Unit 2.

11(2) Market power - Perfect

competition(HL)

What you should know by the end of this chapter

• Assumptions of perfect competition
• Determining price and output in perfect competition
• Total, average and marginal revenue
• Profit maximisation
• Explanation and diagrams of normal profits, abnormal profits and losses
• Efficiency in perfect competition
• Evaluation of perfect competition

Nature of perfect competition

Perfect competition is a theoretical model of how a market behaves under the conditions of the
purest form of competition. There are no examples of pure perfect competition but the
characteristics of perfect competition can be observed in agricultural markets where the industry is
made up of large numbers of small producers. For example, the market for oranges in Australia can
be used as an example of a market that has conditions which are similar to perfect competition, and
this is the example we will use to illustrate perfect competition in this chapter.

Assumptions of perfect competition

Large number of small buyers and sellers

There are a large number of small buyers and sellers in a perfectly competitive market and no one
buyer or seller can influence market price or output. For example, 1,900 commercial farms in
Australia grow and produce oranges. Because each individual firm only makes up a small fraction of
the market output they cannot affect market price and output. We also assume that there are a
large number of buyers so they cannot influence market price and output either.

Homogenous products

Firms in the market sell a homogenous product which means there are no differences between the
goods and services supplied by different firms. In theory the orange farmers all sell the same quality
and type of orange and they all offer the same quality of service to their customers. This means the
buying decisions of consumers of oranges is made purely on price and not on any other factor such
as the quality of the product.

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Perfect knowledge

There is perfect knowledge on the part of buyers and sellers so that all agents in the market know
about the prices being charged by all the producers in the market. This means no firm can charge a
different price in the market without consumers or other firms in the market knowing about the
different price being charged.

No barriers to entry or exit

There are no barriers to entry or exit present in the market. This means the costs of setting up in
the market are not higher than the normal costs of setting up in a market and there are no
additional costs associated with leaving the market. This means, for example, that orange growers
can acquire the land, capital and labour needed to set up and produce oranges without incurring any
extra costs or restrictions associated with entering the market. Firms in the market will only incur
the the normal costs of leaving the market when they shut down production.

Implications of the assumptions

The assumption of perfect competition are important in determining how perfectly competitive
markets behave because they affect the decisions made by consumers and producers in the market.
The assumptions are particularly important in determining the demand and supply conditions in
the market and how the market price is determined.

Price and output in perfect competition

Market price

In perfect competition market demand and supply determine the market price and output. Diagram
2.59 shows how the market demand and supply for oranges determines the price and output in the
market.

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Market demand and supply

In perfect competition the demand curve in the market is based on the law of demand and is the
sum of the demand curves of all in the individual buyers in the market. The supply curve is based on
the law of supply and is derived from the sum of all the marginal cost curves of the individual firms
in the market.

The demand curve facing the firm

The market price is the price each firm in the
perfect market has to charge or take. If the firm
tries to charge more than the market price then
quantity demanded will fall to zero because
consumers can buy exactly the same product
from an alternative supplier at the market price.
There is no incentive for firms to charge less
than the market price because they can sell all
they want at the market price.

The assumptions of the model mean that firms are price takers and face a perfectly elastic demand
curve. This is shown in diagram 2.59.

Revenue
Revenue is the income a firm receives from selling its good or service. There are three ways of
expressing the revenue a business receives:

Total revenue

Total revenue (TR) is the total income a businesses receives and is calculated as:

• price x quantity = total revenue

• P x Q = TR

Average revenue

Average revenue (AR) is the revenue per unit of output sold by a firm and is calculated as:

• total revenue / output = average revenue

• TR / Q = AR
• AR = P

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Marginal revenue

Marginal revenue is the change in total revenue when one more unit of output is sold and is
calculated as:

• change in total revenue / change in output = marginal revenue

• ∆TR / ∆Q = MR

With the perfectly elastic demand curve the firm faces in perfect competition the price the firm
receives is equal to average revenue and marginal revenue. The demand curve the firm faces can be
expressed as: D = AR = MR

In the orange market example, each farm has to charge $2.00 per kilo which equals the average
revenue and marginal revenue for each firm in the market.

Output
Classical economic theory assumes firms in the industry aim to profit maximise which means they
produce where marginal cost equals marginal revenue when marginal cost is rising. In diagram
2.60 the firm produces 40,000 kgs of oranges per month to profit maximise . Adding together the
total output of each producer in the market gives a total market output of 50 million kgs per month.

