IB Microeconomics EQ: What is the model of PERFECT COMPETITION? (HL)

What is perfect competition? Economists are keen model makers! We use the models to help compare, analyse, predict and foster greater understanding of the world in which we live. Perfect Competition (PC) is a model that does not exist in the real world and few markets come close to replicating it’s characteristics. You may ask ‘why we should even concern ourselves with something that is a fictitious portrayal of the economy?’ but our model gives us a base upon which we can build, analyse and formulate our evaluations. If we know what we consider to be perfect while none of us will ever reach that utopia we can at least see how close we can get and draw upon elements of what it means to be BEST.

Assumptions of Perfect Competition The industry is made up of a very large number of small firms All firms are too small to influence price or output and hence are known as price takers Homogenous products produced No barriers to enter or exit the industry Perfect knowledge exists where all producers and consumers are fully aware of market prices, costs etc. Because of these assumptions is assumed or believed that all firms operating under perfect competition will make normal profits in the LR and cannot protect a situation of abnormal profits.

O £ (b) Firm Q (thousands) O (a) Industry P Q (millions) S D PePe MC AR D = AR = MR QeQe AC This the basic PC model… REMEMBER to draw two diagrams side by side…

O £ (b) Firm Q (thousands) O (a) Industry P Q (millions) S D PePe MC AR D = AR = MR QeQe AC This firm is making abnormal profits… but how long will they last?

QeQe P1P1 D 1 = AR 1 = MR 1 AR 1 OO (a) Industry P£ Q (millions) S D (b) Firm MC AC Q (thousands) This firm is loosing money… but how long will they stay in business?

OO (a) Industry P£ P2P2 Q (millions) S D2D2 (b) Firm AR 2 D 2 = AR 2 = MR 2 MC AC AVC Q (thousands) When will the firm decide to shut down in the SR?

12 marks Mark Scheme

Under perfect competition can this position of abnormal profits be maintained into the LR?

Establishment of a LR equilibrium under PC. If firms cannot make profits some will leave the industry leading to a reduction in supply, price rises will restore equilibrium and normal profits for firms that remain in the market.

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