Market Power & Perfect Competition (DP IB Economics)

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Steve Vorster

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
     

ibdp-economics---levels-of-competition-and-concentration-in-different-structures

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

3-4-2-individual-firm-_-market_edexcel-al-economics

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
     

3-4-2-short-run-profit-maximisation_edexcel-al-economics

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 equals space left parenthesis straight P subscript 1 space minus space straight C subscript 1 right parenthesis space cross times space straight Q subscript 1

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

3-4-2-moving-from-profit-to-lr-equilibrium_edexcel-al-economics

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
     

3-4-2-short-run-losses_edexcel-al-economics

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 space left parenthesis straight P subscript 1 space minus space straight C subscript 1 right parenthesis space cross times space straight Q subscript 1

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
       

3-4-2-moving-from-losses-to-lr-equilibrium_edexcel-al-economics

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
       

2-11-1-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

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Steve Vorster

Author: Steve Vorster

Expertise: Economics & Business Subject Lead

Steve has taught A Level, GCSE, IGCSE Business and Economics - as well as IBDP Economics and Business Management. He is an IBDP Examiner and IGCSE textbook author. His students regularly achieve 90-100% in their final exams. Steve has been the Assistant Head of Sixth Form for a school in Devon, and Head of Economics at the world's largest International school in Singapore. He loves to create resources which speed up student learning and are easily accessible by all.

Jenna Quinn

Author: Jenna Quinn

Expertise: Head of New Subjects

Jenna studied at Cardiff University before training to become a science teacher at the University of Bath specialising in Biology (although she loves teaching all three sciences at GCSE level!). Teaching is her passion, and with 10 years experience teaching across a wide range of specifications – from GCSE and A Level Biology in the UK to IGCSE and IB Biology internationally – she knows what is required to pass those Biology exams.