Perfectly Competitive Market | Model Answer
A-level Economics
Explain what is meant by a ‘perfectly competitive market’ (Extract D, line 29) and, using a diagram to help you, analyse how a fall in demand across the retail industry can be expected to affect the sales and profits of an individual retail firm operating in a perfectly competitive market. (10 marks)
Here is a question and answer from the markets and market failure section of the A-level Economics syllabus.
This question is an ‘explain’ and ‘analyse’ question.
need more help?
Book a trial lesson and boost your grades
Explain what is meant by a ‘perfectly competitive market’ (Extract D, line 29) and, using a diagram to help you, analyse how a fall in demand across the retail industry can be expected to affect the sales and profits of an individual retail firm operating in a perfectly competitive market. (10 marks)
Essay Plan
DEFINITIONS
A perfectly competitive market is the far end on the competitive spectrum where a number of assumptions are made. These assumptions are; perfect information, low barriers to entry and exit, many suppliers and many consumers, homogeneous products, price taking behaviour and profit maximising strategy.
The result of these assumptions can be illustrated in the following diagram.
In the diagram AR=D=MR is perfectly elastic, the reason for this is because consumers have perfect information and the market is highly saturated with other competition. This means there is only one price in the market and a competing firm must accept this price in order to survive. Selling at a higher price would mean all demand is diverted to other firms selling at lower prices. The resulting price and quantity is p and q, the firms are also assumed to be profit maximisers, we know this because the condition MR=MC is satisfied in the diagram. This is logical because any other price would result in no customers.
However if there were a decrease in demand in the market the price and quantity would have to change. This is shown as follows.
A decrease in demand would shift the AR=D=MR curve downwards which is illustrated on the diagram above. The market price would therefore decrease, this is because consumers are now willing to pay less for the same good or service. As a result the profit maximising firm would still accept the market price. To profit maximise, the quantity produced by the firm mist now decrease to q1.
Total profit would also decrease as before in the diagram was able to make supernormal profits where as now you can see the firm only makes normal profits. If the industry is to survive, demand can fall no lower, this because the price would be lower than the cost per unit shown on the AC curve.
Furthermore for a greater chance of survival, the retail industry must try to establish lower cost per unit shifting the AC curve downwards. To do this, profits can be reinvested into cost saving methods of production and X-inefficiencies can also be targeted.
Extract D: Trouble on the High Street
The retail industry in the UK receives two thirds of its annual total revenue during the three months leading up to Christmas. Economists therefore pay close attention to Christmas spending as an indicator of the health of the retail sector. In the wake of the credit crunch and the spread of recession in 2008, the UK Government acted in order to try to lift consumer spending by measures such as encouraging interest rates to fall and reducing the rate of VAT. The fall in the value of the pound against the euro hit some British retailers particularly hard, and assisted the process of sorting the retail trade into losers and winners. Among the losers were Woolworths (household goods), Adams (children’s clothing), Zavvi (music and fi lms) and MFI (furniture), all of which went completely or partly out of business. In February 2009, the Confederation of British Industry (CBI) reported that job losses on the High Street, in the previous November and December, were the worst since they started tracking these labour market statistics in 1983. Among the winners were the medium-sized European low-cost supermarket operators such as Lidl and Aldi. They sell a narrower range of products than the large UK companies, with less expensively advertised brands. They also operate on lower profit margins, at one to two per cent of turnover (total revenue) compared with the five to six per cent which large UK supermarkets expect. Such factors enable them to offer low prices in a very competitive market. It can be argued that, in practice, the actual behaviour or conduct of firms in a market might be very competitive and their performance efficient, even if the market structure is basically that of a monopoly or an oligopoly.
In December 2008, analysts reported that, unlike the situation in EU countries such as the UK, Germany and Spain, the retail sector in France had not suffered as quickly from the effects of recession. One reason for this is that as well as being fond of massive supermarkets, French consumers also strongly support a huge number of local markets. These provide outlets for items such as fresh meat and fruit and vegetables from a large number of small firms, which is one of the assumptions in the economist’s model of a perfectly competitive market. There are also producers and consumers who are very knowledgeable about the nature and quality of the products being bought and sold, and who are sensitive to prices. However, even in France there were signs of a slow-down in retailing affecting both small and large firms as Christmas approached.
It is significant that some large UK retailers such as Tesco and Marks and Spencer have a presence on the Continent. The Single European Market (SEM) enables retailers to make full use of economies of scale in such fields as purchasing and marketing. It also reduces many costs, such as those created by differing national standards and regulations. The founders of the SEM were mainly focused on manufacturing, but the free movement of goods, services, capital and labour is also important to retailing. The Single European Market creates clear opportunities for the further expansion of large retailers. Although they might be less obvious, there are also some possible advantages of the SEM for smaller retailers, such as those supplying specialist markets or making use of on-line selling. In 2009, it became clear that the British giant Tesco was one of the winners of the retail industry. This company has been accused of having a monopoly in many British towns. In April, it announced record profits for the previous twelve months.
(Source: news reports: 2008/9)
Want the full model answer?
10 Past Papers with Model Answers on Market Failure
Written by an experienced Economics tutor
Full model answers with diagrams
Suitable for all UK Economics exam boards
Physical booklet
£20.00
All orders will be delivered within 1-2 weeks.