Market Power & Perfect Competition (DP IB Economics)
Revision Note
Written by: Steve Vorster
Reviewed by: Jenna Quinn
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→P2. 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
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