Download Competitive markets and perfect competition

Competitive markets and
perfect competition
Learning Objectives
At the end of this chapter you will be able to
Realise that perfect markets do not exist but that some
degree of perfection is possible
Understand the structure/conduct performance (SCP)
relationship
Understand the benefits of competition to the consumer
Understand what is meant by efficiency
Be able to use diagrammatic analysis to explain
situations that arise in perfect competition
Perfectly competitive markets
We can look at the market as a spectrum
At one end we have perfect competition where there is a
large number of small firms
These are price takers (a firm that has to accept the price dictated by
the market)
At the other end is the natural monopoly where the industry
comprises of one firm only
This is a price maker (it decides the price)
Perfectly competitive markets
Firms operating under conditions of competition have to remain price
competitive and will try to improve the quality of their product/service to stay
ahead of their competitors
Perfect competition is an extreme form of competition and is based on the
following assumptions
Large number of buyers and sellers – this is to ensure the product is sold
and the firm is a price taker
No one is large enough to affect the market price
Buyers and seller have perfect information on product and prices
Homogeneous products (all the same)
Freedom of entrance and exit – cost free to move in and out.
Firms will make normal profit in the long run
All firms have equal access to technological improvements – firms are
unlikely to engage in R&D
Factors of production are perfectly mobile – they can undertake any
types of work in any location
Perfectly competitive markets
Many, if not all, of these assumptions are unrealistic
The model is good because it serves as a benchmark to
compare other market structures
Economists use this as the model that shows how competition
creates an efficient market
While perfect competition may not be possible some
competition is welcome
The diagrams below show the perfectly competitive firm and
the market (industry)
Perfectly competitive markets
The firm has to sell its product at £5 (it is a price taker)
If it sells above this price consumers will go elsewhere
If it sells below this price all the consumers will come to this
firm but they will not be able to service all of their needs and it
will not be maximising its returns
We saw before that the demand curve is perfectly elastic and
D=AR=MR=P (they are all £5)
The diagram of the industry shows that both consumer and
producer surplus are maximised – the market is allocatively
efficient
How many does the firm produce?
We saw before that the profit maximising firm will chose its
output level using the relationship between marginal revenue
and marginal cost
Profit maximising output is where MR = MC
At this point the firm will make £800 revenue
Notice that we label our y axis Revenue and Cost
Short run profits and the industry response
To work out how much profit the firm is making we have to work
out the total costs (profit = total revenue – total costs)
To do this we need to add the average total cost curve (ATC) as per
the diagram below
Don’t forget that the MC curve cuts the ATC curve at its lowest point
We can see that when the output is 10 the firm’s costs will be £60
which means the total costs will be 60 x10 = 600
Profit = Revenue – total costs; 800 – 600 = £200
We include normal profit in total costs so this £200 is abnormal
profit
Short run profits and the industry response
If there are abnormal profits other firms will be attracted to the market (there are
no barrier to entry)
This will shift the supply curve to the right and the price will fall to 60
This means that MR has changed
The output of the firm will have to fall to 8 at the new profit maximising point
(MC=MR)
At this point revenue and costs are equal
This does not mean the firm is making zero profit – it means the firm is making
normal profits
In a perfectly competitive market when there is abnormal profit in the short run
firms keep entering the market until the abnormal profits are competed away and
only normal profits are available
This is the long run equilibrium position for firms in perfect competition; average
total costs equals average revenue
mjmfoodie Video see You Tube
(http://www.youtube.com/watch?v=61GCogalzVc)
Diagram to learn!
 Draw a diagram that illustrates the perfectly competitive firm
when competition enters the market (how it can only make
abnormal profit in the long run)
 Underneath explain step by step (analysis) how this happens
Long run equilibrium and
efficiency
When firms innovate and learn to be
efficient over time we say that they have
dynamic efficiency which is efficiency
over time and concerns creating new
products, new techniques and new
processes
Firms have to undertake R&D and they
need to make supernormal profits to do
this
Firms in a perfectly competitive market
are unlikely to do this because in this
market there is perfect knowledge and
free entry which means that
supernormal profits are competed away
Firms have to be able to protect their
investment and earn supernormal profits
If others are able to copy there is no
point
Long run equilibrium and
efficiency
Firms in perfect competition are
statically efficient – that is efficient at a
point of time
They are productively efficient
because they are working at their MES
(lowest point of the ATC)
and at this same position they are also
allocatively efficient because they are
allocating their resources in the most
efficient way – the MC of the last unit
equals the price of the last unit.
We can tell that they are allocatively
efficient because they are operating
where demand is equal to supply (the
MC curve is their supply curve)
The SPC Model (Structure – Performance – Conduct)
This model can be used to analyse how an industry is likely to operate
The industry structure
the number of buyers and sellers
Degree of product differentiation
Level of barriers to entry
It is assumed that structure can determine the conduct of the industry
Conduct refers to activities of buyers and sellers
Productive capacity
Pricing policies
R & D
Are the buyers in a position of power
Performance is measured in terms of how resources are allocated
Perfectly competition should lead to the optimal allocation of resources
Other market forms can be judged against this benchmark
The SPC Model (Structure – Performance – Conduct)
Some argue that this model is too linear and does not necessarily go from S to P
to C; it could go from C to P to S.
Examiners tips
Examiners often ask questions
about efficiency – ensure you know
what efficiencies apply to perfect
competition
You must be able to explain why
D = AR = MR = P
You must learn the assumptions of
the perfectly competitive market
Practise the diagrams in this section
– it is essential that you can
construct and explain these
diagrams
It is essential that you indicate
where MR = MC on your diagrams
Note that at the profit maximising
output profit per unit is the difference
between average revenue and
average total cost
Make sure you can explain why
normal profits are included in costs
and that supernormal profits will be
competed away