PERFECT COMPETITIONEconomics – Course Companion

Blink & Dorton, 2007, 95-104

Introduction to Perfect Competition

• Perfect competition is a model used as the starting point to explain how firms operate.

• It is a theoretical model based upon some very precise assumptions.

• It is very important, because once we understand the theoretical assumptions it makes it easy to move towards models of markets that are more realistic.

The Assumptions of Perfect Competition

• The industry is made up of a very large number of firms.

• Each firm is so small, relative to the size of the industry, that it is not capable of altering its own output to have a noticeable effect upon the output of the industry as a whole.

• A firm cannot affect the supply chain of the industry and so cannot effect the price of the product.

• Individual firms have to sell at whatever price is set by demand and supply in the industry as a whole. The individual firms are “price takers”

The Assumptions of Perfect Competition

• The firms all produce exactly identical products. Their goods are “homogeneous”.

• It is not possible to distinguish between a good produced in one firm and good produced in another.

• There are no brand names and there is no marketing to attempt to make good different from each other.

The Assumptions of Perfect Competition

• Firms are completely free to enter or leave the industry.

• This means that firms already in the industry do not have the ability to stop new firms from entering it and are also free to leave the industry, if they wish.

• There are no barriers to entry or barriers to exit.

The Assumptions of Perfect Competition

• All producers and consumers have a perfect knowledge of the market.

• The producers are fully aware of market price, costs in the industry and the workings of the market.

• The consumers are fully aware of prices in the market, the quality of the products and the availability of goods.

Perfect Competition in the Real World

• Although we generally say the perfect competition is completely theoretical, there are some industries in the world, that get quite close to be perfectly competitive markets.

• The industries most often used an examples by economists are usually agricultural markets.

Agricultural Markets and Perfect Competition

Case Study: Wheat European Union• There are some large wheat farms in the EU, but they are

very small in relation to the whole wheat-growing industry. • An individual farm could increase its output many times

over without have any noticeable effect on total supply of wheat in the EU.

• A single farm is not able to affect the price of wheat in the EU, since it cannot shift the industry supply curve.

• The farm has to sell at whatever the industry price is.• In addition wheat is wheat, and so there is no way to tell

one farm’s wheat from another.

Agricultural Markets and Perfect Competition

Case Study: Wheat European UnionWhere the Perfect Competition model fails:• Although firms are relatively free to enter or leave the

wheat industry, there are significant costs in doing either and these may affect the decisions of firms.

• Although information is fairly open in the industry, it is unlikely that producers and consumers will have perfect knowledge.

• The wheat industry in the EU may be close to being a perfectly competitive market, but not a precise one.

Demand Curves for the Industry and the Firm in Perfect Competition

• Individual firms in perfect competition will be price-takers, since they cannot affect the price of the industry and so must sell at whatever the market price is.

• It is possible to make assumptions about the demand curve for both the firm and the industry.

The industry in perfect competition will face normal demand and supply curves. We would expect producers to wish to supply more at higher prices and we would expect consumers to demand less as price rises. The industry price would be P and the quantity demanded Q. For individual firms they have to sell at the industry price P, because they are price-takers. If they try and sell at a higher price, then consumers buy the product from another firm, since the goods are homogenous and there is no difference in looks or quality. If they sell at the industry price, the firm can sell as much as it wants, because it will not affect the industry price. The firm has to take the price set by the industry. The firm selling at the industry price, faces perfectly elastic demand at this price.

Profit Maximisation for the firm in Perfect Competition

• Firms maximise profits when they produce at the level of output where MC = MR. • For perfect competition, it possible

to examine the marginal cost curve.

PROFIT MAXIMISATION FOR THE FIRM IN PERFECT COMPETITION The firm takes the price P from the industry and because the demand is perfectly elastic P=D=AR=MR. Profit is maximised where MC=MR, which is at the level of output q. Although the scale of the price axes is the same for the firm and the industry, this is not the case for output. The quantity q is very small in relation to the total industry output, Q, and it would not even register on the output axis for the industry. If it could, it would be large enough to shift the supply curve and thus alter the industry price.

