Perfect Competition

Perfect Competition A2 Economics

Aims and Objectives Aim: • Understand perfectly competitive markets Objectives: • Re-call the assumptions of perfectly competitive markets • Explain how a perfectly competitive firm decides its output. • Analyse how profits differ in the short and long run in perfectly competitive markets.

Starter: PERFECT RECALL- Perfectly Competitive Markets - Assumptions • Many suppliers each with an insignificant share of market • Each firm is too small to affect price via a change in market supply – each individual firm is a price taker • Identical output produced by each firm – homogeneous products that are perfect substitutes for each other • Consumers have complete information about prices • Transactions are costless - Buyers and sellers incur no costs in making an exchange • All firms (industry participants and new entrants) have equal access to resources (e.g. technology) • No barriers to entry & exit of firms in long run – the market is open to competition from new suppliers • No externalities in production and consumption

Starter: PERFECT RECALL- Perfectly Competitive Markets - Assumptions • Many suppliers each with an insignificant share of market • Each firm is too small to affect price via a change in market supply – each individual firm is a price taker • Identical output produced by each firm – homogeneous products that are perfect substitutes for each other • Consumers have complete information about prices • All firms (industry participants and new entrants) have equal access to resources (e.g. technology) • No barriers to entry & exit of firms in long run – the market is open to competition from new suppliers • No externalities in production and consumption

Answer • Transactions are costless - Buyers and sellers incur no costs in making an exchange

Starter: PERFECT RECALL- Perfectly Competitive Markets - Assumptions • Many suppliers each with an insignificant share of market • Identical output produced by each firm – homogeneous products that are perfect substitutes for each other • Consumers have complete information about prices • Transactions are costless - Buyers and sellers incur no costs in making an exchange • All firms (industry participants and new entrants) have equal access to resources (e.g. technology) • No barriers to entry & exit of firms in long run – the market is open to competition from new suppliers • No externalities in production and consumption

Answer • Each firm is too small to affect price via a change in market supply – each individual firm is a price taker

Starter: PERFECT RECALL- Perfectly Competitive Markets - Assumptions • Many suppliers each with an insignificant share of market • Each firm is too small to affect price via a change in market supply – each individual firm is a price taker • Identical output produced by each firm – homogeneous products that are perfect substitutes for each other • Consumers have complete information about prices • Transactions are costless - Buyers and sellers incur no costs in making an exchange • All firms (industry participants and new entrants) have equal access to resources (e.g. technology) • No externalities in production and consumption

Answer • No barriers to entry & exit of firms in long run – the market is open to competition from new suppliers

Re-Cap: Price Takers The Firm The Market Price of X Price of X S • In the market price for product X reaches equilibrium at £5. • Individual firm has to accept this price. • If it sells above £5 consumers will go elsewhere. • If it sells below it will have plenty of consumers, but will not be maximising its returns. D=AR=MR=P £5 D 0 0 10 Quantity Demanded and Supplied

How Many Does a Firm Produce? • Firms wanting to profit maximise will produce where MC = MR. MR=MC at 10 units. Therefore TR = 80 x 10 = £800 MC Revenue & Cost of X D=AR=MR=P £80 0 10 Quantity Demanded and Supplied

How Many Does a Firm Produce? • To be able to calculate profit we need to calculate total costs. • Total Costs = ATC x Output • Output of 10 units the ATC is £60 pu • Total costs = 60x10 = £600 • TR – TC = £200. • As we include normal profit in costs, this £200 is supernormal or abnormal profit. MC Revenue & Cost of X ATC £80 D=AR=MR=P £60 0 10 Quantity Demanded and Supplied

Supernormal Profit • If supernormal profit is being made, other firms will wish to enter the industry in an attempt to earn a portion of these profits. • As there are no barriers to entry they will do so until supernormal profits are eroded away! MC Revenue & Cost of X ATC £80 D=AR=MR=P £60 0 10 Quantity Demanded and Supplied

Market Response: Supernormal Profit Eroded Away The Firm The Market Price of X Revenue & Cost MC S • Initial equilibrium ruling price of £80, individual firm able to make £20pu supernormal profits. • Other firms attracted by supernormal profits shift supply curve right. S1 ATC £80 D=AR=MR=P £80 D=AR=MR=P1 £60 £60 D 0 0 8 10 Quantity Demanded and Supplied

Market Response: Supernormal Profit Eroded Away The Firm The Market Price of X Revenue & Cost MC S • Firms continue to enter until supernormal profit eroded away. • Ruling price falls as does the firms revenue curve. • To maximise profits (MC=MR) it has to reduce its output to 8 units. S1 ATC £80 D=AR=MR=P £80 D=AR=MR=P1 £60 £60 D 0 0 8 10 Quantity Demanded and Supplied

Market Response: Supernormal Profit Eroded Away The Firm The Market Price of X Revenue & Cost MC S • Any output beyond 8 adds more to costs then to revenue. • Firm output has fallen. • Due to entry of other firms, its market share has fallen too! S1 ATC £80 D=AR=MR=P £80 D=AR=MR=P1 £60 £60 D 0 0 8 10 Quantity Demanded and Supplied

Market Response: Supernormal Profit Eroded Away • TR = 60 x 8 = 480 • TC = 60 x 8 = 480 • Firm now making normal profit • This is the long run equilibrium position for a firm in perfect competition. • Where ATC and ATR are equal. • Therefore….. • Normal Profit = ATC = ATR

Worksheet Questions: • Using Microsoft Excel/Microsoft Publisher construct a diagram showing the industry position and, using the equilibrium prices and information from the table above construct the diagram of the firm. • At a price of £60 what quantity would the firm have been producing? • What was its level of supernormal profits or losses? • Explain why a price of £40 is sufficient to keep the firm in the industry.

Perfect Competition