Perfect competition
Characteristics
1. Price taker - the assumption that a perfectly competitive firm can sell whatever quantity at P1 but cannot influence
the ruling price from the whole market. The area below P1 has no sales as it’s irrational as there is no demand and
reduces sales revenue and profits. Above means no demand as products are homogenous and perfect substitutes
2. Homogenous products and perfect substitutes
meaning perfectly elastic demand
3. Infinite number of buyers and sellers
4. No barriers to entry or sunk costs
5. Perfect knowledge
6. Profit maximisation as a key objective
7. Perfectly mobile factors of production
8. No externalities
Profits are lower in concentrated markets
Due to having no barriers to entry, this means profits
easily attract new entrants which increases market
supply and decreases demand for firms in a
concentrated market.
Short run position
Where at least one factor of
production is fixed and
cannot change
In the short run, firms make
supernormal profits
Long run position
Supernormal profits attract
many new entrants causing
the price to fall to P3. Which
lies below the AC curve
causing firms to make a loss
This incentivises firms to
leave the market which
pushes supply up to S2
causing the equilibrium price
to be P2
Since only normal profit is
made, there is no incentive to
leave or enter the market
,Efficiencies
1. Allocatively efficient in both short and long run, P=MC and thus allocative efficiency is achieved. At the ruling price,
consumer and producer surplus is maximised. No one can be made better off so it achieves Pareto optimum
allocation.
Eval:
Ignore negative externalities as profit maximising firms are assumed to only take into account MPC
Therefore, the market mechanism fails to achieve an allocatively efficient outcome
Every firm in every market must be achieving P=MC which is impossible to achieve
2. Productively efficient as output is at the lowest AC curve attained in the long run. Firms with high unit costs wouldn’t
be able to survive as the market price is driven down by the forces of competition meaning X-inefficiency doesn’t
exist.
Eval:
Can only benefit from low level economies of scale meaning the MES has to be small in relation to the market size
Most commonly, perfectly competitive markets don’t benefit from economies of scale
3. Dynamic inefficiency as we assume perfectly competitive markets produce homogenous products with little scope
designated for innovation as they don’t make supernormal profits in the long run
Eval:
On the other hand, the threat of competition should lead to a faster rate of technological diffusion as firms have
to be responsive to the changing needs of consumers
There is greater entrepreneurial activity as for competition to be improved and sustained, there needs to be a
genuine desire on the behalf of entrepreneurs to innovate and invent to drive markets
Evaluate the view that a perfectly competitive market always benefits consumers (20)
P1: Lower prices and allocative efficiency
Lower prices due to high degree of market contestability
The XED of one product is high suggesting consumers are prepared to switch their demand to the most competitively
priced product in the marketplace. This is shown through the elastic demand curve
In both the short and long run, P=MC and thus allocative efficiency is achieved
At the ruling price, both consumer and producer surplus are maximised, so Pareto optimum allocation is achieved
No monopoly power meaning total profits and profit margins are lower
Eval:
This model disregards negative externalities as profit maximising firms are assumed to only take MPC
Therefore, the market mechanisms fail to achieve an allocatively efficient outcome
P2: Low barriers to entry and productive efficiency
Threat of entry provides competition and ensures prices are low
Productive efficiency is achieved at the lowest AC curve
X-inefficiency is reduced as firms with high unit costs wouldn’t be able to survive as the market price is driven down by
the forces of competition meaning X-inefficiency doesn’t exist
Eval:
Can only benefit from small economies of scale meaning the MES has to be small in relation to the market size
Commonly, perfectly competitive markets cannot benefit from economies of scale which limits the size of
production
P3: Dynamic efficiency isn’t achieved
Normal profits mean there is little scope for innovation
Eval:
On the other hand, the threat of competition should lead to a faster rate of diffusion
Greater entrepreneurial activity to innovate and drive markets
, Evaluate the view that technological advancement like the internet make the theory of a perfectly competitive market
more realistic (20)
1. Easy to compare prices meaning perfect information
Bounded rationality and the number of options (heuristics and rules of thumb)
2. Made barriers to entry lower due to services like e-bay is close to perfect competition
Product differentiation/ branding/ persuasive advertising
Internet may support price discrimination
Legal barriers to entry like copyright, designs and patents mean there cannot be homogenous products
3. Enabled the price of many books to fall so firms are only making normal profits. Reduces advantages of scale
economies due to small firms on eBay and Amazon small bookshop partners. Technology can mean firms can track
their marginal costs and revenues meaning operating at profit maximising output is more likely to be able to be used.
A large number of small firms may merge, becoming more monopolistic
Internet allows some monopolies to emerge and grow like Google and Microsoft
Governments should always take the necessary steps to encourage perfectly competitive markets, regardless of the
good or service being produced. To what extent do you agree?
1. Productively efficient and X-inefficiency is reduced ensuring prices are low
a. Cannot benefit from economies of scale. Natural monopolies would be made incredibly inefficient given the
fact it has a very large economy of scale
2. Allocatively efficient as it operates on P=MC and is always profit maximising. Allows consumer and producer surplus to
be maximise.
a. Profit maximising aspects may lead to negative externalities being generated and ignored. In a monopoly
market, these may be reduced through reinvesting profits in greener technology
3. Dynamic inefficiency as normal profits means there is little to invest
a. Could be beneficial as it encourages technology diffusion and greater entrepreneurial activity
b. The lack of consumer choice due to homogenous products may hurt consumer surplus
c. Monopolistic or oligopolistic markets may be more beneficial as they allow product differentiation and some
consumer choice
An optimal allocation is best achieved through a perfectly competitive market structure. To what extent to do you
agree with this statement?
