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Definition
The economist's model of perfect competition is highly
theoretical, but it does provide a useful tool of economic
analysis and helps us to make some sense of real world
conditions. The real world is much too complicated to
understand all at once; it is necessary to examine one
feature at a time. Economists are able to use their model of a
perfect market as a means of assessing the degree of
competition in real world markets. They set out the
conditions necessary for a perfect market and then contrast
these with the situations found in the markets for goods and
services. The degree of competition in these real markets is
based upon the extent to which they approximate to the
model of perfect competition. It is necessary to point out that
the competition referred to here is price competition. Firms
are assumed to be engaged in a rivalry for sales which takes
the form of underselling competitors.
Characteristics
A perfectly competitive market has a number of key
characteristics.
Revenue
Fig. 19.3
Revenue and costs (£)
Fig. 19.4
Long-run equilibrium
The long-run equilibrium of the firm is shown in Fig. 19.6. The
market price has fallen to OP1 arid the most profitable output
is now OQ1, where AR = MR = MC. Note that price, or
average revenue, is now equal to average cost so that the
firm is making only normal profits. There is no
Fig. 19.5
AR = MR = MC = AC
Fig. 19.6
Subnormal profits
Fig. 19.7
The area C1 x YP1 represents the area of loss that the firm is
making. It is costing the firm C1 per unit to produce the good
but the firm is receiving a price of only Pl so it is not covering
all of its costs.
In this situation some firms will leave the industry but some
will remain. Those that stay in the industry will be those that
believe that they will be able to return to earning normal
profits and that currently can cover their variable costs. If the
price a firm is receiving is covering its average variable costs
it will be covering the direct cost of production and may be
making some contribution to average fixed costs. Whereas if
the firm shut down it would not be able to cover any of the
fixed costs that it would still have to meet. Figure 19.8 shows
two firms making subnormal profits. Firm (a) is covering its
average variable cost and will stay in the industry, at least in
the short run, whilst firm (b) is not and will leave the
industry.
Q Quantity 0 Q Quantity
O
(a) Firm A (b) Firm B
Fig. 19.8
energy. It is the marginal firms (i.e. those with the highest costs) which will be
the first to leave the industry when subnormal profits are being made and the
last to enter when supernormal profits are experienced.
As we discussed above the existence of subnormal profits will cause some firms
to leave the industry. This will move the industry's supply curve to the left, raise
price and return profits to the normal profit level. Figure 19.9 shows the industry
and a firm returning to long-run equilibrium where there is no incentive for firms
to enter or leave the industry and where firms are earning normal profit.
In the conditions shown in Fig. 19.10 when the market price is OP the firm will
produce output OQ. If the market price falls to OP1 the firm, in
Costs
/ XZ= Short-run
Price supply curve
Costs/
reven
ue
Fig.
19.9
At this point, however. Price = MC = AC so that the firm will be making no more
than normal profits.
If market price falls below OP2, the firm will be making losses because, at all
outputs, price will be less than average cost. Thus when price is OP3 the firm will
be making losses, but at this price, OQ3 still represents the 'most profitable'
output in the sense that it represents the output at which losses are minimized.
In the short-run, the firm may still produce even when price is less than average
total cost provided it is above average variable cost. So the short-run supply
curve is that part of the MC curve which lies above the AVC curve. In the long run
all costs have to be covered so the long-run supply curve is that part of the MC
curve which lies above the AC curve. It slopes upwards from left to right because
increasing output gives rise to increasing marginal cost.