) = average cost
• Other things remaining the same, there is no further
incentive for movement of firms in and out of the industry
and a long-run equilibrium has been established
18. AC
AVC
P1: Price = average
cost, normal profits
made
P2: Price = average
variable cost
P=Min AVC is the shut
down price for a
competitive firm in
short run
Price
Output
Google and Apple’s RevenueThe Shut Down Price (Short Run)
A business needs to make at least normal profit in
the long run to justify remaining in an industry but
in the short run a firm will continue to produce as
long as price per unit > or equal to average
variable cost (AR = AVC). This is called the
shutdown price in a competitive market.
MC
P
1
P
2
19. Evaluating Assumptions of the Model
• Most firms have some amount of price-setting
power – they are price makers not price takers!
• Dominance in real world markets of differentiated /
branded products
• Highly complex products, there always information
gaps facing consumers
• Impossible to avoid search costs even with the
spread of digital/web technology
• Patents, control of intellectual property, control of
key inputs are all ignored by the competitive model
• Rare for entry and exit in an industry to be costless
20. Econ Efficiency & Perfect Competition
• Allocative efficiency: In both the short and long run, price
is equal to marginal cost (P=MC) and thus allocative
efficiency is achieved. No one can be made better off
without making some other agent at least as worse off –
i.e. we achieve a Pareto optimum allocation of resources.
• Productive efficiency: Productive efficiency occurs when
the equilibrium output is supplied at minimum average
cost. This is attained in the long run for a competitive
market.
• Dynamic efficiency: We assume that a perfectly
competitive market produces homogeneous products – in
other words, there is little scope for innovation designed
purely to make products differentiated from each other
and allow a supplier to establish some monopoly power.
21. Characteristics of Competitive Markets
• Lower prices because of many competing firms. The cross-price
elasticity of demand for one product will be high suggesting that
consumers are prepared to switch their demand to the most
competitively priced products in the marketplace.
• Low barriers to entry – the entry of new firms provides competition
and ensures prices are kept low
• Lower total profits and profit margins than in monopoly
• Greater entrepreneurial activity. For competition to be improved and
sustained there needs to be a genuine desire on behalf of
entrepreneurs to innovate and to invent to drive markets
• Economic efficiency
– Competition will ensure that firms move towards productive
efficiency.
– The threat of competition should lead to a faster rate of
technological diffusion, as firms have to be responsive to the
changing needs of consumers. This is known as dynamic efficiency.
22. The Real World of Imperfect Competition
• Suppliers may exert control over the quantity of goods
and services supplied and also exploit their monopoly
power by having control over market prices
• On the demand-side, consumers may have monopsony
(buying) power against their suppliers because they
purchase a high percentage of total demand.
• There are always some barriers to the contestability of a
market and far from being homogeneous; most markets
are full of heterogeneous products due to product
differentiation
• Most consumers have imperfect information and
preferences are influenced by persuasive marketing
• There may be imperfect competition in related markets
such as the market for key raw materials, labour and
capital goods.