4.1 Perfect competition

DEFINITIONS:

1. Perfect competition: A market structure characterized by a large number of small firms, identical products, freedom of entry and exit, and perfect knowledge among buyers and sellers.
2. Short run perfect competition: A period in perfect competition where firms may earn supernormal profits or incur losses due to fixed factors of production and variable levels of output.
3. Supernormal profit/loss: The profit or loss earned by a firm when its total revenue exceeds or falls short of its total costs, respectively, including both explicit and implicit costs.
4. Long run perfect competition: A period in perfect competition where firms earn normal profits, as any supernormal profits or losses are eliminated through the entry or exit of firms in the market.
5. Normal profits: The minimum level of profit required to keep a firm in business in the long run, where total revenue equals total cost, including opportunity costs.

Explain:

4.1.1 The characteristics of perfect competition

Perfect competition is a theoretical market structure that features several distinctive characteristics:

6. Large Number of Buyers and Sellers: The market has many participants, so no single buyer or seller can influence the market price.
7. Homogeneous Products: The products offered by all sellers are identical, meaning there is no differentiation, and consumers perceive no difference between products from different sellers.
8. Perfect Information: Both buyers and sellers have full knowledge of market prices, product quality, and production methods. This ensures that everyone makes informed decisions.
9. No Barriers to Entry or Exit: Firms can freely enter or exit the market without any significant obstacles. This leads to firms entering when there are profits and leaving when there are losses, ensuring normal profits in the long run.
10. Price Takers: Individual firms are price takers, meaning they accept the market price as given. This is due to the homogeneous nature of the product and the large number of firms, which prevents any single firm from influencing the price.
11. Profit Maximization: Firms aim to maximize their profits by producing at the output level where marginal cost equals marginal revenue (MC = MR).
12. Perfect Mobility of Resources: Factors of production (labour, capital, etc.) can move freely in and out of the industry, ensuring an optimal allocation of resources.

In perfect competition, these characteristics lead to an efficient allocation of resources, where firms produce at the lowest possible cost and prices reflect the true cost of production, resulting in maximized consumer and producer surplus.

4.1.2 Short Run Perfect Competition: Supernormal Profit/Loss

Explanation:

In a perfectly competitive market, firms are price takers due to the large number of firms and homogeneity of products. In the short run, firms can make supernormal profits (also known as abnormal or economic profits) or losses due to differences between price and average total cost (ATC).

Supernormal Profit:

• Supernormal profit occurs when a firm's total revenue exceeds its total costs, including opportunity costs.
• This situation arises when the price (P) is greater than the average total cost (ATC) at the profit-maximizing output level.

Loss:

• A firm incurs a loss when its total revenue is less than its total costs.
• This occurs when the price (P) is less than the average total cost (ATC) at the profit-maximizing output level.

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Diagram Explanation:

In the diagram below, we illustrate both scenarios: supernormal profit and loss.

1. Supernormal Profit:

• P = MR = AR: The horizontal line represents the market price (P), which is equal to marginal revenue (MR) and average revenue (AR) in perfect competition.
• MC: The upward-sloping curve is the marginal cost (MC) curve.
• ATC: The U-shaped curve represents the average total cost (ATC) curve.
• Supernormal Profit: The area where the price (P1) is above the ATC indicates supernormal profit. The difference between the price and ATC at quantity Q1 (where MC = MR) represents the supernormal profit per unit.

13. Loss:

• P = MR = AR: The horizontal line represents the market price (P), which is equal to marginal revenue (MR) and average revenue (AR) in perfect competition.
• MC: The upward-sloping curve is the marginal cost (MC) curve.
• ATC: The U-shaped curve represents the average total cost (ATC) curve.
• Loss: The area where the price (P2) is below the ATC indicates a loss. The difference between the price and ATC at quantity Q1 (where MC = MR) represents the loss per unit.

Key Points:

• In perfect competition, firms maximize profit where MR = MC.
• Supernormal profits attract new firms to the market in the long run, leading to a decrease in market price and the elimination of supernormal profits.
• Losses cause firms to exit the market, reducing supply, increasing the price, and eliminating losses in the long run.

These dynamics ensure that in the long run, firms in a perfectly competitive market earn only normal profit (where P = ATC).

4.1.3 Long Run Perfect Competition: Normal Profits

Key Features of Perfect Competition:

• Many firms: Each firm is a price taker.
• Homogeneous products: Products are identical.
• Free entry and exit: Firms can enter or exit the market with no barriers.
• Perfect information: All buyers and sellers have full information about prices and products.

Explanation:

In the long run, if firms are making supernormal (economic) profits, new firms will enter the market due to the absence of barriers to entry. This increases the market supply, leading to a decrease in the market price. Conversely, if firms are making losses, some firms will exit the market, decreasing the market supply and increasing the market price.

