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Perfect Competition

 

Perfect competition doesn't imply ideal results are produced or economic welfare is maximised.

 

Four characteristics of perfect competition

        There are many buyers and sellers in the market place, none of whom are large enough to influence the price. Sellers are described as being price takers.

        There is freedom of entry and exit into the market, i.e., barriers to entry are low. Firms must be able to establish themselves quickly in the marketplace.

        Buyers and sellers have perfect knowledge, economic agents are fully informed of prices and output in the industry.

        All firms produce a homogeneous (identical) product.

 

 

The agriculture industry is the most commonly used example of perfect competition, it satisfies the above criteria as follows:

        There are a large number of buyers and sellers in a massive market.

        It is easy to buy a farm and equally easy to sell it.

        Farmers know the current market prices for agricultural goods as they are frequently published.

        Farmers produce a range of homogeneous goods.

 

Many governments intervene in the agricultural market by fixing prices or giving subsidies.

 

Demand and revenue

The price of the good is determined in the marketplace via the normal interactions of demand and supply.  The individual firm must accept that price, therefore it faces a perfectly elastic demand curve. If the firm raises its price above that which is set in the market it will lose all of its customers, as it is possible to buy an identical good elsewhere cheaper. The demand curve also equals the AR and MR.

 

 

Cost and supply curves

In the shortrun a firm won't necessarily shut down production if it's making a loss. If a firm has fixed costs of 100, variable costs of 150 and a revenue of 200, it can be seen that by operating the firm loses 50 (200-150-100), but if it was to close down it would incur losses of 100, therefore it make sense to continue operating even at the smaller loss. This is because the firm has fixed costs that it has to pay whatever the level of production, even if it's zero. Any revenue left over after the variable costs have been paid will make a contribution to the fixed costs, this is called loss minimising.

 

The firm's shortrun supply curve will be that part of the MC that is above the SRAVC. In the diagram overleaf, the supply curve will therefore be the part of the MC above P1. The MC is used as the supply curve, because it shows the price that the firm is able to supply an extra unit of output for. 

 

As all factors of production are variable in the longrun, no distinction is made between fixed and variable costs, a longrun average cost curve is used (LRAC). In the longrun a firm will leave the industry if it's making an economic loss, i.e., cost is greater than revenue. The longrun supply curve is therefore the part of the MC above the LRAC.

 

Shortrun equilibrium

The equilibrium price is determined in the by the industry demand and supply curves. Individual firms accept this price to sell their goods at because they are price takers and they supply the level of output that maximises their output. In the diagram below, the firm is making abnormal profits as the AR is greater than the AC at the profit maximising level of output (MR=MC).

 

 

 It is also possible that the firm will be making an economic loss, AR less than AC.

 

 

 Normal profits could be earned by the firm where AR=AC.

 

 

Long run equilibrium

If abnormal profits are being earned, other firms will want to enter the industry shifting the industry supply curve to the right from S1 to SL, lowering the price from P1 to PL. The firm's demand curve shifts downwards from D1 to DL where only normal profits are made, as AR=AC, at the profit maximising level of output (MR=MC). This is the longrun equilibrium position as there is no incentive for firms to enter or leave the industry, this is shown in diagram the below.

 

If losses are being made in the long run firm will leave the industry, shifting the industry supply curve to the left from S1 to SL, raising the price from P1 to PL. The firm's demand curve shifts upwards from D1 to DL where normal profits are made, as AR=AC, at the profit maximising level of output (MR=MC). Again this is the longrun equilibrium position as there is no incentive for firms to enter or leave the industry, this is shown in diagram the below.

Notes on the Internet
Perfect Competition PowerPoint Model
Perfect Competition PowerPoint Presentation
Shut Down Price
Produced by Geoff Riley at RGS Newcastle
Shut-down point
Produced by Drexel University
Perfect Competition
Produced by Drexel University
Perfect Competition Interactive Test
Produced by Oklahoma State University
Perfect Competition Worksheet

 

 

E-mail Steve Margetts