Perfect competition. By the end of this chapter, you should be able to: 7 Perfect competition. 1 Microeconomics. 1 Microeconomics

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1 erfect 7 12 By the end of this chapter, you shoud be abe to: HL expain the assumptions of perfect HL distinguish between the demand curve for the industry and for the firm in perfect HL expain how the firm maximises profit in perfect HL expain and iustrate short-run profit and oss situations in perfect HL expain and iustrate the ong-run euiibrium in perfect HL expain and iustrate the movement from short run to ong run in perfect HL define and iustrate productive efficiency HL define and iustrate aocative efficiency HL expain and iustrate productive and aocative efficiency in the short and ong run in perfect. As we aready know, socia scientists, especiay economists, are mode buiders. We use modes to try to expain how things work and what might be the possibe outcomes of certain economic situations. erfect is a mode used as the starting point to expain how firms operate. It is a theoretica mode, based upon some very precise assumptions. However, athough it is purey theoretica, it is very important because once we have buit our mode of a perfecty competitive market we can then begin to reax the theoretica assumptions that we have made and move towards modes of markets that are much more reaistic. The assumptions of perfect erfect is based upon a number of assumptions. is made up of a very arge number of firms. Each firm is so sma, reative to the size of the industry, that it is not capabe of atering its own output to have a noticeabe effect upon the output of the industry as a whoe. This means that a firm cannot affect the suppy curve of the industry and so cannot affect the price of the product. Individua firms have to se at whatever price is set by demand and suppy in the industry as a whoe. We say that the individua firms are price-takers. s a produce exacty identica products. Their goods are homogeneous. It is not possibe 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. Firms are competey free to enter or eave the industry. This means that the firms aready in the industry do not have the abiity to stop new firms from entering it and are aso free to eave the industry, if they so wish. We say that there are no barriers to entry or barriers to exit. A producers and consumers have a perfect knowedge of the market. The producers are fuy aware of market prices, costs in the industry, and the workings of the market. The consumers are fuy aware of prices in the market, the uaity of products, and the avaiabiity of the goods. Athough we say that it is competey theoretica, there are some industries in the word that get uite cose to being perfecty competitive markets. The industries most often used as exampes by economists are usuay agricutura markets. For exampe, et us consider the growing of wheat in the European Union (EU). There are some arge wheat farms in the EU, but they are very sma in reation to the whoe wheat-growing industry. An individua farm coud increase its output many times over without having a noticeabe effect on the tota suppy of wheat in the EU. Thus a singe farm is not abe to affect the price of wheat in the EU, since it cannot shift the industry suppy curve. The farm has to se at whatever the existing industry price is. In addition, wheat is wheat, and so there is no way to te one farm s wheat from another. o far so good for the assumptions of perfect. However, athough firms are reativey free to enter or eave the wheat industry, there are significant costs in doing either and these may affect the decisions of firms. Aso, athough information is fairy open in the industry it is unikey that producers and consumers wi have perfect knowedge. We can say that the wheat industry in the EU may be cose to being a perfecty competitive market, but is not precisey one. The demand curves for the industry and the firm in perfect We have said that the individua firms in perfect wi be price-takers, since they cannot affect the price of the industry and so must se 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. Figure 7.1 The demand curves for the industry and the firm in perfect 7 erfect 13

2 7 erfect 7 erfect As we can see in Figure 7.1, the industry in perfect wi face norma demand and suppy curves. We woud expect producers to wish to suppy more at higher prices and we woud expect consumers to demand ess as price rises. We woud expect demand to be downward soping and suppy to be upward soping. price woud therefore be and the uantity demanded woud be Q. For the individua firms we know that they wi have to se at the industry price,, because they are price-takers. If they try to se at a higher price then consumers wi simpy buy the product from another firm, since the goods are homogeneous and so there is no difference in ooks or uaity. If they se at the industry price the firm can se as much as it wants, because as it increases output it does not affect the industry suppy curve and so it does not ater the industry price. If the firm can se a that it wishes at the price then it must face a perfecty eastic demand at that price. In Figure 7.1 we can see that the firm derives its price of from the euiibrium price in the industry, where the industry suppy euas the industry demand. This is another expanation of the term price-taker, because the firm has to take the price set in the industry. ossibe short-run profit and oss situations in perfect In the short run in perfect, there are two possibe profit/ oss situations: 1 hort-run abnorma : In this case, which is shown in Figure 7.3, the firms in the industry are making abnorma in the short run. This means that they are more than covering their tota costs, incuding the opportunity costs. = MR the uantity Abnorma Figure 7.3 hort-run abnorma in perfect = AR = MR the cost per unit 14 rofit maximization for the firm in perfect Firms maximize when they produce at the eve of output where 5 MR. For perfect, we now have to add the margina cost curve, shown in Figure 7.2. Q =MR the uantity Figure 7.2 The profit-maximizing eve of output in perfect We can see that the firm takes the price from the industry and, because the demand is perfecty eastic, 55AR5MR. rofit is maximised where 5MR, which is at the eve of output. We must remember that athough the scae of the price axes is the same for the firm and the industry, this is not the case for output. The uantity is very sma in reation to the tota industry output, Q, and it woud not even register on the output axis for the industry. If it coud, then it woud be arge enough to shift the suppy curve and thus ater the industry price. As we can see in Figure 7.3, the firm is seing at the industry price,, and is maximizing by producing at the uantity, where 5MR. At, the cost per unit, average cost, is, and the revenue per unit, average revenue, is, so average cost is ess than average revenue and the firm is making an abnorma profit of on each unit. The shaded area shows the tota abnorma profit. 2 hort-run osses: In this case, shown in Figure 7.4, the firms in the industry are making osses in the short run. This means that they are not covering their tota costs. Figure 7.4 hort-run osses in perfect the cost per unit =MR the uantity In Figure 7.4 the firm is seing at the industry price,, and is maximizing by producing at the uantity, where =MR. However at output, the cost per unit is, which is greater than the price and so the firm is making a oss of on each unit. The shaded area shows the tota oss. Athough making a oss, the firm is sti producing at the profit-maximizing eve of output, because any other output woud create a greater oss. In effect, they are oss minimizing. 15

