PERFECT COMPETITION: AQA Economics Specification Topic 4.1

Topic 4.1 - Individuals, firms, markets and market failure

Snapshot of the AQA syllabus topic area we’ll be covering in this post.

PERFECT COMPETITION: Perfect competition, imperfectly competitive markets and monopoly

AQA students must understand the following content [taken from the syllabus]

• The formal diagrammatic analysis of the perfectly competitive model in the short and long run.

• The implications of the following for the behaviour of firms and the industry: large numbers of producers, identical products, freedom of entry and exit, and perfect knowledge.

• Firms operating in perfectly competitive markets are price takers.

• The proposition that, given certain assumptions, relating for example to a lack of externalities, perfect competition will result in an efficient allocation of resources.

INFORMATION YOU NEED TO KNOW

[NOTE: supporting diagrams and questions at the end]

Introduction:

For the purpose of evaluating market structures and the efficiency of resource allocation, perfect competition acts as a benchmark. The article investigates the short- and long-term formal diagrammatic analysis of the perfectly competitive model. Additionally, it explores the effects of several producers, identical products, unrestricted entry and exit, and complete insider knowledge of business and industry behaviour. We also explore and encourage students to critically evaluate the claim that perfectly competitive markets lead to an optimal allocation of resources.

1. Formal Diagrammatic Analysis [see diagrams below]:

The perfectly competitive model shows how demand and supply curves interact in the short run, with firms maximising profits or minimising losses based on the equality of marginal cost (MC) and marginal revenue (MR). The state of equilibrium of zero economic profit, where MC equals both MR and the market price, can be reached over time by businesses adjusting inputs, leaving the market, or entering it.

Due to enterprises' capacity to modify their business practises over time, the market results in a perfect marketplace that that differs between the short run and the long run. Let's examine the main distinctions between these two timeframes' market results:

Short Run:

1. Profitability: Some businesses may have short-term supernormal profits while others may suffer losses. This is due to the fact that businesses can enter or exit a market but not change their production capacity.

2. Entry and Exit: Firms are encouraged to enter the market if they are making economic profits. Over time, this expands the market's supply, which eventually causes prices to fall and lowers the current enterprises' profits. In contrast, if businesses are losing money, some may leave the market, which would reduce supply and possibly raise prices.

3. Price Determination: Prices are affected in the short run by the interaction of supply and demand in the market. Individual businesses are price takers and are obligated to accept the market price.

Long Run:

1. Zero Economic Profits: In the long run, firms have the flexibility to adjust their production capacity. New firms can freely enter the market, while existing firms can expand or contract their operations. As a result, the market reaches a long-run equilibrium where firms earn zero economic profits (normal profit).

2. Entry and Exit: In response to supernormal profits, new firms enter the market, increasing supply and driving down prices. Conversely, if firms incur losses, some firms may exit the market, reducing supply and pushing prices upward. This process continues until economic profits converge to zero.

3. Efficiency: Perfect competition in the long run leads to productive efficiency, as firms produce at the minimum average cost (at the point MC=AC). Allocative efficiency is also achieved, as resources are allocated to their most valued uses, given consumer preferences (at the point P=MC).

2. Implications for Firms and the Industry:

a. Large Numbers of Producers: Perfect competition centres on a large number of small businesses, none of which possess significant market power. The limitation on individual enterprises' ability to affect pricing places an emphasis on market forces as the key factor in setting prices.

b. Identical Products: Consumers cannot distinguish between homogeneous goods, which guarantees perfect substitutability and price equality among producers.

c. Freedom of Entry and Exit: Without barriers to entry, businesses can freely enter or leave the market, fostering efficiency and competitiveness by allowing new businesses to enter lucrative sectors and inefficient ones to leave.

d. Perfect Knowledge: Both buyers and sellers are fully informed on costs, methods of production, and market conditions, allowing for well-informed decision-making. There is no asymmetric information. This means if Firm X raises the price above the ‘going rate’, every consumer in the market will be informed about it. The result would be that Firm X makes no sales.

