Analysis of perfectly competitive markets Lecture 6. Analysis of perfectly competitive markets Figure 6.1 Market structures in the competitive spectrum Economics for Business

This chapter will help you to: Learning outcomes This chapter will help you to: Appreciate the significance and usefulness of the perfect competition model when analysing real-world markets. Understand the difference between price and output outcomes in the short run and long run in perfectly competitive markets. Recognise the role of supernormal profit as an incentive for new firms to enter competitive markets, leading to a reduction in market price, and therefore the dynamics of competitive markets. Distinguish between allocative and productive efficiency and how these interact to ensure economic efficiency in perfectly competitive markets. Understand the meaning of Pareto optimality and why pareto optimal outcomes occur in perfectly competitive markets. Economics for Business

Conditions for perfect competition Homogeneous (identical) products 吠i.e.the presence of perfect substitutes. No firm with a cost advantage 吠i.e.all firms have identical cost curves. A very large number of suppliers 釦thus no single producer by varying its output can perceptibly affect the total market output and hence the market price. Free entry into and exit from the industry 貌ensuring that competition is sustained over time. No transport and distribution costs to distort competition . Suppliers and consumers who are fully informed about profits, prices and the characteristics of products in the market 防hence ignorance or ‘incomplete information’ does not distort competition. Economics for Business

Production in the short run and long run The short run is the time period in which at least one factor input into the production process is fixed in supply - usually this will be capital or land, although in some cases this can apply to certain types of labour (e.g.highly skilled workers). The long run is the time period in which all factors of production become variable in supply. In the long run,progress can be made towards operating at the optimal scale of production. Economics for Business

Short-run equilibrium Figure 6.2 Perfect competition: short-run equilibrium (profits) Economics for Business

Short-run equilibrium To summarise, in the short-run equilibrium under conditions of perfect competition: The firm is a price-taker, not a price-maker. Marginal revenue equals average revenue and equals price; i.e. MR =AR =P . Profits are maximised where short-run marginal cost equates to marginal revenue (and average revenue). Supernormal profits can be earned given by the extent to which price (and thus average revenue) exceeds short-run average total costs at the profit-maximising output. Economics for Business

Figure 6.3 Perfect competition: short-run equilibrium (losses) Economics for Business

Long-run equilibrium Figure 6.4 Perfect competition: long-run equilibrium (profits) Economics for Business

Long-run equilibrium The firm is still a price-taker . Marginal revenue still equals average revenue and price; i.e. MR =AR =P . But profits are now maximised where long-run marginal costs are equal to marginal revenue (and average revenue). Supernormal profits (or losses) earned in the short run disappear due to market entry (or exit) so that firms in perfect competition earn only normal profits in the long run (AR =ATC). Economics for Business

Productive and allocative efficiency in perfectly competitive markets Productive efficiency occurs when a firm minimises the costs of producing any level given existing technology. Technical efficiency - this occurs when inputs of the factors of production are combined in the firm in the best possible way to produce the maximum physical output. Price efficiency - this occurs when inputs into production are optimally employed, given their prices, so as to minimise production costs. Economics for Business

Figure 6.5 Productive efficiency in perfect competition Economics for Business

Allocative efficiency Allocative efficiency denotes the optimal allocation of scarce resources so as to produce the combination of outputs which best accords with consumers 壇demands. In other words,no other allocation of resources would produce a higher level of economic welfare, given the existing consumer demands. Economics for Business

Pareto optimality A pareto optimum is said to exist when resources cannot be reallocated so as to make one person better off without making someone else worse off. There are three main conditions that must hold in order for a pareto optimum to be achieved. 1 Goods must be optimally distributed between consumers so that no reallocation increases economic welfare. 2 Inputs are allocated in such a way that no reallocation would increase the physical output. 3 Optimal amounts of each output are produced so that no change in output would lead to higher economic welfare. In perfectly competitive markets,these three conditions are met in the long run. Economics for Business

To summarise,under perfect competition: In the short run,until the entry or exit of sufficient firms occurs,supernormal profit or losses can exist. In the long run,once the process of market adjustment is complete,only a normal profit is earned. In the long run a Pareto optimal outcome is achieved. Perfect competition drives profit down to a normal level and provides consumers with low-priced products and services. Also, firms in perfectly competitive markets operate at optimal scale in the long run. Economists favour the perfectly competitive model because it achieves economically efficient and, therefore, welfare maximising results. Economics for Business

Key learning points A perfectly competitive market is one in which there is an extremely high degree of competition with a very large number of firms selling identical products or services, with identical cost conditions,with free entry into and exit from the industry and where ignorance does not distort competition (information is complete for all producers and consumers). Each firm in a perfectly competitive market is a price-taker, it faces a perfectly elastic demand curve. Short-run equilibrium in a perfectly competitive market occurs when profits are maximised (or losses are minimised)and this is where the short-run marginal cost equates to price (and average revenue as well as marginal revenue:i.e.P (=AR)=MR=MC). Long-run equilibrium in a perfectly competitive market is attained where production occurs so that firms can earn a normal profit :i.e. P (=AR)=MR =MC =ATC. Also this will be at the output at which the long-run average cost curve is at its minimum. Economics for Business

Key learning points Perfectly competitive markets are therefore associated with both allocative and productive efficiency. Allocative efficiency denotes the optimal allocation of scarce resources so as to produce the combination of outputs which best accords with consumers’ demands. This will be where price equals marginal cost: P =MC. Productive efficiency occurs when a firm minimises the cost of producing any level of output,using existing technology. Productive efficiency is the product of technical efficiency (resulting from combining inputs to achieve the maximum physical output)and price efficiency (achieved by minimisation of production costs given input prices). Perfect competition is associated with pareto optimal outcomes and is a theoretical benchmark against which the economic welfare effects of real-world markets can be judged. Economics for Business