Market Power & Perfect Competition (DP IB Economics)

Market Power in Perfect Competition

• Market power refers to the ability of a firm to influence and control the conditions in a specific market, allowing them to have a significant impact on price, output, and other market variables
   

The level of market power is low in perfect competition
  

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

• There is little market failure in perfectively competitive industries

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

Diagrammatic Representation of Perfect Competition

• 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 & 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

A diagram that illustrates how an individual firm in perfect competition has to accept the market/industry price (P₁)

• In the short-run, firms can make abnormal profit or losses in perfect competition

• However, they will always return to the long-run equilibrium where they make normal profit

Abnormal Profit in Perfect Competition in the Short-run

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

• The MC curve is the supply curve of the firm
   

A diagram illustrating a perfectly competitive firm making abnormal profit in the short-run as the AR > AC at the profit maximisation level of output (Q₁)

Diagram Analysis

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

  • At this point the AR (P₁) > AC (C₁)

  • The firm is making abnormal profit

Moving from Abnormal Profit in the Short-run to Normal Profit in the Long-run

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

  • They are incentivised by the opportunity to make supernormal profit

  • There are no barriers to entry

    • It is easy to join the industry
      

A diagram illustrating how new entrants shift the industry supply curve to the right (S₁→S₂ ) which changes the industry price from P₁→P₂. The firm can now only sell its products at P₂ and abnormal profits are eliminated

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 (P₂) & the firm is making abnormal profit
    

• Incentivised by profit, new entrants join the industry & supply increases from S₁→S₂

  • Overall quantity in the industry increases from Q₁→Q₂

  • The industry price falls from P₁→P₂
    

• The firm now has to 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

Losses in Perfect Competition in the Short-run

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

A diagram illustrating a perfectly competitive firm 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

Moving from Loss in the Short-run to Normal Profit 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
     

A diagram illustrating how firms leaving the industry shift the industry supply curve to the left (S₁→S₂ ) which changes the industry price from P₁→P_2. The firm can now sell its 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) & the firm is making a loss
    

• Some firms leave the industry & 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
     

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