6.1.2

Perfect Competition

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Perfect Competition

A market being perfectly competitive has a number of implications for firms in the industry.

Illustrative background for Characteristics of perfect competitionIllustrative background for Characteristics of perfect competition ?? "content

Characteristics of perfect competition

  • Firms are in perfect competition when the following conditions hold:
    • Lots of firms produce identical (homogenous) products.
    • Many buyers and many sellers.
    • Sellers and buyers have perfect and relevant information to make rational decisions.
    • Firms can enter and leave the market without restrictions (no barriers to entry or exit).
    • Firms aim to maximise profit.
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Market price in perfect competition

  • The market price is determined solely by supply and demand in the entire market.
  • A perfectly competitive firm must be a very small player in the overall market so that it can increase or decrease output without noticeably affecting the overall quantity supplied and price in the market.
  • So, firms are price takers.
Illustrative background for Allocative efficiency in perfect competitionIllustrative background for Allocative efficiency in perfect competition ?? "content

Allocative efficiency in perfect competition

  • The demand curve is equal to marginal utility (MU) under perfect competition.
  • The supply curve is equal to the marginal cost (MC).
  • So, if the forces of demand and supply determine equilibrium, the equilibrium price and quantity will be where MU=MC.
  • This is allocatively efficient.
  • If there are externalities, perfect competition may not be allocatively efficient, if the long run equilibrium is price is equal to the marginal private cost.
Illustrative background for Productive efficiency in perfect competitionIllustrative background for Productive efficiency in perfect competition ?? "content

Productive efficiency in perfect competition

  • Firms in perfect competition are productively efficient, assuming there are no economies of scale.
  • They will produce where the average cost is minimised because this is the only place normal profit can be made.
  • But if economies of scale exist, a monopoly could be more efficient than a perfectly competitive industry with many firms.
Illustrative background for Dynamic efficiency in perfect competitionIllustrative background for Dynamic efficiency in perfect competition ?? "content

Dynamic efficiency in perfect competition

  • Firms do not make supernormal profits in perfect competition.
  • They may not be able to invest in R&D and in new technologies, so this may not be dynamically efficient.

Illustrating Perfect Competition

The sequence of diagrams below illustrates how a market in perfect competition might respond to changes to return to its long-run equilibrium.

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1) Initial equilibrium

  • Here, the market is in equilibrium.
  • Firms are profit maximising where MR = MC and normal profit is being made by producers because AR = AC at this point.
  • Firms are price takers as they must accept the price reached at the industry equilibrium.
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2) A change

  • Here, the average cost for firms has fallen.
  • The cost of a space at the market has fallen, for example, meaning AC would fall but MC would not.
  • Firms are now making supernormal profit in the short-run.
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3) Returning to equilibrium

  • Supernormal profits and very low barriers to entry would attract new firms to the market.
  • This would shift supply to the right and reduce the equilibrium price.
  • So the supernormal profit is 'eroded' away very quickly and firms in the industry return to making normal profit, albeit at a lower price.

Jump to other topics

1Introduction to Markets

2Market Failure

3The UK Macroeconomy

4The UK Economy - Policies

5Business Behaviour

6Market Structures

7A Global Perspective

8Finance & Inequality

9Examples of Global Policy

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