Perfect Competition (AQA A Level Economics)

Characteristics of Perfect Competition

• The characteristics of perfect competition are as follows

1. There are many buyers and sellers: due to the number of market participants sellers are price takers

2. There are no barriers to entry and exit from the industry: firms can start-up or leave the industry with relative ease which increases the level of competition

3. Buyers & sellers possess perfect knowledge of prices: this assumption presupposes perfect information e.g if one seller lowers their price then all buyers will know about it

4. The products are homogenous: this means firms are unable to build brand loyalty as perfect substitutes exist and any price changes will result in losing customers

Perfectly Competitive Firms are Price Takers

• Firms in perfect competition have low market power, low market share and a low industry concentration ratio

• There is little market failure in perfectly competitive industries

  • This is why governments try to encourage more competition in every sector in their economy 

 Diagram: Individual Firm and Market in Perfect Competition

An individual firm in perfect competition has to accept the market/industry price (P₁)

Diagram analysis

• In order to maximise profit, firms in perfect competition produce up to the level of output where marginal cost = marginal revenue (MC=MR)
  

• The firm does not have any market power so it is unable to influence the price and quantity

  • The firm is a price taker due to the large number of sellers

  • The firm's selling price is the same as the market price, P₁ = MR = AR = Demand

Perfect Competition in the Short-run

• Firms in perfect competition are able to make abnormal profit in the short-run

  • A seller may gain a competitive advantage for a short period of time, which allows them to make abnormal profit

Diagram: A Firm in Perfect Competition Making Abnormal Profit

This firm is making abnormal profit in the short-run as the AR > AC at the profit maximisation level of output (Q₁)

Diagram analysis

• The marginal cost curve (MC) is the supply curve of the firm

• The firms is producing at the profit maximisation level of output, where MC=MR (Q₁)

  • At this point, AR (P₁) > AC (C₁)

  • The firm is making abnormal profit

Abnormal Profit is Eliminated in the Long-run

• If firms in perfect competition make abnormal profit in the short-run, new firms are attracted to the industry

  • They are incentivised by the opportunity to make abnormal profit

  • There are no barriers to entry

    • It is easy to join the industry

Diagram: Abnormal Profits are Eliminated in Long-run

New entrants shift the industry supply curve to the right (S₁→S₂ ) which changes the industry price from P₁→P_2. The firm can now only sell its products at P₂ 

Diagram analysis

• The firm is initially producing at the profit maximisation level of output, where MC=MR (Q₁)

  • At this level of output, AR (P₁) > AC (P₂) and the firm is making abnormal profit

• Incentivised by profit, new firms join the industry and supply increases from S₁→S₂

  • Overall quantity in the industry increases from Q₁→Q₂

  • The industry price falls from P₁→P₂

• The firm hast to now sell its products at the industry price of P₂

  • The output of the firm falls from Q₁→Q₂ as it now has a smaller market share of the larger industry

• At the profit maximisation level of output (MC=MR) the firm is now producing at the point where AR= AC

  • The firm is making normal profit

• In the long-run, firms in perfect competition always make normal profit

  • Firms making a loss leave the industry

  • Firms making abnormal profit see them slowly eradicated as new firms join the industry

Short-run Losses in Perfect Competition

• Firms in perfect competition are able to make losses in the short-run

  • Periods of intense competition can cause prices to fall below the average costs

  • New firms may enter the industry. This results in the market share being divided up between more competitors and some individual firms may start making a loss

Diagram: A Loss Making Perfectly Competitive Firm

This firm is making losses in the short-run as the AR < AC at the profit maximisation level of output (Q₁)

Diagram analysis

• The firms are producing at the profit maximisation level of output, where MC=MR (Q₁)

  • At this level of output, the AR (P₁) < AC (C₁)

  • The firm's loss is equivalent to

Losses are Eliminated in the Long-run

• If firms in perfect competition make losses in the short-run, some will shut down

  • The shut down rule will determine which firms shut down

  • There are no barriers to exit, so it is easy to leave the industry

Diagram: Losses are Eliminated in Long-run

 Firms leaving the industry shift the industry supply curve to the left (S₁→S₂ ) which changes the industry price from P₁→P_2. Remaining firms can now sell products at P₂ which returns it to a position of normal profit

Diagram analysis

• The firm is initially producing at the profit maximisation level of output, where MC=MR (Q₁)

  • At this level of output, the AR (P₁) < AC (C₁) and the firm is making a loss

• Some firms leave the industry, and supply decreases from S₁→S₂

  • Overall quantity in the industry falls from Q₁→Q₂

  • The industry price increases from P₁→P₂

• The firm now has to sell its products at the industry price of P₂

  • The output of the firm increases from Q₁→Q₂ as it now has a larger market share of the smaller industry

• At the profit maximisation level of output (MC=MR) the firm is now producing at the point where AR= AC

  • The firm is making normal profit

• In the long-run, firms in perfect competition always make normal profit

  • Firms making a loss leave the industry

  • Firms making supernormal profit see them slowly eradicated as new firms join the industry

Efficiency in Perfect Competition

• Allocative efficiency occurs at the level of output where average revenue = marginal cost (AR = MC)

  • At this point, resources are allocated in such a way that consumers & producers get the maximum possible benefit

  • No one can be made better off without making someone else worse off

  • There is no excess demand or supply

• Productive efficiency occurs at the level of output where marginal cost = average cost (MC=AC)

  • At this point average costs are minimised

  • There is no wastage of scarce resources & a high level of factor productivity

Diagram: Efficiency in Perfect Competition

A perfectly competitive market benefits from both productive and allocative efficiency in the long-run   

Diagram Analysis

• The firm produces at the profit maximisation level of output where MC=MR (Y)

• The firm is productively efficient as MC=AC at this level of output

• The firm is allocatively efficient as AR (P)=MC

Critical Analysis of Perfect Competition

• Perfect competition is a theoretical market structure

  • It does provide a useful benchmark for evaluating efficiency for real-world market structures, e.g. monopolies and oligopolies

• Perfectly competitive markets has an efficient allocation of resources where resources are allocated to their most valued uses

  • In reality, most firms do not allocate resources in the most optimal way in a free market

  • Firms may not aim to be allocatively and productively efficient. They may focus on short-term gains instead

Example: Water privatisation

• Following the privatisation of the water industry in the UK in 1989, huge inefficiencies arose

• Under private ownership, the main objective of these water companies was to earn short-term profits

  • Dividends increased for shareholders of water companies

• This led to significant underinvestment in infrastructure and maintenance of water supply systems 

  • This led to productive inefficiency, as deferred maintenance led to the deterioration of infrastructure over time. This caused inefficiencies such as leaks, bursts, and service disruptions

  • It also led to allocative inefficiency as the best interest for consumers and society's welfare declined with fall in water quality and service

• The end result of many privatisations (water, electricity, gas, and rail) suggests that free markets do not always achieve efficient resource allocation

  • This almost always means that privatised firms need to be regulated to ensure efficiency is closer to the standard held by perfect competition

• It could be strongly argued that higher efficiencies would be achieved under government ownership