Chapter 7 – Perfect Competition 10/10

Assumption of Perfect Competition(PC)

• The industry is made up of very very large number of firms.

• Firms are so small that they cannot influence price(price takers).

• Output is homogenous. ~> No brands.

• No barriers of entry into market.

• Producers and consumers have perfect knowledge of the market.

<Only exists in theory!!>

CHARACTERISTIC OF PC

HOMOGENOUS PRODUCTS - HARRY

PRICE TAKERS – PICKS his

LARGE NUMBER OF FIRMS - LARGE

NO BARRIERS TO ENTRY - NOSE

Demand(D) curve for and industry and demand curve for in perfect competition

• Firms are price takers so their D curves are perfectly elastic.

• If they raise prices, the consumers will just switch to another firm.

• But the industry as a whole will have a normal D curve.

• If all of the firms raise prices(P), the D will decrease and vice versa.
Profit(π) maximization in perfect competition

• The firm takes price P from the industry and the demand is perfectly elastic

therefore: P = D = AR = MR

• Firms maximize output when MC = MR, at the level of output q.

• The “q” on the “firm” graph doesn't equal the “Q” on the “industry” graph.

• “q” is very small in comparison to “Q” because “q” is output of an individual firm

while “Q” is the output of the whole market.

Short Run(SR) abnormal profits in perfect competition

• The firm is covering more than its total costs including opportunity costs

• At q, the cost per unit = C.

• The AR = P

• C is less than P so the firm is making a profit of P-C on each unit of product sold

• This shaded area is known as abnormal profits

Loss in in perfect competition

• The firm is not covering its total costs including opportunity costs

• At “q”, the cost per unit = C and The AR = P

• P is less than C so the firm is making a loss of C-P on each unit of product sold

• This shaded area is known as losses

• However, they are still producing at the “profit-maximizing” level of output at “q”

because at any other output will cause a greater loss

SR abnormal π to Long Run(LR) normal π in PC

• Abnormal π attract other producers into PC

• No barriers to entry = easy for new producers to enter the market

• Causes the Supply curve of “The industry” graph to shift from S to S1 ~> Increase

in suppliers cause increase in quantity supplied

• Result = QD(quantity demanded) falls due to excess supply

• Effect 1 ~> D curve for “The firm” falls from D to D1

• Effect 2 ~> No more abnormal π,only normal profits,quantity produced by firm falls
• Effect 3 ~> No more attraction of other producers ~> NOW INTO LONG TERM
SR losses to Long Run(LR) normal π in PC

• Firms leave the industry due to short run losses

• Supply(S) of “The industry” shifts from S to S1 ~> Lack of producers cause excess

demand which pushes price up from P to P1

• Firms are price takers so they “take” the price at P1

• Result ~> D curve of “The firm” shifts up from D to D1

• Effect 1 ~> No more losses, only normal profits, quantity produced by firm rises.

• Effect 2 ~> No more producers leave the industry ~> NOW IN LONG TERM

LR equilibrium in PC

• Abnormal π ~> Attract producers ~> Normal π~> Long Run

• Losses ~> Producers leave ~> Normal π ~> Long Run

• THE INDUSTRY WILL ALWAYS ADJUST ITSELF UNTIL A NORMAL PROFIT IS

REACHED

• In this situation where all the firms are making AC, there is no incentive for firms to

leave ~> This puts the PC industry in long term equilibrium until a change occurs
Productive Efficiency and Allocative Efficiency in PC

Productive Efficiency(PE)

• A firm is productively efficient when it is producing at its lowest possible AC

• Lowest average cost = “c”, Productively efficient level of output = “q”

• Therefore PE is where Marginal Cost(MC) = Average Cost(AC)

• Important because it shows weather resources are being wasted or not

Allocative Efficiency(AE)

• AE occurs where suppliers are producing the optimal mix of goods and services

required by consumers

• MC = cost to society and the resources needed to produce an extra unit of a good

• The Price at which the products are sold has to be equal to MC because

1/ If P is larger than MC, the society is paying more than the product is worth

2/ If P is smaller than MC, the society is using more resources than the products

are worth

• Therefore AE is when MC = AR(Average Revenue, the P at which products are

sold)
PE and AE in SR and LR in PC

• Firms making profit and losses in SR are not achieving PE because MC doesn't

equal AC

<PE and AE in short run with losses in PC>

<PE and AE in short run with profits in PC>

• However, in the LR, firms are achieving PE and AE because MC = AR, MC = AC

and MC = MR