3 7 erfect 7 erfect The movement from short run to ong run in perfect If firms are making either short-run abnorma or short-run osses, other firms begin to react and the situation starts to change unti an euiibrium point is reached in the ong run. hort-run abnorma to ong-run norma Let us ook first at the situation of short-run abnorma. The process is shown in Figure 7.5. is making abnorma shown by the shaded area, but this situation wi not continue for ong. ince there is perfect knowedge and no barriers to entry, firms outside of the industry that coud aso produce the good wi start to enter the industry, attracted by the chance to make abnorma. At first, this wi have no rea effect, because the firms are reativey sma. However, as more and more firms enter the industry, attracted by the abnorma, the industry suppy curve wi start to shift to the right. hort-run osses to ong-run norma Now take the situation of short-run osses. The process is shown in Figure 7.6. As we can see, the firm is making osses shown by the shaded area, but this situation wi not remain the same. ome firms in the industry wi, after a time, start to eave the industry. At first this wi have no rea effect, because the firms are reativey sma. However, as more and more firms eave the industry, unabe to achieve norma profit, the industry suppy curve wi start to shift to the eft. As the industry suppy curve starts to shift from towards 1, the industry price wi begin to rise from towards 1. As the firms in the industry are price-takers, the price that they can charge wi start to rise and their demand curves wi start to shift upwards. This means that the osses that they had been making begin to get smaer. As the industry suppy curve starts to shift from towards 1, the industry price wi begin to fa from towards 1. Because the firms in the industry are price-takers, the price that they can charge wi start to fa and their demand curves wi start to shift downwards. This means that the abnorma that they had been making wi start to be competed away =1 1=AR1=MR1 1 Q 1 1 Figure 7.6 The movement from short-run osses to ong-run norma profit 1 Q1 1=1 Abnorma profit 1 1=AR1=MR1 Figure 7.5 The movement from short-run abnorma profit to ong-run norma profit This process wi continue as ong as there are abnorma in the industry. Eventuay the industry suppy curve reaches 1, where the price is 1. At this point, the firms are taking the price of 1 and the demand curve is 1 5AR 1 5MR 1. We now find that the firms are making norma with the price per unit eua to the cost per unit, i.e The entrepreneurs of the firms in the industry are satisfied, because they are exacty covering their opportunity costs. However, there is now no abnorma profit to attract more firms into the industry and so the industry is in a ong-run euiibrium situation. No one wi now enter and no one wi now eave. The outcome is a much bigger industry producing Q 1 units, with smaer firms each producing 1 units. This process wi continue as ong as there are osses being made in the industry. Eventuay the industry suppy curve reaches 1, where the price is 1. At this point, the firms are taking the price of 1 and the demand curve is 1 =AR 1 =MR 1. We now find that the firms are making norma, with the price per unit eua to the cost per unit, i.e. 1 = 1. Now the entrepreneurs of the firms in the industry are satisfied, because they are exacty covering a of their costs, incuding their opportunity costs. There woud be no reason to eave the industry as the firm coud not do better esewhere. However, there is now no abnorma profit to attract more firms into the industry and so the industry is in a ong-run euiibrium situation. No one wi now enter and no one wi now eave. The outcome wi be a smaer industry producing ony Q 1 units, with sighty arger firms, each producing 1 units. Long-run euiibrium in perfect We can concude that, in the ong run, firms in perfect wi make norma. This is because, even if they are making short-run abnorma or short-run osses, the industry wi adjust with firms entering or eaving the industry unti a norma profit situation is reached

