Thursday, 20 December 2012

Principles of Economics - Perfect Competition

Perfect Competition is a market structure that follows these assumptions:

  • Firms are price takers - each firm has no impact on the price in the market, they take the price the market forces set.
  • Freedom of entry into the market - there are low barriers to entry so anyone could potentially set up in this market.
  • Firms produce identical products - the taxi market for example, each taxi firm offers an identical product.
  • Producers and consumers have perfect knowledge - both producers and consumers know everything there is to be known about the market.

However, few, if any, industries are actually perfectly competitive.

In the short run, the number of firms is fixed. In the long run, if supernormal profits are being made then new firms will enter the industry. If losses are being made, firms will leave the industry. 

Short run equilibrium of the firm:

This is what the market looks like in the short run in perfect competition. The price is Pe, and is set by the demand and supply forces. It is horizontal because firms are price takers. Due to price being constant, the red dotted line is also the average revenue, the marginal revenue and the demand for the firm as they're all the same. Qe is the amount produced by the firm because this is the amount at which profits are maximised (MC = MR). There is slight profit being made because the average revenue is higher than the average cost at the production point.

This is where the long run can be introduced. In the long run, firms see these profits being made and enter the industry. These means the industry supply increases, shifting the supply curve to the right on the left hand diagram above. Price falls, which means each firms demand falls until the point it is equal to the average cost. At this point, firms break even and make no profit. Firms will stop entering the industry now.

As far as the public interest goes with perfect competition, it has its benefits and drawbacks. The benefits are as follows:

  • Firms produce at the least cost output.
  • Firms that are inefficient will be forced out.
  • Prices are minimised.
  • Consumers determine what and how much is produced.

The drawbacks are:
  • There us very little incentive to invest in new technology.
  • Goods are all the same, lack of variety for consumers.

That ties up this post about perfect competition. Thank you for reading, keep checking back and sharing. Have a good day!


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