Theme 3 Topic 4.2

Question 1

What is perfect competition

Answer 1

A market structure in which individual firms have no market power due to the amount of competition & are unable to influence the price

Question 2

Characteristics of perfect competition

Answer 2

1. There are many buyers and sellers: due to the number of market participants, sellers are price takers
2. There are no barriers to entry and exit from the industry: firms can start-up or leave the industry with relative ease, which increases the level of competition
3. Buyers and sellers possess perfect knowledge of prices: this assumption presupposes perfect information, e.g if one seller lowers their price, then all buyers will know about it
4. The products are homogenous: this means firms are unable to build brand loyalty as perfect substitutes exist and any price changes will result in losing all customers. Demand is therefore perfectly price elastic

Question 3

SR vs LR profit max

Answer 3

In order to maximise profit, firms in perfect competition produce up to the level of output where marginal cost = marginal revenue (MC=MR)
The firm does not have any market power so it is unable to influence the price and quantity
The firm is a price taker due to the large number of sellers
The firm’s selling price is the same as the market price, P1 = MR = AR = Demand

In the short-run, firms can make supernormal profit or losses in perfect competition
However, they will always return to the long-run equilibrium where they make normal profit

Question 4

Short run profit max

Answer 4

Firms in perfect competition are able to make supernormal profit in the short-run
The MC curve is the supply curve of the firm

The firms is producing at the profit maximisation level of output where MC=MR (Q1)
At this point the AR (P1) > AC (C1)
The firm is making supernormal profit = (P - C) x Q

Question 5

Short run losses

Answer 5

Firms in perfect competition are able to make losses in the short-run

The firms are producing at the profit maximisation level of output where MC=MR (Q1)
At this level of output, the AR (P1) < AC (C1)
The firm’s loss is equivalent to (P - C) X Q

Question 6

Moving SR profits to LR equilibrium

Answer 6

If firms in perfect competition make supernormal profit in the short-run, new entrants are attracted to the industry
They are incentivised by the opportunity to make supernormal profit
There are no barriers to entry
It is easy to join the industry

Question 7

Moving SR profits to LR equilibrium diagram analysis

Answer 7

The firm produces where MC = MR (profit maximisation).
At this output, AR > AC, so the firm earns supernormal profit.

Supernormal profit attracts new firms (no barriers to entry).
Industry supply increases (S₁ → S₂).
Market price falls (P₁ → P₂).
The firm must now sell at the lower industry price.
Its demand curve shifts down, reducing its output and market share.

The firm again sets MC = MR, but now AR = AC.
Supernormal profit is eliminated → firms earn normal profit.
If firms make losses, they exit, restoring normal profit.

Question 8

Moving from short-run losses to long-run equilibrium

Answer 8

If firms in perfect competition make losses in the short-run, some will shut down
The shut down rule will determine which firms shut down
There are no barriers to exit, so it is easy to leave the industry

Question 9

Moving from short-run losses to long-run equilibrium diagram analysis

Answer 9

The firm produces where MC = MR (profit maximisation).
At this output, AR < AC, so the firm makes a loss.

Losses force firms to leave the industry.
Industry supply decreases (S₁ → S₂).
Market price rises (P₁ → P₂).
The firm sells at the higher industry price.
Its demand curve shifts up, increasing its output and market share.

The firm again produces where MC = MR, but now AR = AC.
Losses are eliminated → firms earn normal profit.
If supernormal profit appears, new firms enter, pushing profit back to normal.