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Perfect Competition • Many buyers & sellers (no individual has mkt power) • Homogeneous product – no branding or differentiation • Perfect information – consumers always know what’s on offer for what prices • Freedom of entry & exit – no “barriers to entry” So… firms are price takers. The Demand Curve in Perfect Competition • Since the firm is a price taker and an insignificant part of the total market, the individual firm has no control over the price it can charge, but it can sell as much as it wants at that price. The demand curve, therefore will be “perfectly elastic” (horizontal) at the market price. • Since this demand curve has the same price (average revenue) at all quantities, AR will be equal to MR. Perfect Competition – Cost Curves Price £ Individual Firm Price £ MC Market S AR = MR Mkt Price D Qpm Quantity Quantity Price is determined in the market – firms can sell as much as they like at this price. Perfect Competition – Short Run / Long Run Price £ Individual Firm Price £ Market S MC AC AR = MR Mkt Price Supernormal Profits Qpm Quantity D Quantity If, in the short run, if mkt price is above AC, firms can earn supernormal profits – this attracts more firms into the industry Perfect Competition – Short Run / Long Run Individual Firm – short run £ £ MC P Individual Firm – long run Market S £ S1 AC P1 AR = MR MC1 AC1 AR1 = MR1 D Qpm Q Q Qpm Q In the short run, if price is above AC, firms earn supernormal profits – this attracts firms into the industry, lowering price and eroding supernormal profits back to normal profits in long run. Perfect Competition – short run / long run Price £ Individual Firm Price £ Market MC AC S Loss Mkt Price AR = MR D Qpm Quantity Quantity If, in the short run, mkt price is below ave. cost, firms can make losses – this leads firms to leave the industry Perfect Competition – short run / long run Individual Firm – short run £ Individual Firm – long run Market £ £ MC MC1 AC S1 P AC1 S AR1 = MR1 AR = MR D Qpm Q Q Qpm Q If, in the short run, mkt price is below ave. cost, firms can make losses – this leads firms to leave the industry, raising price and profits back to the “normal” level for remaining firms. Perfect Competition – Long Run Price £ Individual Firm Price £ MC AC Mkt Price Market S AR = MR D Quantity Quantity Perfect competition – shut down point Price £ Individual Firm Price £ MC SRATC Mkt Price Market S SRAVC AR = MR D Quantity Quantity This firm is making a loss. But they will continue producing in the short run because P ˃ SRAVC. Perfect competition – shut down point Price £ Individual Firm Price £ Market MC S SRATC Mkt Price SRAVC AR = MR D Quantity This firm is making a loss. They will shut down because P ˂ SRAVC. *Shut down point is where P = SRAVC* Quantity Let’s think about what the firm’s supply curve might look like… (not on the spec… just interesting) Perfect Competition Efficiency Allocative Efficiency Since P = MR, and the firm will produce where MR = MC, then MC = P Productive Efficiency In the long run, production will settle at the min. AC. Dynamic Efficiency Producers will strive to keep up with each other so as to make normal profit at the market price equal access barriers to entry/exit insignificant homogeneous complete information no costs costless competition Price taker Evaluating the Perfect Competition Model • Strong assumptions are made about - homogeneity of product - absence of sunk costs - freedom of entry/exit - complete information being available • This “perfect” situation rarely exists
