Competitive Markets

Content Perfect competition Competition and resource allocation Dynamics of competition and competitive market processes

Perfect Competition Perfectly competitive markets have a large number of firms producing identical products As the products are the same consumers do not display a preference for one firm over another There are no barriers to entry or exit so it is easy for firms to come in to or leave the market All consumers have access to information on the firms and products in the market place and they have good knowledge of the products Each producer is responsible for a very small % of the total quantity supplied in the market Potential profits for firms in this type of market are low

Perfect Competition – Long run This is the long run equilibrium position PQ The firm is making a normal profit at this point

Perfect Competition – Short Run In the short run equilibrium price is determined by the interaction of the market demand and market supply curves The equilibrium price is the market clearing price and this is used by all firms as they are price takers As market price is the same regardless of quantity AR = MR In the short run if the price is above costs a business is able to make supernormal profits

Perfect Competition The yellow area shows profits earned by the firm The firm will be receiving the supernormal profits due to their cost curve Due to perfect knowledge in the market any differences in costs will be eradicated in the long term as firms know about each others behaviour

Competition and the Efficient Allocation Of Resources Given the following assumptions: –Many small firms –Complete freedom of entry / exit –Many individual buyers –Products are perfect substitutes –Perfect knowledge –Absence of externalities (private costs and benefits are equal to social costs and benefits) Perfect competition results in the efficient allocation of resources

Perfect Competition and Efficiency The model of perfect competition achieves efficiency in three ways: –Allocative efficiency: Price = MC and therefore consumer and producer surpluses are maximised –Productive efficiency: In the long run in perfect competition equilibrium output is produced where average costs are at their lowest point –Dynamic efficiency: As products are all virtually the same one business is unable to differentiate their product and gain monopoly power

Perfect competition and assumptions In the real world the conditions of perfect competition rarely exist Most markets have some barriers to entry / exit especially barriers to contestability In the majority of markets some consumers purchase a greater % of output than others giving themselves increased power Most consumers face imperfect information and therefore may not make informed choices about products

Perfect competition and assumptions Consumers are susceptible to other influences when making their purchasing decisions such as advertising and promotional tools Most products produce some externalities in production and consumption Most products are not exactly the same – products tend to be differentiated and therefore consumers tend to prefer certain products to others

Perfect Competition – A Reality? One of the few markets that nears perfect competition is the currency market because: –All goods in the market are perfect substitutes –There are a large amount of firms selling currency –There are a large amount of consumers –There is good quality information and most buyers / sellers have a high degree of expertise However this is still not perfect as there are : –Barriers to entry –Government influences on the market

Dynamics of competition and competitive market processes In addition to efficiency there are a number of benefits that in the short and long run can lead to a number of benefits In perfectly competitive markets firms need to keep their costs to a minimum this results in reduced wastage of resources Competition in the domestic market increases international competitiveness resulting in gains from trade

Benefits of Competition Short term: Firms are encouraged to make cost savings by: –Increasing productivity –Innovating This allows firms to cut the price of products Consumers benefit from lower prices, more choice and higher quality products

Benefits of competition Firms in perfectly competitive markets also compete on non price factors such as quality of service which provide benefits for the consumers The main benefits of competition in the long term relate to the efficient allocation of resources

Summary Perfect competition is a market structure with lots of small firms all producing similar products This model is based on a number of assumptions including that firms are price takers, there are no barriers to entry / exit and that products are perfect substitutes In reality the majority of markets do not resemble the model of perfect competition Perfectly competitive markets allocate resources efficiently within the economy Perfectly competitive markets create advantages for the consumer and the producer as they encourage costs to be reduced and increase consumer choice