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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. The demand curve, therefore will be “perfectly elastic” (horizontal) at the market price. Any change in price will result in a complete disappearance of demand. • Since this demand curve has the same price (average revenue) at all quantities, AR will be equal to MR. (The extra revenue gained from selling one more unit will be equal to the price of that unit, since the price does not change for different quantities.) Perfect Competition – Cost Curves Price £ Individual Firm Price £ MC AC Mkt Price Market S AR = MR D 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 Mkt Price AR = MR Supernormal Profits 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 S £ £ £ MC P Individual Firm Market MC1 AC P1 AR = MR AC1 AR1 = MR1 D D1 Q Q Q In the short run, if price is above AC, firms earn supernormal profits – this attracts firms into the industry, eroding supernormal profits back to normal profits in long run. (↓ D and ↑ AC with more competitors.) Perfect Competition – short run / long run Price £ Individual Firm Price £ Market MC AC S Loss Mkt Price AR = MR D Quantity Quantity If, in the short run, mkt price is below ave. cost, firms fan make losses – this leads firms to leave the industry Perfect Competition – short run / long run Market Individual Firm £ Individual Firm £ £ MC MC1 AC AC1 S P AR1 = MR1 AR = MR D Q D1 Q Q If, in the short run, mkt price is below ave. cost, firms fan make losses – this leads firms to leave the industry, raising profits back to the “normal” level for remaining firms. (↑D and ↓AC with less competitors) Perfect Competition – Long Run Price £ Individual Firm Price £ MC AC Mkt Price Market S AR = MR D Quantity Quantity 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. 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
