1.5.2: Perfect Competition (HL only)

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    Definitions

     

    1. Productive efficiency exists when goods are produced at the lowest possible cost per unit of output. This is achieved at the point where average total cost is at its lowest value, this is where MC = AC.
    2. Allocative efficiency occurs where suppliers are producing at optimal mix of goods and services required by consumers. In this scenario, the firms sells the last unit of output it produces at the amount it costs to make it. It is the level of output where MC = AR.
    3. Perfect competition is a market structure where there are very large number of small firms, producing identical products. There are no barriers to entry or exit and all firms have perfect knowledge of the market.

     

    Assumptions of the model

    • Made up of very large number of firms.
    • Each firm is small, so they can’t affect the supply curve of the industry and the price of the product. Therefore, firms are ‘price-takers’.
    • Produce identical products.
    • No barriers to entry or exit.
    • All producers and consumers have perfect knowledge about the market.
    • Always results in normal profits in the long run.

     

    Profit maximization

    • Happens where MC = MR.
    • Also represents long-run equilibrium in perfect competition.
    • Firms are productive and allocative efficient at this point.

    Movement from short run to long run in perfect competition

     

    1. Short run abnormal profits to long run normal profits

    • When there is perfect knowledge and no barriers to entry, firms outside the industry that could produce the product will enter the industry because they’re attracted to abnormal profits.
    • As more and more firms come to the market, the supply curve shifts to the right, which results in a fall in price.

    This causes the demand to shift downwards, which causes the abnormal profits to be be gone.

     

    2. Short run losses to long run normal profits

    • When firms start to leave the industry, unable to achieve normal profit, the industry supply curve shifts to the left.
    • This causes the price to increase and demand curves shifts upwards.
    • This leads to the loss made my firm getting smaller as there’s less firms in the market.

    Productive efficiency and Allocative efficiency

    • Productive efficiency is where MC = AC.
    • Allocative efficiency is where MC = AR.