3.4.2 Perfect competition

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    a) Characteristics of perfect competition:
    • Many buyers and sellers • Sellers are price takers • Free entry to and exit from the market • Perfect knowledge • Homogeneous goods • Firms are short run profit maximisers • Factors of production are perfectly mobile
    In this market, price is determined by the interaction of demand and supply
    In a competitive market, profits are likely to be lower than a market with only a few large firms
    This is because each firm in a competitive market has a very small market share.
    So their market power is very small.
    If the firms make a profit, new firms will enter the market, due to low barriers to entry, because the market seems profitable.
    New firms will increase supply in the market, which lowers the average price.
    This means that the existing firms’ profits will be competed away.
    Advantages and disadvantages of a perfectly competitive market:

    How useful is perfect competition?
    Assumptions aren’t meant to reflect real world markets where most assumptions aren’t satisfied
    Pure competition is largely devoid of what most people would call real competition behaviour by businesses
    The model provides a theoretical benchmark against which we compare and contrast imperfectly competitive markets
    Price Taking firm
    Competitive firms have little direct influence on the ruling market price
    In contrast, a monopoly business can make pricing decisions
    When most firms in a market are price takers, there is only a small % difference in the price of the selected products in a market
    Examples:
    Local farmers selling their produce to large supermarkets
    RJB mining selling coal to the electricity generator
    British steel selling as much as it can at the ruling international price of steel
    Example Question
    Discuss whether the internet makes markets more perfectly competitive?

    b) Profit maximising equilibrium in the short run and long run
    c) Diagrammatic analysis
    In the short run, firms can make supernormal profits
    In the long run where profits are competed away, only normal profits are made

    This causes supply in the market to increase, as shown by the shift in the supply curve from S to S1. The price level in the market falls as a consequence. Since firms are price takers, they must accept this new, lower price.
    In the long run, competitive pressure ensures equilibrium is established. The supernormal profits have been competed away, so firms only make normal profits in the long run (MC = MR)
    The new equilibrium at P=MC means firms produce at the new output of Q2 in the long run

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