The Model of Perfect Competition

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1 The Model of Perfect Competition

2 Key issues The meaning of perfect competition Characteristics of perfect competition and output under competition Competition and economic efficiency Wider benefits of competition in markets

3 Assumptions behind a perfectly competitive market Many suppliers - each with an insignificant share of the market Each firm is too small to affect price via a change in market supply each business is a price taker Identical output produced by each firm i.e. homogeneous products that are perfect substitutes for each other Consumers have complete information about prices

4 Assumptions behind a perfectly competitive market Transactions are costless - Buyers and sellers incur no costs in making an exchange All firms (i.e. industry participants and new entrants) have equal access to resources (e.g. technology) No barriers to entry and exit of firms in long run market is open to competition from new suppliers No externalities in production and consumption

5 Examples of perfectly competitive markets? Agricultural markets Pig farming, cattle Farmers markets for apples, tomatoes, etc. Wholesale markets for vegetables, fish, flowers Street food markets in developing countries

6 Examples of perfectly competitive markets? Foreign exchange dealing: Homogeneous product - US dollar or the Euro Many buyers and sellers Usually each trader is small relative to total market and has to take price as given Sometimes, traders can move currency markets

7 Approximations of perfect competition Fruit sellers at a weekly local market Chinese restaurants in a big city s Chinatown

8 -taking firms Competitive firms in competitive markets have little direct influence on the ruling market price Examples of price-taking behaviour: Local farmers selling to large supermarkets A local steel firm selling as much as it can at the ruling international price of steel The law of one price may hold true most of the existing firms sell at the prevailing price

9 Short-run price and output Market forces determine the price MS MD

10 Short-run price and output Market forces determine the price MS MD

11 Short-run price and output Market forces determine the price MS Taking MD

12 Short-run price and output Market forces determine the price MS Taking AR=MR MD

13 Short-run price and output Market forces determine the price MS Assume profit maximizing firms AR=MR MD

14 Short-run price and output Market forces determine the price MS Assume profit maximizing firms AR=MR MD Q1

15 Short-run price and output MS MR= Maximum Profits AR=MR MD Q1

16 Short-run price and output MS MR= Maximum Profits AR=MR 1 MD Q1

17 Short-run (abnormal) profits MS Profits = (-1) x Q1 AR=MR 1 MD Q1

18 Abnormal profits Profits = (-1) x Q1 AR=MR Possible for firms in a perfectly competitive market to make abnormal (i.e. Supernormal) profits in the short run 1 This is where price > Remember that normal profit is assumed to be included in the curve Q1

19 Effect of a rise in market demand MS AR=MR MD Q1

20 Effect of a rise in market demand MS AR=MR MD2 MD Q1

21 Effect of a rise in market demand MS P2 AR=MR MD2 MD Q1

22 Effect of a rise in market demand MS P2 P2 AR2=MR2 AR=MR MD2 MD Q1

23 Effect of a rise in market demand MS P2 P2 AR2=MR2 AR=MR MD2 MD Q1 Q2

24 Effect of a rise in market demand MS New level of supernormal profits P2 P2 AR2=MR2 AR=MR MD2 MD Q1 Q2

25 What is a long-run equilibrium? Usual interpretation of a long run equilibrium is as follows: (1) The quantity of the product supplied in the market equals the quantity demanded by all consumers (2) Each firm in the market maximizes its profit, given the prevailing market price (3) Each firm in the market earns zero economic profit (i.e. normal profit) so there is no incentive for other firms to enter the market You Tube video on perfect competition

26 Long-run equilibrium price MS AR=MR MD

27 Long-run equilibrium price MS MS2 AR=MR P2 MD

28 Long-run equilibrium price MS P2 MS2 AR=MR AR2=MR2 MD

29 Long-run equilibrium price MS P2 MS2 AR=MR AR2=MR2 MD Q2

30 The long-run equilibrium MS In the long run equilibrium, normal profits are made, i.e. price = average cost MS2 P2 AR2=MR2 MD Q2

31 The long-run equilibrium Normal profit is the profit just sufficient to keep a business in their current market in the long run In the long run equilibrium, normal profits are made i.e. price = average cost It is also the opportunity cost of capital AR2=MR2 Profits act as an incentive for enterprise Q2

32 Competition and economic efficiency Economic efficiency has several meanings: Productive efficiency when output is produced at the lowest feasible average cost (either in the short run or the long run) Allocative efficiency Achieved when the market provides goods and services that meet consumer needs and wants Achieved when the price of output reflects the true marginal cost of production This is where price=marginal cost

33 Productive efficiency Cost per unit Productive efficiency occurs when the equilibrium output is supplied at minimum average cost. This is attained in the long run for a competitive market LR Q1 Q2 Q3

34 Allocative efficiency Allocative efficiency achieved when it is impossible to make someone better off without making someone else worse off Also called Pareto Optimality No trades are left that would make one person better off without hurting someone else Occurs when price = marginal costs of production This occurs in the long run under perfect competition

35 Allocative efficiency Consumer Surplus Market Supply When price is equal to marginal cost (P=), allocative efficiency is achieved. At the ruling price, consumer and producer surplus are maximized. Producer Surplus Market Demand No one can be made better off without making some other agent at least as worse off i.e. we achieve a Pareto optimum allocation of resources Q1

36 Allocative inefficiency P2 Consumer Surplus Market Supply Deadweight loss of welfare Producer Surplus Market Demand Q2 Q1

37 Competition and economic efficiency Technological efficiency where maximum output is produced from given inputs Dynamic efficiency Refers to the range of choice and quality of service Also considers the pace of technological change and innovation in a market

38 Importance of a competitive environment The standard view is that competition drives an improvement in welfare and efficiency Competition forces under-performing firms out of the market and shifts market share to more efficient firms in the long run Competition encourages firms to innovate and adopt best-practise techniques

39 How useful is model of perfect competition? Assumptions are not meant to reflect real world markets where most assumptions are not satisfied Pure competition is devoid of what most people would call real competitive behaviour by businesses! The model provides a theoretical benchmark used to compare and contrast imperfectly competitive markets Consider perfect competition as an interesting point of reference but one with few real world applications Useful when considering The effects of monopoly / imperfect competition The case for free international trade

40 Real world imperfect competition! 1. Most suppliers have a degree of control over market supply 2. Some buyers have monopsony power against suppliers because they purchase a significant percentage of total demand 3. Most markets have heterogeneous products due to product differentiation and constant innovation 4. Consumers nearly always have imperfect information and their preferences and choices can be influenced by the effects of persuasive marketing and advertising 5. Finally there may be imperfect competition in related markets such as the market for essential raw materials, labour and capital goods.

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