Lecture Notes: Perfect Competition

Introduction

• Perfect competition is a theoretical extreme, not a realistic market structure.
• Used as a benchmark to assess the efficiency of real-world market structures.

Characteristics of Perfectly Competitive Market

• Numerous Buyers and Sellers: Infinite buyers and sellers, leading to intense competition.
• Homogeneous Products: Firms sell identical goods and services.
• Price Takers:
  • Firms cannot set their own prices; they take the market price.
  • Raising prices results in losing all customers; lowering prices reduces revenue without benefit.
• No Barriers to Entry/Exit: Firms can freely enter or leave the market without costs.
• Perfect Information:
  • Consumers know about prices and quality.
  • Producers know about prices, technology, and costs.
• Profit Maximization: Firms produce where Marginal Cost (MC) equals Marginal Revenue (MR).

Long-Run Equilibrium

• Defined as the point where normal profit is made.
• Supernormal or subnormal profits are only short-run equilibria.
• Market does not change when normal profit is achieved.

Behavior of Firms

Supernormal Profit

• Short-run occurrence where average revenue exceeds average cost.
• Dynamics:
  • Attracts new firms due to lack of entry barriers and perfect information.
  • Supply shifts right, price falls until supernormal profit is eliminated, leaving normal profit.
• Diagram:
  • Market on left, firm on right.
  • Supernormal profit shown by average cost below average revenue.
  • Long-run adjustment drawn backwards to avoid errors.

Subnormal Profit

• Occurs when average cost is above average revenue, leading to losses.
• Dynamics:
  • Firms exit due to losses; supply shifts left, price rises until normal profit remains.
• Diagram:
  • Losses shown by average cost above average revenue.
  • Long-run adjustment involves drawing revenue curves first.

Efficiency Analysis

Allocative Efficiency

• Achieved when price equals marginal cost.
• Implies resources follow consumer demand, leading to low prices and high consumer surplus.

Productive Efficiency

• Achieved when firms operate at the lowest point on the average cost curve.
• Exploits any economies of scale.

X Efficiency

• Firms minimize waste and cost, producing on the average cost curve.

Dynamic Efficiency

• Not achieved due to lack of long-run supernormal profit.
• No reinvestment in innovation or new technology, hindering market progress.

Conclusion

• Perfect competition achieves static efficiencies (allocative, productive, X efficiency).
• Lacks dynamic efficiency due to absence of supernormal profits.
• Watch further videos for detailed understanding.