5.3 - PERFECT COMPETITION

5.3 - PERFECT COMPETITION

• many buyers and sellers, sellers are price takers, free entry to and exit from the market, perfect knowledge, homogeneous goods, firms are short run profit maximisers, factors of production are perfectly mobile
• determined by interaction of supply and demand.
• likely to be lower than market with only a few large firms because each firm in competitive market has very small market share. market power is very small. If firms make a profit, new firms will enter market, due to low barriers to entry, because market seems profitable. new firms will increase supply in the market, which lowers average price. means that the existing firms’ profits will be competed away.
• in long run, there is lower price. P =MC, so there is allocative efficiency. since firms produce at bottom of AC curve, there is productive efficiency. supernormal profits produced in short run might increase dynamic efficiency through investment.
• assumptions of model rarely apply in real life. in reality, branding, product differentiation, adverts and positive and negative externalities, mean that competition is imperfect in long run, dynamic efficiency might be limited due to lack of supernormal profits. since firms are small, there are few or no economies of scale
• CHARACTERISTICS
• PRICE
• PROFIT
• ADVANTAGES
• DISADVANTAGES

Slide 2

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• in short run, firms can make supernormal profits. in long run where profits are competed away, only normal profits are made.
• diagram shows short run equilibrium for perfectly competitive market. firm is a price taker, and accepts industry price of P1. in short run, firm produces an output of Q1. blue shaded rectangle shows area of supernormal profits earned in short run. assumed that firms are short run profit maximisers.

Slide 3

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• shows long run equilibrium for a perfectly competitive market. supernormal profits made by existing firms means that new firms have incentive to enter industry. since there are no barriers to entry in a perfectly competitive market, new firms are able to enter industry. causes the supply in the market to increase, as shown by shift in the supply curve from S to S1. price level in market falls as a consequence. since firms are price takers, they must accept new, lower price. in long run, competitive pressure ensures equilibrium is established. supernormal profits have been competed away, so firms only make normal profits in long run. new equilibrium at P=MC means firms produce at the new output of Q2 in the long run.