Perfect competition

An ideal model of the market system, and used by economists to explain the workings of markets in practice; ie deviations from the conditions of perfect competition could be used to explain why some markets appeared uncompetitive. This is a good theory to use to explain why many policy makers are so in favour of competition.

Necessary conditions 1 Lots of buyers and sellers none of whom on their own can influence the price ie they are complete price-takers: On the selling side firms face perfectly elastic demand curves On the buying side firms face perfectly elastic supply curves

price P

Demand

Quantity 2 A homogeneous product; the products of each individual firm must be perfect substitutes for each other, ie there is no product differentiation;

Perfect knowledge. Consumers must have perfect knowledge of all prices being charged in the Firms must have perfect knowledge of profit levels being earned in all

market, industries 4

Freedom of entry and exit to the industry. There must be no barriers to entry to the industry eg patents, state

monopolies -

There must be no exit barriers such as sunk costs

5 Equal or no transport costs. No firm should face a cost advantage compared to other firms in the industry The equilibrium of the firm in perfect competition

The short run

The time period when firms cannot alter their fixed factors nor leave / enter the industry. Existing firms can only increase output by altering their variable factors like materials and labour.

Firms are assumed to be profit maximisers so they will produce where MC = MR

The level of profit. Normal profit is the level of profit that firms must receive in order to remain in a particular industry; it will refelect the risks of that particular industry; it is regarded as a cost since if not met, the entrepreneur will move to the next best alternative. We therefore include it in average cost. If price = AC then the firm is earning normal profit ( not just covering its other costs! ). Profit in excess of normal is called abnormal or supernormal profit. (Also sometimes called pure profit )

Profit = (AR - ATC) x Q (Price minus average costs ) times output

The minimum short period shut down price. The price which just allows the firm to cover its variable costs; this is the price that corresponds to the lowest value of average variable costs. This is therefore the lowest price at which the firm would supply in the short run. ( In the short run the firm need not cover its fixed costs. )

Why not?

The short-run supply curve of the firm in perfect competition is therefore the MC curve above the minimum value of AVC.

In the long run the firm must cover all its costs so the lowest price it would supply at is that which corresponds to the lowest value of ATC. The long-run supply curve of the firm is therefore the MC curve above the minimum value of ATC.

The long run

This is the time period when the firm can alter all its factors, including its location, and can leave the industry; other firms are also able to enter the industry eg in pursuit of high ( abnormal profits ).

In the long run under conditions of perfect competition, price will be driven down to the minimum level at which firms can produce, that is the price that gives normal profit. Firms will enter an industry where there are abnormal profits to be earned, so driving down the price. This means that in the long run supply is perfectly elastic at the minimum price Pl, shown by the solid black line in the diagram below.

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The optimality of perfect competition

It can be shown that if perfect competition prevails prevails throughout the economy, and if there are no discrepancies between private and social costs and benefits, then this will result in maximum economic efficiency, ie the maximum benefit to society. In particular it results in maximum productive and allocative efficiency. Productive efficiency is the minimisation of costs in production; ie being at the lowest point on the ATC curve. Allocative efficiency means producing the mix and quantity of goods and services that the economy wants, if it is economic to do so; this is given at the point where price = marginal costs for all goods. If this were not so then there would be under or over production. The demand curve shows the money value of benefits received by consumers, while the MC curve shows the costs of supplying them; so the difference between the two curves is the difference between benefits and costs. Perfect competition can be shown to maximise this area. [ It can be split into consumer surplus and producer surplus ]