3. Price Takers: Price takers are businesses that operate in totally competitive markets, which implies that they have no power over market prices. Instead, they alter their output to increase profit by manufacturing at the level where marginal cost and market price are equal. If firms were to raise their prices above the marginal cost, it would result in no sales (due to perfect information). If firms were to decrease their prices to below marginal cost, it would make no sense (as firms would eventually make losses). In a competitive market, MC = MR maximises profit for firms, and this is synonymous with normal profits.

4. Efficient Resource Allocation:

Perfect competition is thought to lead to an ideal allocation of resources under some assumptions. Externalities like pollution or spillover effects are not present, which enables the market to operate at allocative efficiency, where resources are allocated to the most valuable uses. Competitive pressures also encourage businesses to produce at the lowest possible average cost, which boosts productivity.

However, if externalities are present, then the market is likely to fail. This is because businesses operate at the point MC=MR. A business would not be taking into account external costs, so in the presence of externalities, a perfectly competitive market will over or underallocate resources.

Perfecly competitive firms experience ‘static efficiency’. This means they are both allocatively and productively efficient.

However, we cannot assume that perfectly competitive markets are dynamically efficient.

Dynamic efficiency occurs when efficiency is improved over time. To be dynamically efficient firms would need to be able to:

1. Conduct R&D (research and development): to improve products or invent new ones

2. Invest: into new technologies, training, capital goods etc. in order to make the production process more efficient and lower costs in the future

We cannot expect perfectly competitive firms to be able to achieve this because they are small price taking firms that make normal profits. Normal profits means they make just enough profit to survive, so there won't be any left over to significantly reinvest into the business.

On the other hand, large firms such as monopolies can experience dynamic efficiency, because they are able to make supernormal profits in the long run. In the dynamic sense, you could argue that a monopoly is more efficient than a perfectly competitive firm.

Conclusion:

Real-world market performance and resource allocation are measured against the standard of perfect competition. This model serves as a benchmark for efficiency analysis due to its attributes of numerous producers, identical products, freedom of entry and exit, and perfect information. However, taking into account the intricacies of the actual world and probable market failures, students should critically evaluate the claim that perfect competition always results in an optimal resource allocation. Students gain insights into market dynamics and the ideal circumstances for attaining optimal resource allocation in a variety of economic scenarios by comprehending the subtleties of perfect competition.

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SUPPORTING DIAGRAMS

perfect competition is an ideal market structure on a sliding scale of potential market structures. It’s not a realistic structure because there are too many assumptions made (such as perfect information). But it’s a useful market structure to make a reference to when analysing a real-world market’s level of economic efficiency

diagram to show the outcome of perfect competition in the short run. The left hand side shows the industry or market demand/supply curves. By comparision, the right hand side shows us the firms revenue/cost curve. The firm is able to make supernormal profis in the short run at the point MC=MR (point A). This is because the market price is higher than the cost per unit (average cost)

diagram to show the outcome of perfect competition in the long run. The left hand side shows the industry or market demand/supply curves. By comparision, the right hand side shows us the firms revenue/cost curve. The firm is not able to make supernormal profis in the long run at the point MC=MR (point B). This is because the market price is the same as the cost per unit (average cost)

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SUPPORTING QUESTION

Question: In perfect competition, how does the level of profit earned by firms differ between the short run and the long run?

Answer:

Businesses in perfect competition may experience short-term economic profits or losses. This is due to the fact that they are unable to change their production capacity and are dependent on the current market pricing. Due to factors like cheap costs or high demand, some businesses may make supernormal profits, while others may face losses if their costs are higher than their revenues.

On the other hand, businesses under perfect competition generate normal profits in the long run. This happens as new businesses enter the market in response to abnormal profits being made, expanding the market's supply and lowering prices until the point where price and cost per unit meet. Similar to this, if businesses in the market are losing money, some may leave the market, lowering supply and driving up prices. This cycle repeats itself until losses also reach zero.

As a result, businesses only make normal profits in the long run under perfect competition, paying all expenses, including the opportunity cost of capital. Economic profits do not exist over the long term, which indicates that resources are allocated efficiently, enterprises are producing at the lowest possible average cost, and prices accurately reflect the costs of production.

[NOTE: it is also advisable that you draw a diagram or two in the real exam to support this question. Check above for options]