Perfect competition

Question 1

What are the conditions for perfect competition

Answer 1

1. Many buyers and sellers
2. Firms are selling homogenous goods so they are price takers
3. No barriers to entry or exit
4. Perfect information so consumers know about prices and quality and producers know about prices, technology and costs
5. Firms are profit maximisers (MC=MR)

Question 2

What is the long run equilibrium for a firm in perfect competition

Answer 2

Normal profit, any other type of profit is a short run equilibrium

Question 3

How can we draw the diagram for the whole market in perfect competition

Answer 3

• Price against quantity graph
• Draw supply and demand and mark the equilibrium price P1
• This is where the firm gets the price from as they are price takers so draw a dotted line across to the firm diagram

Question 4

How can we draw the diagram for the specific firm in perfect competition

Answer 4

• (Price/costs/revenue) against (quantity) graph
• At P1 (the market price) draw a horizonal line which is AR = MR = D1
• Draw a smiley face AC curve (due to law of diminishing returns)
• Draw the MC curve which cuts AC at the minimum point

Question 5

How can you show short run supernormal profits on a perfect competition diagram

Answer 5

• Draw AC to be below AR
• Firm is profit maximiser so produces where MC = MR at quantity Q2
• Vertical distance between AR and AC at Q2 is the unit supernormal profit
• x by Q2 to get area of total supernormal profit

Question 6

Explain the process by which short run supernormal profits are eroded

Answer 6

• Firms will see the supernormal profit and want to enter the market due to the profit incentive
• It is easy for new firms to enter the market as there are no barriers to entry and there is perfect information of market conditions
• Supply in market will continually rise causing price to fall until the difference between AR (price) and AC is 0 i.e. normal profit at which point firms have no incentive to enter the market anymore

Question 7

What is the easiest way to show the erosion of supernormal profits in the long run on a diagram

Answer 7

• Start by drawing the long run price P2 ( line showing AR2 = MR2 = D2) on the diagram of the firm
• This is at the minimum point of the AC curve as the difference between AR and AC needs to be 0 at MC=MR and MC cuts AC at the minimum point i.e. price is falling
• Draw a dotted line back across to market diagram to mark on P2 as this price came from the market
• Draw the shifted out supply curve accordingly so it now cuts demand at price P2 and quantity Q3
• Draw Q4 on the firm diagram to mark the new MC = MR which occurs at the minimum point of the AC curve where AR=AC so the firm makes normal profits

Question 8

How can you show short run subnormal profits on a perfect competition diagram

Answer 8

• Draw AC to be above AR
• Firm is profit maximiser so produces where MC = MR at quantity Q2
• Vertical distance between AC and AR at Q2 is the unit subnormal profit i.e. unit loss
• x by Q2 to get area of total subnormal profit i.e. total loss

Question 9

Explain the process by which short run subnormal profits are eroded

Answer 9

• Firms will see the subnormal profit and want to leave the market and produce their opportunity cost instead where they can make profits
• It is easy for firms to leave the market as there are no barriers to exit
• Supply in market will continually fall causing price to rise until the difference between AC and AR (price) is 0 i.e. normal profit at which point firms have no incentive to leave the market anymore

Question 10

What is the easiest way to show the erosion of subnormal profits in the long run on a diagram

Answer 10

• Start by drawing the long run price P2 ( line showing AR2 = MR2 = D2) on the diagram of the firm
• This is at the minimum point of the AC curve as the difference between AR and AC needs to be 0 at MC=MR and MC cuts AC at the minimum point i.e. price is rising
• Draw a dotted line back across to market diagram to mark on P2 as this price came from the market
• Draw the shifted in supply curve accordingly so it now cuts demand at price P2 and quantity Q3
• Draw Q4 on the firm diagram to mark the new MC = MR which occurs at the minimum point of the AC curve where AR=AC so the firm makes normal profits

Question 11

How efficient is a firm in perfect competition in the long run

Answer 11

Static efficiency:
- Allocatively efficient as P = MC
- Productively efficient as min point of AC curve
- X efficient as producing on the AC curve
Dynamic efficiency:
- Not dynamically efficient as no LR supernormal profits

Question 12

What determines whether a firm in perfect competition will leave the market or stay if subnormal profits are being made

Answer 12

Leave and produce opportunity cost if they are unable to cover their average variable costs

Question 13

Why is the shutdown condition based on whether the firm can meet its variable costs

Answer 13

• If firm shuts down, TR = 0 and TVC = 0 but still has to pay fixed costs so loss = TFC
• If firm continues, their loss = TFC + TVC - TR

They should shutdown if TFC<TFC+TVC-TR as they can minimise the lost, so if TR<TVC

They should continue if TFC>TR-TFC-TVC so if TR>TVC

If TR=TVC, it doesn’t matter but they may continue to satisfy loyal customers and workers

Question 14

What does a firm who continues in the loss making market aim for

Answer 14

• That other firms who can’t meet their variable costs will leave, causing long run equilibrium of normal profit or maybe even supernormal profits in the short run
• However, if losses keep persisting, they will have to leave eventually so not shutting down is only for a short while

Question 15

What is the expression for the shutdown condition

Answer 15

Consider shutting down if AR = AVC

Question 16

How can you show a firm that is making subnormal profit but shouldn’t shutdown on a diagram

Answer 16

• Draw AR = MR = D
• Draw AVC so that min point is below AR
• Draw AC above AR (loss)
  AC should be slightly above AVC and tending towards AVC (as AFC tends towards 0)
• draw mc which passes through min point of both avc and ac
• Draw area of subnormal profit
• Explain how AR > AVC so don’t shutdown yet

Question 17

How can you show a firm that is making subnormal profit but should shutdown on a diagram

Answer 17

• Draw AR = MR = D
• Draw AVC above AR
• Draw AC above AR (loss)
  AC should be slightly above AVC and tending towards AVC (as AFC tends towards 0)
• Draw area of subnormal profit
• Explain how AR < AVC so shutdown