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7 ● ● 7 ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● Perfect competition HL explain the assumptions of perfect competition HL distinguish between the demand curve for the industry and for the firm in perfect competition HL explain how the firm maximises profit in perfect competition HL explain and illustrate short-run profit and loss situations in perfect competition HL explain and illustrate the long-run equilibrium in perfect competition HL explain and illustrate the movement from short run to long run in perfect competition HL define and illustrate productive efficiency HL define and illustrate allocative efficiency HL explain and illustrate productive and allocative efficiency in the short and long run in perfect competition. As we already know, social scientists, especially economists, are model builders. We use models to try to explain how things work and what might be the possible outcomes of certain economic situations. 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. However, although it is purely theoretical, it is very important because once we have built our model of a perfectly competitive market we can then begin to relax the theoretical assumptions that we have made and move towards models of markets that are much more realistic. The assumptions of perfect competition Perfect competition is based upon a number of assumptions. l l l 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. This means that a firm cannot affect the supply curve of the industry and so cannot affect 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. We say that the individual firms are “price-takers”. 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 a good produced in another. There are no brand names and there is no marketing to attempt to make goods different from each other. ● ● ● ● ● l Perfect competition l Firms are completely free to enter or leave the industry. This means that the 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 so wish. We say that there are no barriers to entry or barriers to exit. All producers and consumers have a perfect knowledge of the market. The producers are fully aware of market prices, costs in the industry, and the workings of the market. The consumers are fully aware of prices in the market, the quality of products, and the availability of the goods. Although we say that it is completely theoretical, there are some industries in the world that get quite close to being perfectly competitive markets. The industries most often used as examples by economists are usually agricultural markets. For example, let us consider the growing of wheat in the European Union (EU). 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 having a noticeable effect on the total supply of wheat in the EU. Thus 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 existing industry price is. In addition, wheat is wheat, and so there is no way to tell one farm’s wheat from another. So far so good for the assumptions of perfect competition. However, 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. Also, although information is fairly open in the industry it is unlikely that producers and consumers will have “perfect knowledge”. We can say that the wheat industry in the EU may be close to being a perfectly competitive market, but is not precisely one. The demand curves for the industry and the firm in perfect competition We have said that the 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. This means that we can make certain assumptions about the demand curves for both the firm and the industry. The industry The firm S P P D=AR=MR D 0 0 Q Quantity 102 ● ● 1 Microeconomics 1 Microeconomics By the end of this chapter, you should be able to: ● Price ($) ● Price ($) ● Quantity Figure 7.1 The demand curves for the industry and the firm in perfect competition 103 7 Perfect competition If the firm can sell all that it wishes at the price P then it must face a perfectly elastic demand at that price. In Figure 7.1 we can see that the firm derives its price of P from the equilibrium price in the industry, where the industry supply equals the industry demand. This is another explanation of the term “price-taker”, because the firm has to take the price set in the industry. Profit maximization for the firm in perfect competition Firms maximize profits when they produce at the level of output where MC 5 MR. For perfect competition, we now have to add the marginal cost curve, shown in Figure 7.2. The firm The industry P MC Price ($) Price ($) S D=AR=MR D 0 0 Q Quantity In the short run in perfect competition, there are two possible profit/ loss situations: 1Short-run abnormal profits: In this case, which is shown in Figure 7.3, the firms in the industry are making abnormal profits in the short run. This means that they are more than covering their total costs, including the opportunity costs. The industry The firm P P q MC=MR determines the quantity MC AC D = AR = MR Abnormal profits C AC determines the cost per unit D 0 q 0 Q Quantity Quantity Figure 7.3 Short-run abnormal profits in perfect competition As we can see in Figure 7.3, the firm is selling at the industry price, P, and is maximizing profits by producing at the quantity q, where MC5MR. At q, the cost per unit, average cost, is C, and the revenue per unit, average revenue, is P, so average cost is less than average revenue and the firm is making an abnormal profit of P–C on each unit. The shaded area shows the total abnormal profit. 2Short-run losses: In this case, shown in Figure 7.4, the firms in the industry are making losses in the short run. This means that they are not covering their total costs. The firm S C P P AC determines the cost per unit MC Losses MC=MR determines the quantity D 0 We can see that the firm takes the price P from the industry and, because the demand is perfectly elastic, P5D5AR5MR. Profit is maximised where MC5MR, which is at the level of output q. We must remember that 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, then it would be large enough to shift the supply curve and thus alter the industry price. 