This process continues until firms are making normal profits, where total revenue equals total cost (including opportunity costs). At this point, there is no incentive for firms to either enter or exit the market.

Diagram:

Long Run Equilibrium in Perfect Competition

The diagram below illustrates a firm in long-run equilibrium earning normal profits:

14. Market Diagram:

• Supply Curve (S): Upward sloping, showing the relationship between price and quantity supplied.
• Demand Curve (D): Downward sloping, showing the relationship between price and quantity demanded.
• Equilibrium Price (P): The price at which the quantity demanded equals the quantity supplied.
• Equilibrium Quantity (Q): The quantity bought and sold at the equilibrium price.

15. Firm Diagram:

• Marginal Cost (MC): The cost of producing one more unit of output.
• Average Total Cost (ATC): The total cost per unit of output.
• Marginal Revenue (MR) and Price (P): In perfect competition, MR equals price due to the firm being a price taker.
• Output (q): The quantity produced by the firm.

Key Points in the Diagram:

• Market Diagram: The intersection of the supply and demand curves determines the equilibrium price (P) and quantity (Q).
• Firm Diagram: The firm produces where marginal cost (MC) equals marginal revenue (MR), which is also the price (P) in perfect competition. The average total cost (ATC) curve is tangent to the price line (P), indicating that the firm is making normal profits (TR = TC).

In the long run, due to the entry and exit of firms, the market adjusts such that all firms make normal profits, operating at the minimum point of their average total cost (ATC) curve, ensuring no economic profits or losses.

4.1.4 Individual Firm in Perfect Competition as a Price Taker

In a perfectly competitive market, an individual firm is considered a price taker. This means that the firm accepts the market price as given and cannot influence it through its own level of output.

Explanation:

1. Perfect Competition Characteristics:

• Many Buyers and Sellers: There are numerous firms and consumers, so no single firm can affect the market price.
• Homogeneous Products: All firms sell identical products.
• Free Entry and Exit: Firms can enter or leave the market freely.
• Perfect Information: All participants have complete information about prices and products.

2. Price Taker Behaviours:

• In perfect competition, the firm's demand curve is perfectly elastic at the market price. This means the firm can sell any quantity of the good at the prevailing market price but cannot sell at a higher price.

Diagram:

Here's a simplified diagram to illustrate the concept:

Key Points in the Diagram:

• Horizontal Demand Curve: The horizontal line at price P1 represents the firm's demand curve. It is perfectly elastic, meaning the firm can sell any quantity at this price.
• Price Taker: The firm has no control over the price and must accept P1 as given.

Additional Detail:

• Marginal Revenue (MR): In perfect competition, the marginal revenue (MR) is equal to the price (P). Since the firm can sell any quantity at price P1, the MR curve also lies on the same horizontal line.
• Profit Maximization: The firm maximizes profit where Marginal Cost (MC) equals Marginal Revenue (MR). The firm adjusts its output level to ensure that the cost of producing an additional unit is equal to the revenue gained from selling that unit.

In summary, in a perfectly competitive market, an individual firm is a price taker and faces a perfectly elastic demand curve at the market price. This reflects the firm's inability to influence the market price through its output decisions.

4.1.5 Equilibrium Price and Output for a Firm in Perfect Competition

Characteristics of Perfect Competition:

1. Many Buyers and Sellers: No single buyer or seller can influence the market price.
2. Homogeneous Products: Goods offered by different sellers are identical.
3. Free Entry and Exit: Firms can freely enter or exit the market.
4. Perfect Information: All buyers and sellers have complete information about prices and products.

Market Equilibrium:

The market equilibrium occurs where the market supply curve (S) intersects the market demand curve (D).

Diagram:

Here is a typical diagram illustrating market equilibrium in perfect competition:

• Market Supply Curve (S): Shows the total quantity supplied by all firms at each price level.
• Market Demand Curve (D): Shows the total quantity demanded by consumers at each price level.
• Equilibrium Point (E): The point where the supply curve intersects the demand curve. This determines the equilibrium price (P*) and equilibrium quantity (Q*).

Firm in Perfect Competition:

A firm in perfect competition is a price taker, meaning it accepts the market price determined by the intersection of supply and demand.

Firm's Equilibrium:

The individual firm's equilibrium occurs where its marginal cost (MC) equals the market price (P*), which is also its marginal revenue (MR).

Diagram for Individual Firm:

• _P:_The equilibrium market price.
• MR = AR = D: The marginal revenue, average revenue, and demand curve for the individual firm, which is horizontal at the market price P*.
• MC: The marginal cost curve of the firm.
• _Q:_The equilibrium output level for the firm, where MC intersects MR.

