# Perfect Competition. Perfect competition a pure market

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4 Establishing price and output in the short run under perfect competition The previous diagram shows the short run equilibrium for perfect competition. In the short run, the twin forces of market demand and market supply determine the equilibrium market-clearing price for the industry. In the diagram below, a market price P1 is established and output Q1 is produced. This price is taken by each of the firms. The average revenue curve (AR) is their individual demand curve. Since the market price is constant for each unit sold, the AR curve also becomes the Marginal Revenue curve (MR). For the firm, the profit maximising output is at Q2 where MC=MR. This output generates a total revenue (P1 x Q2). The total cost of producing this output can be calculated by multiplying the average cost of a unit of output (AC1) and the output produced. Since total revenue exceeds total cost, the firm in this example is making abnormal (economic) profits. This is not necessarily the case for all firms. It depends on their short run cost curves. Some firms may be experiencing sub-normal profits if average costs exceed the market price. For these firms, total costs will be greater than total revenue. Short run losses

5 The adjustment to the long-run equilibrium If most firms are making abnormal (or supernormal) profits, this encourages the entry of new firms into the industry, which if it happens will cause an outward shift in market supply forcing down the ruling market price. The increase in supply will eventually reduce the market price until price = long run average cost. At this point, each firm in the industry is making normal profit. Other things remaining the same, there is no further incentive for movement of firms in and out of the industry and a long-run equilibrium has been established. This is shown in the next diagram.

6 We are assuming in the diagram above that there has been no shift in market demand, i.e. we are considering an outward shift in market supply brought about by the entry of new competing firms each of whom is supplying a homogeneous product to the market. The effect of increased supply is to force down the market price and cause an expansion along the market demand curve. But for each supplier, the price they take is now lower and it is this that drives down the level of profit made towards the normal profit equilibrium. In an exam you may be asked to trace and analyse what might happen if There was a change in market demand (e.g. arising from changes in the relative prices of substitute products or complements) There was a cost-reducing innovation affecting all firms in the market or an external shock that increases the variable costs of all producers. Effects of a change in market demand We now consider how a competitive market adjusts to a change in market demand in both the short and the long run. In the short run, businesses are operating with at least one fixed factor. Therefore the elasticity of the supply curve depends on the amount of spare capacity, the level of existing stocks and also the time scale of the production process in other words how fast and at what cost the industry can expand supply when demand changes. In the long run, because of freedom of entry and exit into and out of the industry, we expect the market supply curve to be more elastic in response to a change in demand. The diagram below shows an outward shift of demand with short run market supply deemed to be relatively inelastic (in which case the short run adjustment in the market drives prices higher) but where long run market supply is elastic, putting downward pressure on price as market output increases.

7 Pure competition and economic efficiency Perfect competition can be used as a yardstick to compare with other market structures because it displays high levels of economic efficiency. 1. Allocative efficiency: In both the short and long run in perfect competition we find that price is equal to marginal cost (P=MC) and thus allocative efficiency is achieved. At the ruling market price, consumer and producer surplus are maximised. No one can be made better off without making some other agent at least as worse off i.e. the conditions are in place for a Pareto optimum allocation of resources. 2. Productive efficiency: Productive efficiency occurs when the equilibrium output is produced with average cost at a minimum. This is not achieved in the short run, but is attained in the long run equilibrium for a perfectly competitive market. 3. Dynamic efficiency: We assume that a perfectly competitive market produces homogeneous products in other words, there is little scope for innovation designed purely to make products differentiated from each other and thereby allow a supplier to develop and then exploit a competitive advantage in the market to establish some monopoly power. Some economists claim that perfect competition is not an optimal market structure for high levels of research and development spending and the resulting product and process innovations. Indeed it may be the case that monopolistic or oligopolistic markets are more effective in creating the environment for research and innovation to flourish. A cost-reducing innovation from one producer will, under the assumption of perfect information, be immediately and without cost transferred to all of the other suppliers. That said, a competitive market (i.e. a contestable market) provides the discipline on firms to keep their costs under control, to seek to minimise wastage of scarce resources and to refrain from exploiting the consumer by setting high prices and enjoying high profit margins. In this sense, a more competitive market can stimulate improvements in both static and dynamic efficiency over time. It is certainly one of the main themes running through the recent toughening-up of UK and European competition policy as this introductory passage to a competition white paper demonstrates: Gains from competition Competitive markets provide the best means of ensuring that the economy's resources are put to their best use by encouraging enterprise and efficiency, and widening choice. Where markets work well, they provide strong incentives for good performance - encouraging firms to improve productivity, to reduce prices and to innovate; whilst rewarding consumers with lower prices, higher quality, and wider choice. By encouraging efficiency, competition in the domestic market - whether between domestic firms alone or between those

8 and overseas firms - also contributes to our international competitiveness. Source: The long run of perfect competition, therefore, exhibits optimal levels of economic efficiency. But for this to be achieved all of the conditions of perfect competition must hold including in related markets. When the assumptions are dropped, we move into a world of imperfect competition with all of the potential that exists for various forms of market failure. The next diagram shows how when price and output is not at the competitive equilibrium, the result is a deadweight loss of economic welfare. The competitive price and output is P1 and Q1 respectively.

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