0 Q AC D=AR=MR Quantity Figure 7.2 The profit-maximizing level of output in perfect competition 104 MC = MR determines the quantity Price ($) S The industry P Perfect competition Possible short-run profit and loss situations in perfect competition Price ($) 1 Microeconomics For the individual firms we know that they will have to sell at the industry price, P, because they are price-takers. If they try to sell at a higher price then consumers will simply buy the product from another firm, since the goods are homogeneous and so 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 as it increases output it does not affect the industry supply curve and so it does not alter the industry price. ● 1 Microeconomics As we can see in Figure 7.1, 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. We would expect demand to be downward sloping and supply to be upward sloping. The industry price would therefore be P and the quantity demanded would be Q. Price ($) ● Price ($) 7 Quantity q Quantity Figure 7.4 Short-run losses in perfect competition In Figure 7.4 the firm is selling at the industry price, P, and is maximizing 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-maximizing” level of output, because any other output would create a greater loss. In effect, they are loss minimizing. 105 7 Perfect competition The 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. 1 Microeconomics Since there is perfect knowledge and no barriers to entry, firms outside of the industry that could also produce the good will start to enter the industry, attracted by the chance to make abnormal profits. 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. As the industry supply curve starts to shift from S towards S1, the industry price will begin to fall from P towards P1. Because the firms in the industry are price-takers, the price that they can 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”. Perfect competition Some firms in the industry will, after a time, start to leave the industry. At 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 profit, the industry supply curve will start to shift to the left. 1 Microeconomics Short-run abnormal profits to long-run normal profits Let us look first at the situation of short-run abnormal profits. The process is shown in Figure 7.5. The firm is making abnormal profits shown by the shaded area, but this situation will not continue for long. ● Short-run losses to long-run normal profits Now take the situation of short-run losses. The process is shown in Figure 7.6. As we can see, the firm is making losses shown by the shaded area, but this situation will not remain the same. As the industry supply curve starts to shift from S towards S1, the industry price will begin 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. The firm The industry S1 S P1 Price ($) ● Price ($) 7 MC C P1=C1 D1=AR1=MR1 Losses D=AR=MR P P AC D The industry 0 Price ($) S S1 P Price ($) The firm MC C P1=C1 Abnormal profit D=AR=MR D1=AR1=MR1 D 0 Q Q1 Quantity 0 q1 q Quantity Figure 7.5 The movement from short-run abnormal profit to long-run normal profit This process will continue as long as there are abnormal profits in the industry. Eventually the industry supply curve reaches S1, where the price is P1. At this point, the firms are “taking” the price of P1 and the demand curve is D15AR15MR1. We now find that the firms are making normal profits with the price per unit equal to the cost per unit, i.e. P15C1. The entrepreneurs of the firms in the industry are satisfied, because they are exactly covering their opportunity costs. However, there is now no abnormal profit to attract more firms into the industry and so the industry is in a long-run equilibrium situation. No one will now enter and no one will now leave. The outcome is a much bigger industry producing Q1 units, with smaller firms each producing q1 units. 106 0 Q Quantity q q1 Quantity Figure 7.6 The movement from short-run losses to long-run normal profit AC P P1 Q1 This process will continue as long as there are losses being made in the industry. Eventually the industry supply curve reaches S1, where the price is P1. At this point, the firms are “taking” the price of P1 and the demand curve is D1=AR1=MR1. We now find that the firms are making normal profits, with the price per unit equal to the cost per unit, i.e. P1=C1. Now the entrepreneurs of the firms in the industry are satisfied, because they are exactly covering all of their costs, including their opportunity costs. There would be no reason to leave the industry as the firm could not do better elsewhere. However, there is now no abnormal profit to attract more firms into the industry and so the industry is in a long-run equilibrium situation. No one will now enter and no one will now leave. 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 We can conclude that, 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. 107 7 Perfect competition The firm Price ($) S Student workpoint 7.1 AC Be a thinker—explain and illustrate D=AR=MR P P 1 Why is a firm in perfect competition a “price-taker”? 2Draw the following diagrams. Be sure to use a ruler and include accurate labels. Also be sure that your MC curves cross at the minimum of AC. D 0 0 Q q Quantity Quantity Figure 7.7 Long-run equilibrium in perfect competition In Figure 7.7, the firms are making normal profits in the long run. They are selling at the price P, which they are taking from the industry. MC is equal to MR so they are maximizing profits by producing q, and at that output P is equal to AC so they are making normal profits. a A firm in perfect competition earning abnormal profits c A firm in perfect competition in its longrun equilibrium earning normal profits At the output q, the firm in Figure 7.8 is able to produce at the most efficient level of output, i.e. the lowest average cost of production. This is the cost c. So q is known as the productively efficient level of output. We know from chapter 6 that MC always cuts AC at its lowest point, and so we can say that the productively efficient level is where: MC 5 AC 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 and resources are not being wasted by inefficient use. Allocative efficiency This measure of efficiency is sometimes also called the socially optimum level of output. 