Lecture 6.
Analysis of perfectly competitive
markets
Figure 6.1 Market structures in the competitive spectrum
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Learning outcomes
This chapter will help you to:
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Appreciate the significance and usefulness of the perfect
competition model when analysing real-world markets.
Understand the difference between price and output outcomes in
the short run and long run in perfectly competitive markets.
Recognise the role of supernormal profit as an incentive for new
firms to enter competitive markets, leading to a reduction in market
price, and therefore the dynamics of competitive markets.
Distinguish between allocative and productive efficiency and how
these interact to ensure economic efficiency in perfectly
competitive markets.
Understand the meaning of Pareto optimality and why pareto
optimal outcomes occur in perfectly competitive markets.
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Conditions for perfect competition
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Homogeneous (identical) products 吠i.e.the presence of
perfect substitutes.
No firm with a cost advantage 吠i.e.all firms have identical
cost curves.
A very large number of suppliers 釦thus no single
producer by varying its output can perceptibly affect the total
market output and hence the market price.
Free entry into and exit from the industry 貌ensuring that
competition is sustained over time.
No transport and distribution costs to distort
competition .
Suppliers and consumers who are fully informed about
profits, prices and the characteristics of products in the
market 防hence ignorance or ‘incomplete information’ does
not distort competition.
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Production in the short run and long run
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The short run is the time period in which at least one
factor input into the production process is fixed in
supply - usually this will be capital or land, although
in some cases this can apply to certain types of
labour (e.g.highly skilled workers).
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The long run is the time period in which all factors of
production become variable in supply. In the long
run,progress can be made towards operating at the
optimal scale of production.
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Short-run equilibrium
Figure 6.2 Perfect competition: short-run equilibrium (profits)
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Short-run equilibrium
To summarise, in the short-run equilibrium under
conditions of perfect competition:
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The firm is a price-taker, not a price-maker.
Marginal revenue equals average revenue and
equals price; i.e. MR =AR =P .
Profits are maximised where short-run marginal
cost equates to marginal revenue (and average
revenue).
Supernormal profits can be earned given by the
extent to which price (and thus average
revenue) exceeds short-run average total costs
at the profit-maximising output.
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Figure 6.3 Perfect competition: short-run equilibrium (losses)
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Long-run equilibrium
Figure 6.4 Perfect competition: long-run equilibrium (profits)
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Long-run equilibrium
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The firm is still a price-taker .
Marginal revenue still equals average revenue and
price; i.e. MR =AR =P .
But profits are now maximised where long-run
marginal costs are equal to marginal revenue (and
average revenue).
Supernormal profits (or losses) earned in the short
run disappear due to market entry (or exit) so that
firms in perfect competition earn only normal profits
in the long run (AR =ATC).
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Productive and allocative efficiency in
perfectly competitive markets
Productive efficiency occurs when a firm minimises
the costs of producing any level given existing
technology.
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Technical efficiency - this occurs when inputs of
the factors of production are combined in the firm
in the best possible way to produce the maximum
physical output.
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Price efficiency - this occurs when inputs into
production are optimally employed, given their
prices, so as to minimise production costs.
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Figure 6.5 Productive efficiency in perfect competition
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Allocative efficiency
Allocative efficiency denotes the optimal
allocation of scarce resources so as to
produce the combination of outputs which best
accords with consumers 壇demands.
In other words,no other allocation of resources
would produce a higher level of economic
welfare, given the existing consumer demands.
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Pareto optimality
A pareto optimum is said to exist when resources cannot be
reallocated so as to make one person better off without
making someone else worse off.
There are three main conditions that must hold in order for a
pareto optimum to be achieved.
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Goods must be optimally distributed between consumers so that
no reallocation increases economic welfare.
Inputs are allocated in such a way that no reallocation would
increase the physical output.
Optimal amounts of each output are produced so that no
change in output would lead to higher economic welfare.
In perfectly competitive markets,these three conditions are met
in the long run.
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To summarise,under perfect competition:
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In the short run,until the entry or exit of sufficient firms
occurs,supernormal profit or losses can exist.
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In the long run,once the process of market adjustment
is complete,only a normal profit is earned.
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In the long run a Pareto optimal outcome is achieved.
Perfect competition drives profit down to a normal level and
provides consumers with low-priced products and services.
Also, firms in perfectly competitive markets operate at
optimal scale in the long run. Economists favour the perfectly
competitive model because it achieves economically efficient
and, therefore, welfare maximising results.
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Key learning points
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A perfectly competitive market is one in which there is an
extremely high degree of competition with a very large number
of firms selling identical products or services, with identical
cost conditions,with free entry into and exit from the industry
and where ignorance does not distort competition (information
is complete for all producers and consumers).
Each firm in a perfectly competitive market is a price-taker, it
faces a perfectly elastic demand curve.
Short-run equilibrium in a perfectly competitive market
occurs when profits are maximised (or losses are
minimised)and this is where the short-run marginal cost
equates to price (and average revenue as well as marginal
revenue:i.e.P (=AR)=MR=MC).
Long-run equilibrium in a perfectly competitive market is
attained where production occurs so that firms can earn a
normal profit :i.e. P (=AR)=MR =MC =ATC. Also this will be at
the output at which the long-run average cost curve is at its
minimum.
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Key learning points
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Perfectly competitive markets are therefore associated
with both allocative and productive efficiency.
Allocative efficiency denotes the optimal allocation of
scarce resources so as to produce the combination of
outputs which best accords with consumers’ demands. This
will be where price equals marginal cost: P =MC.
Productive efficiency occurs when a firm minimises the
cost of producing any level of output,using existing
technology.
Productive efficiency is the product of technical efficiency
(resulting from combining inputs to achieve the maximum
physical output)and price efficiency (achieved by
minimisation of production costs given input prices).
Perfect competition is associated with pareto optimal
outcomes and is a theoretical benchmark against which
the economic welfare effects of real-world markets can be
judged.
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