Possible short-run profit and loss situations in perfect competition

In the short run in perfect competition, there are two possible profit/loss situations:1. Short-Run Abnormal Profits2. Short Run losses

SHORT RUN ABNORMAL PROFITS IN PERFECT COMPETITION

The firms in the industry are making abnormal profits in the short run. This mean they are more than covering their total costs, including opportunity costs. The firm is selling at the industry price, P, and maximising profits by producing at the quantity q, where MC=MR. A q, the cost per unit, average cost, is C and the revenue per unit, average revenue, is P. Average cost is less than the average revenue and the firm is making an abnormal profit of P-C on each unit. The shaded area shows the total abnormal profits.

SHORT RUN LOSSES IN PERFECT COMPETITION

In this graph the firms in the industry are making losses in the short run. This means they are not covering their total costs. The firm is selling at the industry price P, and is maximising profits by producing at the quantity q, where MC=MR. However, at output q, the cost per unit is C, which is greater than the price and so the firm is making a loss of C-P on each unit. The shaded area shows the total loss. Although making a loss, the firm is still producing at the “profit-maximising” level of output, because any other output would create a greater loss. In effect they are loss minimising.

Movement from Short Run to Long Run in Perfect Competition

• If firms are making either short-run abnormal profits , or short run losses, other firms begin to react and the situation starts to change until an equilibrium point is reached in the long run.

Short Run Abnormal Profits to Long Run-Normal Profits

• When abnormal profits are being recorded, firms outside the industry that could also produce the good will start to enter the industry.

• At first this will have no real effect, because the firms are relatively small.

• However, as more and more firms enter the industry, attracted by the abnormal profits, the industry supply curve will start to shift to the right.

THE MOVE FROM SHORT RUN ABNORMAL PROFIT TO LONG RUN NORMAL PROFIT

As the industry supply curve starts to shift from S towards S1. the industry price will begin to fall from P towards P1 . As the firms in the industry are price-takers, the price that they charge will start to fall and their demand curves will start to shift downwards. This means that the abnormal profits that they had been making will start to be “competed away”. The process will continue as long as there are abnormal profits in the industry. Eventually the industry supply curve reaches S1. At this point, the firms are taking the price of P1 and the demand curve is D1 = AR 1 = MR1 As a result firms are making normal profits with the price per unit equal to the cost per unit. Eg: P1 = C1 Entrepreneurs of the firms in the industry are satisfied because they are covering their opportunity costs.

Normal Profits lead to Market Equilibrium

• As there is now NO abnormal profits to attract more firms into the industry, the industry is in a long run equilibrium situation.

• Non one will now enter the and non one will now leave.

• The output is a much bigger industry producing at Q1 units, with smaller firms, each producing Q1 units.

Short Run Losses to Long Run Normal Profits

• Some firms in the industry will, after a time, start to leave the industry.

• Aft first this will have no real effect, because the firms are relatively small.

• However, as more and more firms leave the industry, unable to achieve normal profits, the industry supply curve will shift to the left.

THE MOVEMENT FROM SHORT RUN LOSSES TO LONG-RUN NORMAL PROFIT

As the industry supply curve starts to shift from S towards S1 the industry price will start to rise from P towards P1. As the firms in the industry are price-takers, the price that they can charge will start to rise and their demand curves will start to shift upwards. This means that the losses that they had been making begin to get smaller. This process will continue as along as there are losses being made in the industry. Eventually the industry supply curve reaches S 1 where the price is P1. At the point the firms are `taking` the price of P1 and the demand curve is D1=AR1 = MR1. Firms are now making normal profits, where the price per unit equal to the cost per unit, eg: P1 = C1

Normal Profits lead to Market Equilibrium

• Just as in the previous example, normal profits lead to market equilibrium because firms are covering all their costs, including opportunity costs.

• There would be no reason to leave the industry as the firm could not do better elsewhere.

• The outcome will be a smaller industry producing only Q1 units, with slightly larger firms, each producing q1 units.

Long-Run Equilibrium in Perfect Competition

Summary• In the long run firms in perfect competition

will make normal profits. • This is because, even if they are making short-

run abnormal profits or short-run losses, the industry will adjust with firms entering or leaving the industry until a normal profit situation is reached.

LONG RUN EQUILIBIRUM IN PERFECT COMPETITION – SUMMARYFirms are selling at P, which are they are taking from the industry.MC is equal to MR, so they are maximising profits by producing q and, at that output P is equal to AC, so they are making normal profits.

Why would equilibrium change?