Explanation:

• Market Equilibrium (E): At the market level, the equilibrium price (P*) and quantity (Q*) are determined where the market supply and demand curves intersect.
• Firm's Equilibrium: At the firm level, each firm produces the quantity where its marginal cost (MC) equals the market price (P*). The firm's marginal revenue (MR) curve is horizontal at the market price, reflecting that it can sell any quantity at this price.

In summary, the equilibrium price and output in a perfectly competitive market ensure that supply equals demand. Individual firms accept this market price and adjust their output to where their marginal cost equals the market price.

4.1.6 Allocative Efficiency in Perfect Competition

Allocative efficiency occurs when resources are distributed in a way that maximizes consumer and producer surplus. In other words, it is achieved when the goods and services produced are those most desired by society, and they are provided at a price that reflects the marginal cost of production.

Short Run and Long Run in Perfect Competition

Short Run:

• Firms may make supernormal profits or losses.
• Prices can fluctuate due to changes in demand or supply.
• Firms may not be at their most efficient point due to fixed factors of production.

Long Run:

• Firms only make normal profits due to the entry and exit of firms in the market.
• All factors of production are variable, and firms can adjust their scale of operations.
• Firms operate at the lowest point of their average total cost curve, achieving productive efficiency.

Allocative Efficiency in Perfect Competition

In both the short run and the long run, allocative efficiency is achieved in perfect competition because the price (P) equals the marginal cost (MC) of production. This means that the value consumers place on a good (reflected by the price they are willing to pay) is equal to the cost of the resources used to produce it.

Diagram:

Below is a diagram to illustrate allocative efficiency in both the short run and the long run in a perfectly competitive market.

Short Run Allocative Efficiency:

• D = AR = MR = P: The demand curve is perfectly elastic in perfect competition, indicating that firms are price takers.
• MC: The marginal cost curve.
• Qe: The equilibrium quantity where P = MC.
• Allocative Efficiency: Achieved at point Qe where P = MC.

Long Run Allocative Efficiency:

• LRMC: Long-run marginal cost curve.
• LRAC: Long-run average cost curve.
• Qe: The equilibrium quantity where P = LRMC.
• Allocative Efficiency: Achieved at point Qe where P = LRMC, and also where P = LRAC ensuring productive efficiency.

Key Points:

• In the short run, firms can make supernormal profits or losses, but P = MC ensures allocative efficiency.
• In the long run, the entry and exit of firms ensure that only normal profits are made, P = LRMC = LRAC, indicating both allocative and productive efficiency.

Allocative efficiency is achieved in both the short run and the long run in perfect competition because the price mechanism ensures that the quantity of goods produced is socially optimal, reflecting consumers' preferences and the cost of resources.

4.1.7 Productive Efficiency in Long-Run Perfect Competition

Definition: Productive efficiency occurs when goods are produced at the lowest possible cost, meaning that firms are producing at the minimum point of their average cost (AC) curve. In the context of long-run perfect competition, all firms in the industry achieve productive efficiency.

Explanation:

1. Perfect Competition Characteristics:

• Many Firms: Numerous small firms compete against each other.
• Homogeneous Products: Firms sell identical products.
• Free Entry and Exit: Firms can freely enter or exit the market.
• Perfect Information: All buyers and sellers have full information about prices and products.

2. Long-Run Equilibrium:

• In the long run, firms in perfect competition make normal profits (zero economic profit). This is because if firms were making supernormal profits, new firms would enter the market, increasing supply and driving down prices until only normal profits are made. Conversely, if firms were making losses, some would exit the market, reducing supply and driving up prices until normal profits are restored.

3. Productive Efficiency:

• Firms achieve productive efficiency when they produce at the lowest point on their average cost (AC) curve. In the long run, perfect competition drives firms to this point due to the pressure of entry and exit.

Diagram:

Here's a simplified diagram illustrating productive efficiency in the long run under perfect competition:

2. Price Equals Minimum AC: In the long run, firms produce where price (P) equals the minimum average cost (AC), ensuring that they are operating at the lowest possible cost.

Key Points in the Diagram:

1. MC (Marginal Cost) Curve: The upward-sloping marginal cost curve intersects the AC curve at its lowest point.
2. AC (Average Cost) Curve: The U-shaped average cost curve represents the cost per unit of output.
3. Productive Efficiency Point (Q): In the long run, the equilibrium quantity Q* is where the marginal cost (MC) equals average cost (AC) at the minimum point of the AC curve.

Explanation of the Diagram:

• In long-run equilibrium, the market price (P) equals the minimum point of the AC curve.
• At this point, firms produce the quantity Q* where MC = AC.
• This equilibrium ensures that firms are producing at the lowest possible cost, indicating productive efficiency.

In summary, in the long run, firms in a perfectly competitive market achieve productive efficiency by producing at the minimum point of their average cost curve, driven by the competitive pressures of free entry and exit.