Perfect Competition

January 2010 Home Farm is one of many small firms producing lettuces and attempting to maximise profits. Explain the circumstances in which Home Farm might make supernormal profits in the short run, but only normal profits in the long run. (15 marks; 20 minutes max!)

Recap on the conditions that exist in a perfectly competitive market. A large numbers of buyers and sellers. Buyers or sellers cannot influence the ruling market price by their own actions. All buyers and seller can trade as much as they want at the ruling market price. All buyers and sellers possess perfect market information. Their exists freedom of entry and exit to and from the market. Individuals firm’s products are homogenous (uniform).

The importance of perfect competition The benchmark for the efficient performance of markets in general where the theory to be derived from firm behaviour is greater then the practical application of the model. While competition is not perfect, it is accepted that some competition in markets is beneficial. There are no hard and fast rules as to what levels of competition are best, behaviour of firms in any market structure is an important indicator as to whether competition exists or not, even if it necessary in a market.

Perfect competition:- how much should firms produce and at what price? Long run equilibrium for a firm in perfect competition We have already established that the characteristics of perfect competition ensure that:- Firms are long run profit maximisers. That is they will produce at point at which MR=MC. Will produce at the optimum level of output. That is at the bottom of their ATC curve. The MC curve cuts the ATC at its lowest point. Long run equilibrium in perfect competition is established at the point at which MC=P=AR=MR=D=ATC P MC ATC P1 P=AR=MR=D Q1 Q

How is the long run equilibrium position in perfect competition derived? The determination of price and quantity supplied The determination of market/industry price The determination of individual firm price P P S P1 P=AR=MR=D D QDS1 QDS Q Q

The firm’s revenue in a perfectly competitive market Output Price per unit (£) Total revenue Average revenue (£) Marginal revenue (£) - 300 1 2 600 3 900 4 1200 5 1500

How is the long run equilibrium position in perfect competition derived? The determination of cost and quantity produced Firms will produce at the lowest point of their ATC curve. The minimum cost of producing each unit of output. This is also the point at which the MC curve cuts the ATC curve (a mathematical certainty). These points are known as the points of optimum efficiency (lowest cost combination of fixed and variable factors) and productive efficiency (lowest point of the ATC curve) P P1 Q1 Q

How is the long run equilibrium position in perfect competition derived? The determination of price and quantity supplied The determination of market/industry price The determination of individual firm price P P MC S ATC P1 P=AR=MR=D D QDS1 QDS Q Q

Dynamic efficiency and the erosion short run supernormal profits A firm gains competitive advantage by accessing new technology thus reducing its ATC. A wedge is created between market price and the ATC. The firm is able to enjoy supernormal profits. The signalling function of profits creates an incentive for more firms to enter the market causing the supply curve to shift to the right. The increase in supply creates a situation of excess supply putting pressure on prices to fall. Prices fall. The increase in the number of firms reduces the market share of existing firms. The wedge between market price and ATC is reduced, but still supernormal profits exist and firms continue to enter the market. (moths and lights) The dynamic nature of the market sees the above steps being repeated until a new equilibrium is established where prices have fallen sufficiently to erode all supernormal profits. Long run equilibrium is restored where MC=ATC=P=AR=MR=D

Dynamic efficiency and the erosion short run supernormal profits A diagrammatic representation The market/industry The firm P P MC S1 ATC S2 P1 P=AR=MR=D P2 P=AR=MR=D D1 QDS1 QDS2 QDS Q2 Q1 Q

Dynamic efficiency and the erosion short run supernormal profits A diagrammatic representation

Dynamic efficiency and the elimination of short run subnormal profits Industry costs rise due to an external shock such rising factor prices. A wedge is created between market price and the ATC. The firm now faces a situation of subnormal profits. The signalling function creates an incentive for firms to leave the market causing the supply curve to shift to the left. The decrease in supply creates a situation of excess demand putting pressure on prices to rise. Prices rise. The decrease in the number of firms increases the market share of existing firms that are able to survive the subnormal profits. The wedge between market price and ATC is reduced, but still subnormal profits exist and firms continue to exit the market. (moths and lights) The dynamic nature of the market sees the above steps being repeated until a new equilibrium is established where prices have risen sufficiently to eliminate all the subnormal profits. Long run equilibrium is restored where MC=ATC=P=AR=MR=D

Dynamic efficiency and the elimination of short run subnormal profits A diagrammatic representation The market/industry The firm P P MC S2 ATC S1 P2 P=AR=MR=D P1 P=AR=MR=D D1 QDS2 QDS1 QDS Q2 Q1 Q

Dynamic efficiency and the elimination of short run subnormal profits A diagrammatic representation