• If the industry demand curve changes or their is a change in the costs that the firm faces, short run abnormal or profits or losses may result. BUT...

• The industry will once again adjust, with firms entering or leaving until long run equilibrium is established.

Productive and Allocative Efficiency in Perfect Competition

• One of the efficiency measures used by economists is that of productive efficiency.

What is productive efficiency?

• A firm is said to be productively efficient if it produces its product at the lowest possible unit cost (average cost)

PRODUCTIVE EFFICIENCY

At the output q, the firm is able to produce at the most efficient level of output – the lowest average cost of production. This is the cost c. So q is known as the productively efficient level of output. We know that MC always cuts the AC at its lowest point.The Productively Efficient Level is MC=AC.

Productive Efficiency

• Productive efficiency is important in Economics, because if a firm is producing at the productively efficient level of output, then they are combining their resources as efficiently as possible.

• Resources are not being wasted by inefficient use.

Allocative Efficiency OR The Socially Optimum Level of Output (102)

• Allocative efficiency occurs when suppliers are producing the optimal mix of goods and services required by consumers.

• Price reflects the value that consumers place on a good and is shown on the demand curve (average revenue)

• Marginal cost reflects the costs to society of all the resources used in producing an extra unit of a good, including the normal profit required for a firm to stay in business.

Allocative Efficiency OR The Socially Optimum Level of Output (102)

• If price were to be greater than marginal cost, then the consumers would value the good more than it cost to make it.

• If both sets of stakeholders are to meet at the optimal mix, then output would expand to the point where price equals marginal cost.

• Similarly, if the marginal cost were to be greater than the price, then society would be using more resources to produce the good than the value it gives to consumers and output would fall.

When does allocative efficiency occur?

• Allocative efficiency occurs where marginal cost (the cost of producing one more unit) is equal to average revenue (the price received for a unit).

ALLOCATIVE EFFICIENCY

The above graphs show the allocatively efficient level of output for a firm with a normal demand curve and for a firm with a perfectly elastic demand curve. For both case the required output will be MC=AC.

Allocative Efficiency

• Allocative efficiency is important in Economics, because if a firm is producing at the allocatively efficient level of output there is a situation of “Pareto Optimality” where it is impossible to make one person better off without making someone else worse off.

PRODUCTIVE AND ALLOCATIVE EFFICIENCY WITH SHORT RUN PROFITS IN PERFECT COMPETITION

If a firm is making abnormal profits in the short run, they are producing at the profit maximising level of output q (where in MC=MR) and the allocatively efficient level of output q2 (where MC=AR) . However, the firm is not producing at the most efficient level of output, q1 (where MC=AC).

PRODUCTIVE AND ALLOCATIVE EFFICIENCY WITH SHORT RUN LOSSES IN PERFECT COMPETITION

If a firm is making losses in the short run, they are producing at the profit maximising level of output q (where in MC=MR) and the allocatively efficient level of output q2 (where MC=AR) . However, the firm is not producing at the most efficient level of output, q1 (where MC=AC).

PRODUCTIVE AND ALLOCATIVE EFFICIENCY IN THE LONG RUN IN PERFECT COMPETITION

Profit maximising firms in the long run in perfect competition all produce at the lowest point of their long run average cost curves. As we assume that there is perfect knowledge in the industry, all of the firms will face the same cost curves. They are all selling at the same price and minimising their average costs by producing where MC=AC. It should also be noted that all of the profit maximising firms in the long run are also producing at the allocatively efficient level of output, where MC=AR.

PerfectCompetition

AbnormalProfitspossible?

Looses possible?

Allocatively efficient?

Productively efficient?

Short RunLong Run

CHECK LIST: SHORT RUN VS LONG RUN – PERFECT COMPETITION

EXAMINATION QUESTIONS Short Response Questions

1. With the help of a diagram, explain how it possible for a firm in perfect competition to earn abnormal profits in the short run.

2. With the help of a diagram, explain how it is possible for a firm in perfect competition to earn abnormal profits in the long run.

3. Explain whether or not a firm in perfect competition earning abnormal profits is productively and allocatively efficient.

EXAMINATION QUESTIONS Essay Questions

1a. Explain the characteristics of a perfectly competitive market structure.

1b. Evaluate the extent to which it is possible for a firm in perfect competition to earn abnormal profits.