Lecture 9

The UK’s European university
Economics for Accounting

ECON3007
Autumn Term
9. Market Structures I: Perfect and Imperfect
Competition
Aims and reading
• Aims
• Explain key features of a perfectly competitive market
• Price and output decisions in the short run and long run
in a perfectly competitive market
• Reading
• Gillespie, Chapters 11 and 12
Page 2
Perfect competition
Short run and long run equilibrium
Page 3
Introduction
• Up until now we have seen :

• How the supply and demand interact to provide the
overall market price and quantities
– The price mechanism
• How much consumers choose of a given good, for all
levels of price
– Through consumer choice
• How much producers produce of a good, for all levels

of price
– Through the model of the firm
4
Conditions of perfect competition
Perfect competition is defined by the following five conditions:
1. Large number of buyers and sellers

2. Homogeneous products
3. Free entry and exit from the market
4. Perfect information
5. Perfect mobility of factors of production
All five are required for a market to be

perfectly competitive
5
1. Large number of agents

• There are many producers and consumers
• None is large enough to individually influence the

market outcome (either price or quantity)
• All agents in the market (firms and consumers) are

price takers (as opposed to monopoly where firms can
set prices)
6
2. Homogeneous products
• The good is exactly the same regardless of who
produces it
• Consumers cannot tell which firm produced a specific
item
– Example: a bag of popcorn
• Consumers have no preferences with respect to

producers
• There are no brands
– No “brand loyalty”!
7
3. Free entry and exit from the market

• Agents are free to enter and exit markets in
response to changing market conditions
• There are no barriers to entry or exit: no costs
involved, no new information required
8
4. Perfect information
• Agents are constantly informed of the changing
market conditions
• Agents also know all the characteristics of the
goods
• Buyers know what all firms are charging
• Firms know what profits are being made in the
industry
9
5. Perfect mobility of factors of production

• Inputs to production can change markets freely
– Labour allocated to a given production can costlessly switch to
any other production
– The same applies to capital
• This is a corollary of free entry and exit from the market
10
• If one of these conditions fails to hold, then we have

imperfect competition
• This set of conditions is never met in reality!
• We have markets with few firms, distinct brands,
products are not homogenous, information is never
perfect, and mobility between markets is often a
problem
• But the concept of perfect competition is important as a

benchmark for assessing the different kinds of imperfect
competition
11
• We will look at different types of imperfect

competition
• monopoly
• duopoly
• oligopolies
• monopolistic competition
• By using the benchmark of perfect competition

we can compare the characteristics of the
models
12
Firm and industry in perfect competition
The firm in perfect competition is a price taker

Perfect competition
Page 14
SR and LR in perfect competition
• Profit motive: it is assumed that firms try to maximise profit
• The profit of a firm is given by:

  TR  TC
• Firms try to generate as much revenue as possible
• The quantity that maximises profits will not necessarily
be the same as the one that maximises revenue!
15
• Starting from 0, a firm will increase its output until

an increase in output no longer increases profits
 TR TC
0  
q q q
or mR = mC
• Profits are maximum when the revenue of selling an
extra unit just covers the extra cost of producing that unit
• In perfect competition mR = price = mC
Why?
16
Firm-market equilibrium
Firm level Market level
Price Price
mC
Zero profits
in equilibrium AC S
d=mR
p
D
q Quantity Q Quantity
17
Price Price
mC Imagine a positive demand shock
Positive (e.g.: increase in income)
profits in SR
  p  q  TC AC S
d2=mR2
p2
d=mR
p
D2
Total Cost D
q q2 Quantity Q Q2 Quantity
18
Price Price
mC Positive profits attract firms
Return to to the market (free entry +
zero profits perfect information)
in LR AC S
S2
d2=mR2
p2
d=mR
p
D2
q q2 Quantity Q2 Q3 Quantity
19
• Zero profits doesn’t mean no profit.

Price It means the firm makes enough
mC just to stay in business and not
Zero profits to do something else
in LR • Resources are allocated
equilibrium AC efficiently and welfare is
maximised because
p = mR = mC, which means
d=mR that marginal cost of
p production equals marginal
utility of production. This is the
condition for an optimal
q Quantity allocation of resources
• This is what is called in
microeconomics economic
efficiency
20
• Allocative efficiency occurs when the extra benefit to

society equals the extra costs –that is, P = MC
• Productive efficiency occurs when firms are producing at

the minimum of the average cost curve
21
In the short run

• Abnormal profits or losses can be made by firms
In the long run

• Only normal profits can be made due to entry and exit of
firms
• Allocative efficiency is achieved (price= marginal cost)
• Productive efficiency is achieved (minimum average
cost)
Economic surplus
• Economic surplus measures:

• the net benefit to the consumers of purchasing the good
on the market
• the net benefit to the producer of selling the good on the
market
• Consumer surplus is the difference between the maximum

amount a consumer would have been prepared to pay for a
product and what the consumer actually paid
• Producer surplus is the difference between the minimum

price required for a firm to supply a good and the price that
is actually paid
23
Economic surplus
Surplus under perfect competition
P
Consumer surplus
All those
consumers willing (area below the demand and above P*)
to buy above P*
S
P*
All those
producers willing D
to supply below
P*
Producer surplus
(area above the supply and below P*)
Q* Q
24
Economic surplus
• Surplus is maximised under perfect competition

• It serves as the benchmark for models of competition
• Surplus is key to measuring welfare

• It is an important policy tool for understanding why
certain market structures need to be regulated or
deregulated
• Surplus is also important for understanding how

interventions into the market such as price ceilings/floors
and taxes influence the welfare of consumers and
producers
25
Economic surplus
Long run equilibrium, we have P = MR = MC = AC

What have we learnt?
• A firm in perfect competition is a price taker
• Firms profit-maximize where Price (P) = Marginal revenue

(MR) = Marginal cost (MC)
• In the short run, in perfect competition, firms can make

abnormal profits or losses
• In the long run, due to the entry and exit of firms, only
normal profits are made
• In the long run, in perfect competition, firms are

allocatively and productively efficient

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The UK’s European university

Economics for Accounting

Short run and long run equilibrium

• Up until now we have seen :

• How much producers produce of a good, for all levels

Perfect competition is defined by the following five conditions:

1. Large number of buyers and sellers

All five are required for a market to be

1. Large number of agents

• None is large enough to individually influence the

• All agents in the market (firms and consumers) are

• Consumers have no preferences with respect to

3. Free entry and exit from the market

5. Perfect mobility of factors of production

• This is a corollary of free entry and exit from the market

• If one of these conditions fails to hold, then we have

• But the concept of perfect competition is important as a

• We will look at different types of imperfect

• By using the benchmark of perfect competition

The firm in perfect competition is a price taker

Short run and long run equilibrium

• Profit motive: it is assumed that firms try to maximise profit

• The profit of a firm is given by:

• Starting from 0, a firm will increase its output until

• In perfect competition mR = price = mC

• Zero profits doesn’t mean no profit.

• Allocative efficiency occurs when the extra benefit to

• Productive efficiency occurs when firms are producing at

In the short run

In the long run

• Economic surplus measures:

• Consumer surplus is the difference between the maximum

• Producer surplus is the difference between the minimum

• Surplus is maximised under perfect competition

• Surplus is key to measuring welfare

• Surplus is also important for understanding how

Long run equilibrium, we have P = MR = MC = AC

• A firm in perfect competition is a price taker

• Firms profit-maximize where Price (P) = Marginal revenue

• In the short run, in perfect competition, firms can make

• In the long run, in perfect competition, firms are

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