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Equilibrium
Short run equilibrium

The industry will be in short run equilibrium when demand equals supply. This means an
equilibrium price and output in the industry, but this equilibrium situation can change if abnormal
profits or losses are being made by firms in the market.

Long run equilibrium

Similar to short run equilibrium this is the output where market demand equals supply, but firms in
the market are all making normal profit. Because there are no abnormal profits or losses in the
market means there are no pressures on market price and output to change.

Profits and Losses

Normal Profit
Normal profit is the minimum profit firms need to earn to remain in a particular market. Normal
profit is achieved when total cost is equal to total revenue or average total cost equals average
revenue:

ATC = AR

Diagram 2.61 shows firms in the perfect market for oranges where each producer is earning normal
profit.

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Abnormal profits
Abnormal profit is earned by a firm when the entrepreneur earns more than the minimum profit
required to keep the firm in the industry. This means total revenue is greater than total cost:

AR > ATC x Q.

In the orange market example, an increase in demand for oranges causes the market price to rise
from $2.00 to $2.50 and this means individual firms in the industry are receiving a higher price which
results in AR rising above ATC leading to abnormal profits.

In diagram 2.62 this can be calculated as:

• $2.50 - $2.20 = $0.30 per unit

• $0.30 x 44,000 = $13,200 total abnormal profit.

New firms see this is an opportunity to make abnormal profits and enter the orange market. This
leads to an increase in market supply which causes the market price to fall reducing the abnormal
profit of the existing producers until firms stop entering the market and profits return to normal.

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Losses
Losses occur when total cost is less than total revenue which can be expressed as:

ATC > AR X Q.

This means firms are making less than normal profit so entrepreneurs will start to leave the
industry because they are not making enough profit to keep them in the market. Diagram 2.63
shows how a fall in market demand from D to D1 for oranges leads to losses as the market price falls
from $2.00 to $1.60 and average revenue falls below average total cost.

In diagram 2.63 losses can be calculated as:

• $2.05 - $1.60 = -$0.45 per unit

• -$0.45 x 35,000 = -$15,750

As firms leave the industry the market price rises and the profit for the remaining firms in the
market will return to normal.

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 Efficiency in perfect competition

Productive (technical) efficiency

Productive efficiency is achieved when all firms in the industry are producing where they achieve the
highest output per unit of resource input. This mean each firm in the market is producing at the
profit maximising output at the minimum point of average total cost:

MC = minimum ATC

This is achieved in perfect competition when firms are making normal profits, but not abnormal
profit or losses. This is shown in the diagram 2.64 at output 40,000 kgs.

Economists believe that the pressure of intense competition which exists in perfect competition
forces firms to be productively efficient. If a firm cannot achieve the minimum average total costs
of its competitors it will make losses and be forced out of the market. Productive efficiency is
achieved when the firm is making normal profit, but it will not be achieved when the firm is making
abnormal profit (output is above the productively efficient level) and losses (output is below the
productively efficient level). This is shown in diagram 2.62 and 2.63.

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Allocative efficiency
Allocative efficiency is achieved when resources are allocated in a market to maximise/social
community surplus. This occurs when market demand equals market supply. We assume there are
no positive or negative externalities in the market. Allocative efficiency is shown in diagram 2.64.
This is achieved in all profit-making situations in perfect competition. This occurs because no single
firm can affect market price and all firms are forced to charge the market price. If one firm tried to
charge a price above marginal cost the demand for their product would fall the zero.

Evaluation of perfect competition

Perfectly competitive markets will lead to productive and allocative efficiency in the long run. This
means all resource are being used efficiently and the market will maximise the welfare of consumers
and producers. However, the model has some weaknesses:

• No markets fully achieve the strict conditions of perfect competition. There will always be
some differences in the goods sold by different producers and some barriers to entry are
likely to exist in every market for some producers.
• Only a small number of industries in an economy come close to being perfectly competitive.
Many markets in the economy exist with conditions that are completely different to perfect
competition. For example, markets are often dominated by large businesses that account for
a high proportion of total market output. It is difficult to believe perfect competition would
be the most efficient market structure in the car industry.
• Perfect competition might achieve allocative and productive efficient output in the long run,
but the good and services sold in the market offer no real choice to consumers because of
the assumption of homogenous products. For example, imagine a perfect market for shoes
where all the shoes in the market are exactly the same.
• The model makes no allowance for positive or negative externalities which will affect
welfare in society.

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