4 7 erfect 7 erfect Figure 7.7 Long-run euiibrium in perfect In Figure 7.7, the firms are making norma in the ong run. They are seing at the price, which they are taking from the industry. is eua to MR so they are maximizing by producing, and at that output is eua to so they are making norma. In this situation there is no incentive for firms to enter or eave the industry and so the euiibrium wi persist unti there is a change in either the industry demand curve or in the costs that the firms face. If this does happen, then firms wi be making either short-run abnorma or short-run osses and the industry wi once again adjust, with firms entering or eaving unti ong-run euiibrium is restored. tudent workpoint 7.1 Be a thinker expain and iustrate 1 Why is a firm in perfect a price-taker? 2 raw the foowing diagrams. Be sure to use a ruer and incude accurate abes. Aso be sure that your curves cross at the minimum of. a A firm in perfect earning abnorma b A firm in perfect making economic osses c A firm in perfect in its ongrun euiibrium earning norma rice refects the vaue that consumers pace on a good and is shown on the demand curve (average revenue). Margina cost refects the cost to society of a the resources used in producing an extra unit of a good, incuding the norma profit reuired for the firm to stay in business. If price were to be greater than margina cost, then the consumers woud vaue the good more than it cost to make it. If both sets of stakehoders are to meet at the optima mix, then output woud expand to the point where price euas margina cost. imiary, if the margina cost were to be greater than the price, then society woud be using more resources to produce the good than the vaue it gives to consumers and output woud fa. Aocative efficiency occurs where margina cost (the cost of producing one more unit) is eua to average revenue (the price received for a unit). Thus the aocativey efficient eve of output is where: = AR The cost The vaue = to producers to consumers roductive and aocative efficiency in perfect roductive efficiency One of the efficiency measures used by economists is that of productive efficiency. A firm is said to be productivey efficient if it produces its product at the owest possibe unit cost (average cost). This is shown in Figure 7.8. At the output, the firm in Figure 7.8 is abe to produce at the most efficient eve of output, i.e. the owest average cost of production. This is the cost c. o is known as the productivey efficient eve of output. We know from chapter 6 that aways cuts at its owest point, and so we can say that the productivey efficient eve is where: 5 roductive efficiency is important in economics, because if a firm is producing at the productivey efficient eve of output then they are combining their resources as efficienty as possibe and resources are not being wasted by inefficient use. Aocative efficiency This measure of efficiency is sometimes aso caed the sociay optimum eve of output. ost ($) c Figure 7.8 roductive efficiency =AR 1 MR 2 Figure 7.9 Aocative efficiency In Figure 7.9, we can see the aocativey efficient eve of output for a firm with a norma demand curve and for a firm with a perfecty eastic demand curve. In both cases we are ooking for the output where 5AR 2 1 for the firm with a norma demand curve and 2 when the demand is perfecty eastic. Aocative efficiency is important in economics, because if a firm is producing at the aocativey efficient eve of output there is a situation of areto optimaity where it is impossibe to make one person better off without making someone ese worse off. We wi ook at this in more detai when we consider market faiure in hapter 12. roductive and aocative efficiency in the short run in perfect If a firm is making abnorma in the short run in perfect, we can see from Figure 7.1 that athough they are producing at the profit-maximizing eve of output, (where 5MR), and the aocativey efficient eve of output, 2 (where 5AR), the firm is not producing at the most efficient eve of output, 1 (where 5). 18 Aocative efficiency occurs where suppiers are producing the optima mix of goods and services reuired by consumers. 19

5 7 erfect 7 erfect Aso shown in Figure 7.12 is the fact that a of the profit-maximizing firms in the ong run in perfect are aso producing at the aocativey efficient eve of output, because they produce where 5AR. Abnorma 1 2 Figure 7.1 roductive and aocative efficiency with short-run in perfect In the same way, if a firm is making osses in the short run in perfect, we can see from Figure 7.11 that athough they are producing at the profit-maximising eve of output, (where 5MR), and the aocativey efficient eve of output, 2 (where 5AR), once again the firm is not producing at the most efficient eve of output, 1 (where 5). tudent workpoint 7.2 Fi in the spaces in the tabe beow with either a yes or a no. erfect hort run Long run Abnorma possibe? Examination uestions aper 1, part (a) uestions possibe? Aocativey efficient? 1 With the hep of a diagram, expain how it is possibe for a firm in perfect to earn abnorma in the short run. roductivey efficient? [1 marks] 1 2 Figure 7.11 roductive and aocative efficiency with short-run osses in perfect roductive and aocative efficiency in the ong run in perfect As we can see in Figure 7.12, profit-maximizing firms in the ong run in perfect a produce at the owest point of their ong-run average cost curves. Because we assume that there is perfect knowedge in the industry, a of the firms wi face the same cost curves, and so they are a seing at the same price and minimizing their average costs by producing where 5. 2 With the hep of a diagram, expain how it is impossibe for a firm in perfect to earn abnorma in the ong run. 3 Expain whether or not a firm in perfect earning abnorma is productivey and aocativey efficient. aper 1, essay uestion 1 a Expain the characteristics of a perfecty competitive market structure. b Evauate the extent to which it is possibe for a firm in perfect to earn abnorma. [1 marks] [1 marks] [1 marks] [15 marks] 11 (=MR) 1 (=) 2 (=AR) Figure 7.12 roductive and aocative efficiency in the ong run in perfect 111