108 Allocative efficiency occurs where suppliers are producing the optimal mix of goods and services required by consumers. Allocative efficiency occurs where marginal cost (the cost of producing one more unit) is equal to average revenue (the price received for a unit). Thus the allocatively efficient level of output is where: MC = AR The cost The value = to producers to consumers MC MC D=AR=MR D=AR Productive and allocative efficiency in perfect competition 0 MR q1 0 Output q2 Output Figure 7.9 Allocative efficiency Cost ($) Productive efficiency One of the efficiency measures used by economists is that of productive efficiency. A firm is said to be productively efficient if it produces its product at the lowest possible unit cost (average cost). This is shown in Figure 7.8. Perfect competition Price reflects the value that consumers place on a good and is shown on the demand curve (average revenue). Marginal cost reflects the cost to society of all the resources used in producing an extra unit of a good, including the normal profit required for the firm to stay in business. 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. b A firm in perfect competition making economic losses In this situation there is no incentive for firms to enter or leave the industry and so the equilibrium will persist until there is a change in either the industry demand curve or in the costs that the firms face. If this does happen, then firms will be making either short-run abnormal profits or short-run losses and the industry will once again adjust, with firms entering or leaving until long-run equilibrium is restored. ● 1 Microeconomics 1 Microeconomics MC Price ($) The industry Price ($) ● Price ($) 7 MC AC c 0 q Output Figure 7.8 Productive efficiency In Figure 7.9, we can see the allocatively efficient level of output for a firm with a normal demand curve and for a firm with a perfectly elastic demand curve. In both cases we are looking for the output where MC5AR 2q1 for the firm with a normal demand curve and q2 when the demand is perfectly elastic. Allocative efficiency is important in economics, because if a firm is producing at the allocatively efficient level of output there is a situation of “Pareto optimality” where it is impossible to make one person better off without making someone else worse off. We will look at this in more detail when we consider market failure in Chapter 12. Productive and allocative efficiency in the short run in perfect competition If a firm is making abnormal profits in the short run in perfect competition, we can see from Figure 7.10 that although they are producing at the profit-maximizing level of output, q (where MC5MR), and the allocatively efficient level of output, q2 (where MC5AR), the firm is not producing at the most efficient level of output, q1 (where MC5AC). 109 7 ● 7 Perfect competition The industry Price ($) Price ($) MC AC P P Student workpoint 7.2 D 0 Fill in the spaces in the table below with either a yes or a no. q1 q q2 0 Q Quantity Quantity Perfect competition Figure 7.10 Productive and allocative efficiency with short-run profits in perfect competition In the same way, if a firm is making losses in the short run in perfect competition, we can see from Figure 7.11 that although they are producing at the profit-maximising level of output, q (where MC5MR), and the allocatively efficient level of output, q2 (where MC5AR), once again the firm is not producing at the most efficient level of output, q1 (where MC5AC). The industry Price ($) Price ($) P MC AC C Losses P D=AR=MR D 0 0 Q Quantity q q1 q2 Quantity Figure 7.11 Productive and allocative efficiency with short-run losses in perfect competition Productive and allocative efficiency in the long run in perfect competition As we can see in Figure 7.12, profit-maximizing firms in the long run in perfect competition all produce at the lowest point of their long-run average cost curves. Because we assume that there is perfect knowledge in the industry, all of the firms will face the same cost curves, and so they are all selling at the same price and minimizing their average costs by producing where MC5AC. The industry Abnormal profits possible? Losses possible? Allocatively efficient? Productively efficient? Short run Long run Examination questions The firm S 1 Microeconomics 1 Microeconomics D=AR=MR Abnormal profits C Perfect competition Also shown in Figure 7.12 is the fact that all of the profit-maximizing firms in the long run in perfect competition are also producing at the allocatively efficient level of output, because they produce where MC5AR. The firm S ● Paper 1, part (a) questions 1With the help of a diagram, explain how it is possible for a firm in perfect competition to earn abnormal profits in the short run. [10 marks] 2With the help of a diagram, explain how it is impossible for a firm in perfect competition to earn abnormal profits in the long run. [10 marks] 3Explain whether or not a firm in perfect competition earning abnormal profits is productively and allocatively efficient. [10 marks] Paper 1, essay question 1a Explain the characteristics of a perfectly competitive market structure. b Evaluate the extent to which it is possible for a firm in perfect competition to earn abnormal profits. [10 marks] [15 marks] The firm P MC Price ($) Price ($) S AC P D=AR=MR D 0 0 Q Quantity 110 q (MC=MR) q1 (MC=AC) q2 (MC=AR) Quantity Figure 7.12 Productive and allocative efficiency in the long run in perfect competition 111