Introduction

The degree to which a market or industry can be described as competitive depends in part on how many suppliers are seeking the demand of consumers and the ease with which new businesses can enter and exit a particular market in the long run. The spectrum of competition ranges from highly competitive markets where there are many sellers, each of whom has little or no control over the market price - to a situation of pure monopoly where a market or an industry is dominated by one single supplier who enjoys considerable discretion in setting prices, unless subject to some form of direct regulation by the government.In many sectors of the economy markets are best described by the term oligopoly - where a few producers dominate the majority of the market and the industry is highly concentrated. In a duopoly two firms dominate the market although there may be many smaller players in the industry. Competitive markets operate on the basis of a number of assumptions. When these assumptions are dropped - we move into the world of imperfect competition. These assumptions are discussed below


Assumptions behind a Perfectly Competitive Market

1. Many suppliers each with an insignificant share of the market – this means that each firm is too small relative to the overall market to affect price via a change in its own supply – each individual firm is assumed to be a price taker

2. An identical output produced by each firm – in other words, the market supplies homogeneous or standardised products that are perfect substitutes for each other. Consumers perceive the products to be identical

3. Consumers have perfect information about the prices all sellers in the market charge – so if some firms decide to charge a price higher than the ruling market price, there will be a large substitution effect away from this firm

4. All firms (industry participants and new entrants) are assumed to have equal access to resources (technology, other factor inputs) and improvements in production technologies achieved by one firm can spill-over to all the other suppliers in the market

5. There are assumed to be no barriers to entry & exit of firms in long run – which means that the market is open to competition from new suppliers – this affects the long run profits made by each firm in the industry. The long run equilibrium for a perfectly competitive market occurs when the marginal firm makes normal profit only in the long term

6. No externalities in production and consumption so that there is no divergence between private and social costs and benefits


Short Run Price and Output for the Competitive Industry and Firm:

In the short run the equilibrium market price is determined by the interaction between market demand and market supply. In the diagram shown above, price P1 is the market-clearing price and this price is then taken by each of the firms. Because the market price is constant for each unit sold, the AR curve also becomes the Marginal Revenue curve (MR). A firm maximises profits when marginal revenue = marginal cost. In the diagram above, the profit-maximising output is Q1. The firm sells Q1 at price P1. The area shaded is the economic (supernormal profit) made in the short run because the ruling market price P1 is greater than average total cost.

***Figure 1***

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Not all firms make supernormal profits in the short run. Their profits depend on the position of their short run cost curves. Some firms may be experiencing sub-normal profits because their average total costs exceed the current market price. Other firms may be making normal profits where total revenue equals total cost (i.e. they are at the break-even output). In the diagram below, the firm shown has high short run costs such that the ruling market price is below the average total cost curve. At the profit maximising level of output, the firm is making an economic loss (or sub-normal profits)

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The Effects of a change in Market Demand


In the diagram below there has been an increase in market demand (ceteris paribus). This causes an increase in market price and quantity traded. The firm's average revenue curve shifts up to AR2 (=MR2) and the profit maximising output expands to Q2. Notice that the MC curve is the firm's supply curve. Higher prices cause an expansion along the supply curve. Following the increase in demand, total profits have increased. An inward shift in market demand would have the opposite effect. Think also about the effect of a change in market supply - perhaps arising from a cost-reducing technological innovation available to all firms in a competitive market.

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Long run price and output under perfect competition


The Long Run Adjustment Process

If most firms are making abnormal profits in the short run there will be an expansion of the output of existing firms and we expect to see the entry of new firms into the industry. Firms are responding to the profit motive and supernormal profits act as a signal for a reallocation of resources within the market. The addition of new suppliers causes an outward shift in the market supply curve. This is shown in the diagram below.

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Making the assumption that the market demand curve remains unchanged, higher market supply will reduce the equilibrium market price until the price = long run average cost. At this point each firm is making normal profits only. There is no further incentive for movement of firms in and out of the industry and a long-run equilibrium has been established.
The entry of new firms shifts the market supply curve to MS2 and drives down the market price to P2. At the profit-maximising output level Q3 only normal profits are being made. There is no incentive for firms to enter or leave the industry. Thus a long-run equilibrium is established.

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Does perfect competition lead to economic efficiency?


Perfect competition is used as a yardstick to compare with other market structures (such a monopoly and oligopoly) because it displays high levels of economic efficiency. In both the short and long run, price is equal to marginal cost (P=MC) and therefore allocative efficiency is achieved – the price that consumers are paying in the market reflects the factor cost of resources used up in producing / providing the good or service.
Productive efficiency occurs when price is equal to average cost at its minimum point. This is not achieved in the short run – firms can be operating at any point on their short run average total cost curve, but productive efficiency is attained in the long run because the profit maximising output is achieved at a level where average (and marginal) revenue is tangential to the average total cost curve. The long run of perfect competition, therefore, exhibits optimal levels of static economic efficiency.
There is of course another form of economic efficiency – dynamic efficiency – which relates to aspects of market competition such as the rate of innovation in a market, the quality of output provided over time.

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Economic efficiency


Efficiency is one of the most important concepts to use in you're A Level Economics course. There are several meanings of the term - but they generally relate to how well an economy allocates scarce resources to meets the needs and wants of consumers. Make sure you know your definitions well, can illustrate them using appropriate diagrams and can apply them to particular situations


Static Efficiency

Static efficiency exists at a point in time and focuses on how much output can be produced now from a given stock of resources and whether producers are charging a price to consumers that fairly reflects the cost of the factors of production used to produce a good or a service. There are two main types of static efficiency


Allocative Efficiency

Allocative efficiency is achieved when the value consumers place on a good or service (reflected in the price they are willing to pay) equals the cost of the resources used up in production. Condition required is that price = marginal cost. When this condition is satisfied, total economic welfare is maximised.

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Pareto defined allocative efficiency as a situation where no one could be made better off without making someone else at least as worth off.
Under monopoly, a business can keep price above marginal cost and increase total revenue and profits as a result. Assuming that a monopolist and a competitive firm have the same costs, the welfare loss under monopoly is shown by a deadweight loss of consumer surplus compared to the competitive price and output. This is shown in the diagram below.

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This can be illustrated using a production possibility frontier - all points that lie on the PPF can be said to be allocatively efficiency because we cannot produce more of one product without affecting the amount of all other products available. Point A is allocatively efficient - but at B we can increase production of both goods by making fuller use of existing resources or increasing the efficiency of production.

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