Monopolistic competition
Characteristics
1. Price taker - the assumption that a perfectly competitive firm can sell whatever quantity at P1 but cannot influence
the ruling price from the whole market. The area below P1 has no sales as it’s irrational as there is no demand and
reduces sales revenue and profits. Above means no demand as products are homogenous and perfect substitutes
2. Homogenous products and perfect substitutes
meaning perfectly elastic demand
3. Infinite number of buyers and sellers
4. No barriers to entry or sunk costs
5. Perfect knowledge
6. Profit maximisation as a key objective
7. Perfectly mobile factors of production
8. No externalities
Profits are lower in concentrated markets
Due to having no barriers to entry, this means profits
easily attract new entrants which increases market
supply and decreases demand for firms in a
concentrated market.
Short run position
Where at least one factor of
production is fixed and
cannot change
In the short run, firms make
supernormal profits
Long run position
Supernormal profits attract
many new entrants causing
the price to fall to P3. Which
lies below the AC curve
causing firms to make a loss
This incentivises firms to
leave the market which
pushes supply up to S2
causing the equilibrium price
to be P2
Since only normal profit is
made, there is no incentive to
leave or enter the market
,Efficiencies
1. Allocatively efficient in both short and long run, P=MC and thus allocative efficiency is achieved. At the ruling price,
consumer and producer surplus is maximised. No one can be made better off so it achieves Pareto optimum
allocation.
Eval:
Ignore negative externalities as profit maximising firms are assumed to only take into account MPC
Therefore, the market mechanism fails to achieve an allocatively efficient outcome
Every firm in every market must be achieving P=MC which is impossible to achieve
2. Productively efficient as output is at the lowest AC curve attained in the long run. Firms with high unit costs wouldn’t
be able to survive as the market price is driven down by the forces of competition meaning X-inefficiency doesn’t
exist.
Eval:
Can only benefit from low level economies of scale meaning the MES has to be small in relation to the market size
Most commonly, perfectly competitive markets don’t benefit from economies of scale
3. Dynamic inefficiency as we assume perfectly competitive markets produce homogenous products with little scope
designated for innovation as they don’t make supernormal profits in the long run
Eval:
On the other hand, the threat of competition should lead to a faster rate of technological diffusion as firms have
to be responsive to the changing needs of consumers
There is greater entrepreneurial activity as for competition to be improved and sustained, there needs to be a
genuine desire on the behalf of entrepreneurs to innovate and invent to drive markets
Evaluate the view that a perfectly competitive market always benefits consumers (20)
P1: Lower prices and allocative efficiency
Lower prices due to high degree of market contestability
The XED of one product is high suggesting consumers are prepared to switch their demand to the most competitively
priced product in the marketplace. This is shown through the elastic demand curve
In both the short and long run, P=MC and thus allocative efficiency is achieved
At the ruling price, both consumer and producer surplus are maximised, so Pareto optimum allocation is achieved
No monopoly power meaning total profits and profit margins are lower
Eval:
This model disregards negative externalities as profit maximising firms are assumed to only take MPC
Therefore, the market mechanisms fail to achieve an allocatively efficient outcome
P2: Low barriers to entry and productive efficiency
Threat of entry provides competition and ensures prices are low
Productive efficiency is achieved at the lowest AC curve
X-inefficiency is reduced as firms with high unit costs wouldn’t be able to survive as the market price is driven down by
the forces of competition meaning X-inefficiency doesn’t exist
Eval:
Can only benefit from small economies of scale meaning the MES has to be small in relation to the market size
Commonly, perfectly competitive markets cannot benefit from economies of scale which limits the size of
production
P3: Dynamic efficiency isn’t achieved
Normal profits mean there is little scope for innovation
Eval:
On the other hand, the threat of competition should lead to a faster rate of diffusion
Greater entrepreneurial activity to innovate and drive markets
, Evaluate the view that technological advancement like the internet make the theory of a perfectly competitive market
more realistic (20)
1. Easy to compare prices meaning perfect information
Bounded rationality and the number of options (heuristics and rules of thumb)
2. Made barriers to entry lower due to services like e-bay is close to perfect competition
Product differentiation/ branding/ persuasive advertising
Internet may support price discrimination
Legal barriers to entry like copyright, designs and patents mean there cannot be homogenous products
3. Enabled the price of many books to fall so firms are only making normal profits. Reduces advantages of scale
economies due to small firms on eBay and Amazon small bookshop partners. Technology can mean firms can track
their marginal costs and revenues meaning operating at profit maximising output is more likely to be able to be used.
A large number of small firms may merge, becoming more monopolistic
Internet allows some monopolies to emerge and grow like Google and Microsoft
Governments should always take the necessary steps to encourage perfectly competitive markets, regardless of the
good or service being produced. To what extent do you agree?
1. Productively efficient and X-inefficiency is reduced ensuring prices are low
a. Cannot benefit from economies of scale. Natural monopolies would be made incredibly inefficient given the
fact it has a very large economy of scale
2. Allocatively efficient as it operates on P=MC and is always profit maximising. Allows consumer and producer surplus to
be maximise.
a. Profit maximising aspects may lead to negative externalities being generated and ignored. In a monopoly
market, these may be reduced through reinvesting profits in greener technology
3. Dynamic inefficiency as normal profits means there is little to invest
a. Could be beneficial as it encourages technology diffusion and greater entrepreneurial activity
b. The lack of consumer choice due to homogenous products may hurt consumer surplus
c. Monopolistic or oligopolistic markets may be more beneficial as they allow product differentiation and some
consumer choice
An optimal allocation is best achieved through a perfectly competitive market structure. To what extent to do you
agree with this statement?
Monopolistic competition
