Perfect Competition

Market Structures

Perfect Competition

• It is a theoretical model.

Perfect Competition

• Assumptions:• Large number of firms.

• Assumptions:• Individual firms are “price takers”.

Perfect Competition

• Assumptions:• Homogeneous products.

Perfect Competition

• Assumptions:• Freedom of entry and exit.

Perfect Competition

• Assumptions:• Perfect knowledge of the market.

Perfect Competition

Demand curves for industry and firm in perfect competition

• Industry:• Normal demand and supply

curves.• More supply at higher price and

less demand and higher price.• Firm:• Price takers.• Have to accept the industry

price.

Profit maximization for the firm in perfect competition

• Profit maximization rule: MC=MR• For a firm, P=D=AR=MR

Short run abnormal profit in perfect competition

• Firms are more than covering their total cost, including opportunity cost.

Short-run abnormal profit to long-run normal profit

Short-run abnormal profit attracts more firms to the industry.(Freedom of entry)

Supply curve shifts to the right.(S to S1) This pulls down the price. (P to P1) Demand curve shifts downwards. (D to

D1) At new price, P= C In the long-run there is no abnormal

profit.

Short-run loss in perfect competition

• Firms are not covering their total cost.

Short-run losses to log-run normal profit

• Due to losses, a few firms will leave the industry.(Freedom of exit)

• Supply curve shifts to the left.(S to S1)

• Industry price begin to rise.(P to P1)

• Demand curve shifts upwards.(D to D1)

• At new price, P=C (normal profit)

Long-run equilibrium

• In the long-run, firms in perfect competition can make only normal profit.

• Freedom of entry and exit eliminates the short-run abnormal profit and short-run losses.

• In the long-run equilibrium, there is no incentive for firms to enter or leave the

industry.

Productive and allocative efficiency

• Productive efficiency:• A firm is productive efficient

when it produces at its lowest possible unit cost(average cost)

• MC=AC• This means the combination

of resources is efficient and there no wastage of resources.

Productive and allocative efficiency

• Allocative Efficiency:• This is socially optimum

level of output.• Producers are producing

the optimal mix of goods and services required by consumers.

• Price reflects the value that consumers place on a good.

• MC=AR Cost to producers

The value to consumers

Pareto Optimality

• Allocative efficiency means there is Pareto optimality.

• Situation where it is impossible to make one person better off without making someone else worse off.

• An economic state where resources are allocated in the most efficient manner.

•MC=MRProfit maximization

•MC=ACProductive efficiency

•MC=ARAllocative efficiency

Productive and allocative efficiency in the short run in perfect competition

• Profit maximization level of output is at q(MC=MR)

• Allocative efficiency is at q2 (MC=AR)

• Productive efficiency is at q1 (MC=AC)

Productive and allocative efficiency in the short run in perfect competition

• Profit maximization level of output is at q(MC=MR)

• Allocative efficiency is at q2 (MC=AR)

• Productive efficiency is at q1 (MC=AC)

Productive and allocative efficiency in the long run

• In the long run, Profit maximization level of output=productive efficiency=allocative efficiency.

• This is because, there is perfect knowledge and same cost curves.

Examples of perfect competition:

– Financial markets – stock exchange, currency markets, bond markets?–Agriculture?

Advantages of Perfect Competition:

High degree of competition helps allocate resources to most efficient use

Price = marginal costs

Normal profit made in the long run

Firms operate at maximum efficiency

Consumers benefit