Quick Quiz On 2 separate diagrams For a firm facing a downward sloping demand curve: Illustrate normal profit Illustrate abnormal profit

Market Structures

Perfect Competition Oligopoly Monopoly Monopolistic Competition The theory of the firm examines how prices and output vary under these different market structures

Perfect Competition is based upon a number of assumptions Many buyers and many sellers Firms are ‘price takers’ (perfectly elastic D curve) No barriers to entry or exit Homogeneous products Perfect information Perfect factor mobility If these conditions exist, the market system can produce an optimal allocation of scarce resources

What markets have features of perfect competition?

When perfect competition exists, resources are allocated through price signals Fierce competition ensures that costs are minimised and that resources are used sparingly (firms will produce at their lowest average total cost hence will be productively efficient) Inefficient firms will be driven out of the market; only those with the lowest costs will survive Prices will be pushed downwards It ensures that consumer sovereignty prevails – firms become price takers Normal profit is made in the long- run (normal profit is the minimum level of profit required to keep the factors of production in their current use in the long run) Note: Despite the lack of real- world examples, the model plays a very important part in economic analysis and policy. Many economists would argue that achieving perfect competition (or moving towards it) would bring a number of advantages and is therefore used as a standard to judge the shortcomings of real world industries and can help form policies towards industries.

Possible short-run profit and loss situations in perfect competition

Recall... The output level for a firm with a perfectly inelastic demand curve using MC and D=AR=MR

£ Output MC D= AR= MR P q Remember MC=MR determines quantity AC determines cost per unit and AR is the price per unit s/r abnormal profits in perfect competition AC C

£ Quantity MC D= AR= MR P q Remember MC=MR determines quantity AC determines cost per unit and AR is the price per unit s/r loss in perfect competition AC C

The movement from short- run to long- run in perfect competition If firms are making either short- run abnormal profits or short- run losses, other firms react and the situation starts to change until an equilibrium point is reached in the long run

If abnormal profits are being made in the short- run... New firms enter the market (due to assumptions) attracted by the abnormal profit Industry supply curve shifts to the right so the market price falls As firms are price takers, their D curves shift downwards until any abnormal profit has been ‘competed away’

£ Quantity MC D= AR= MR P q AC C D1= AR1= MR1 P1= C1 S S1 P P1 q1 £ Quantity D Short- run abnormal profits to long- run normal profits

If subnormal profits are being made in the short- run… When AC>AR Can occur if demand falls or costs rise Some firms will leave the industry, some will remain Recall the shut down price… Those who are receiving a price equal to or above their AVC will remain open, those who are not will shut down Note: It is usually assumed that firms have identical cost curves, however this is not very realistic…

Marginal Firms Those with the highest costs The firms who are first to leave an industry when subnormal profit is being made and the last to enter when supernormal profits are made

Activity Illustrate the movement from short- run loss to long run normal profits in perfect competition

£ Quantity MC D= AR= MR P=C1 q1 AC C D1= AR1= MR1 P S1 S P1 P q £ Quantity D Short- Run loss to long- run normal profits

£ Quantity MC AC D= AR= MR P S P q £ Quantity D Long- run equilibrium in perfect competition

In theory, perfect competition produces a long- run equilibrium where all firms earn only normal profits and produce at minimum cost

Productive Efficiency in Perfect Competition A firm is productively efficient if it produces at it lowest possible average cost (the lowest point on its lowest possible AC curve) As MC always cuts AC at its lowest we can say that where MC=AC is the productively efficient output level

Allocative Efficiency in Perfect Competition Socially optimum level of output When there is no excess supply or demand What is demanded is being produced Note. Does not necessarily mean that there is a ‘fair’/ equal distribution of income.

Allocative Efficiency occurs where MC= AR i.e. The cost of producing an extra unit is equal to the value placed on a unit P reflects the value consumers place on a good shown by D (AR) curve. MC reflects the cost to society of all the resources used in producing an extra unit of the good, incl. the normal profit. Recall: Assumption of perfect information

The Firm’s Supply Curve under PC Firms are profit maximisers so output is set where MC=MR As MR=AR (i.e. Price) in PC, the individual firm will adjust their output so that P=MC s/r MC curve above AVC curve l/r MC curve above AC curve

£ Quantity MC AR= MR P3 AC AVC AR1= MR1 AR2= MR2 AR3= MR3 P1 P2 P Q3Q2Q1Q LR S Curve= MC above AC SR S Curve= MC above AVC

When there is perfect competition… Fierce competition ensures that costs are minimised and that resources are used sparingly Inefficient firms will be driven out of the market; only those with the lowest costs will survive Prices will be pushed downwards It ensures that consumer sovereignty prevails – firms become price takers

Activities on Perfect Competition WS7 Data Response