hi everybody perfect competition a theoretical extreme we're not trying to say it's a realistic Market structure but very important to assess the efficiency of Real World Market structures as a benchmark here so therefore it's very important that we understand this really well and we understand the conclusions we get at the end let's understand this Market structure by looking at characteristics first we'll then go to how firms behave on diagrams will then evaluate using efficiency at the end so what are the characteristics of a perfectly competitive market structure well there are many buys and sellers in truth infinite buyers and sellers very very intense extreme competition here each firm is selling homogeneous goods and services that means identical goods and services and for that reason firms are price takers they have no ability to set their own prices if a new firm enters the market they have to charge the price that's being charged by all other firms in the market they take the price from the Market here they can't set their price if they try and raise the price above the market price they're going to lose all their demand no customers at all if they reduce their price what a silly thing to do they're going to lose revenue and lose profit without gaining anything in the process so firms are price takers taking the price from the market there are no barriers to entry and exit so any firm that wants to enter or exit the market can do so freely without any cost whatsoever there is perfect information of market conditions what does that mean for consumers it means consumers know about prices and quality in the market and for producers they know about prices they know about technology and costs in the market very important we also assume that firms that profit maximizes meaning firms will produce where MC is equal to Mr let's go straight to the long run equilibrium in perfect competition the long run in perfect competition is defined as when normal profit is being made any profit outside of normal profit is a short run equilibrium in perfect competition normal profit is long run equilibrium there is no tendency for the market to change there and it looks something like this right so we see that there is a market on the left the firm on the right the firm is taking the price from the market and at quantity Q2 there is normal profit being made right we don't understand this at all right now what we need to understand is how supernormal profit and subnormal profit cannot last in the long run why why are they only short run equilibrium and therefore why do we end up here in the long run very interesting how firms behave let's consider that now let's start by understanding how super normal profit is only a short run equilibrium not a long run equilibrium in perfect competition remember whenever we draw these perfect competition diagrams we have to draw the market on the left and the firm on the right because these firms are price take it so we have to show where these guys are getting the price from so let's start by drawing the market we're going to have Supply and demand where the two meet we have an equilibrium price and quantity let's call it P1 and q1 firms are price takers so we're going to take that price of P1 across and that price is going to be the average revenue curve the marginal revenue curve and the demand curve for this individual firm absolutely now we have to show super normal profit to show that we know that average cost is going to be below average revenue average revenue is going to be higher than average cost and that's how we're going to show super normal profit so if we draw um average cost quite far below the average revenue curve like that marginal cost Cuts average cost at its lowest point so let's put that on next lovely great so the crucial thing we have to get average cost drawn correctly in this case below AR this firm is a profit maximizer so they're going to produce what MC is equal to Mr so we have to go there to get a profit maximization quantity let's call that quantity Q2 and at that quantity it should be clear to see the super normal profit we need to compare average revenue and average cost well average revenue is up here at the Red Dot average cost is down here average revenue is greater than average cost the vertical difference there is the unit super normal profit multiply that by quantity Q2 so we take this point across let's call it C1 we're left with a lovely box and we shade that box in that box represents the total area of super normal profit being made by The Firm so there is the total supern normal profit but as we've said this is only a short run position for firms in perfect competition this is not going to last in the long run and why because of two crucial characteristics this profit is going to attract new firms into the market new firms is going to think look at all these wonderful juicy supernormal profits I want a piece of that pie and they can enter why can they enter because there are no to entry and because there is perfect information of market conditions that's why they can enter the market as they enter the market what happens Supply is going to shift to the right as Supply shifts to the right the price is going to fall and that's going to keep happening until there is no more incentive to enter the market I.E until all these super normal profits are taken away and normal profit is left at the end that's the theory very simple to understand that logic the Dynamics of competition but we don't draw it in that order if we draw it in that order things can easily go wrong so the best way to draw this long run adjustment is to go backwards we know from the diagram I showed you before that the long run position is going to be down here right the long run position is going to be there with quantity produced right here you can just learn it as the minimum point of average cost that's going to be a long run quantity there so we need to start backwards let's put our Revenue curves on first so our new Revenue curves are going to be here aren't they they're going to be here at that price so we'll call that a R2 MR2 and D2 that's going to be a lower price of P2 and that lower price would have come from the market here it would have come from there and how would it have come from there supplyer would have shifted right to cut demand here so our new supply curve has got to be parallel and it's got to cut demand there brilliant now we just have to add on our quantities so there's our quantity in the market q1 to Q3 and our profit Max position for the firm now is over here and we ending up at a long run position of Q4 and at that position of Q4 we can see that normal profit is left so new firms enter the market the price will fall and this process will keep happening until there is no more Super normal profit left only normal profit remains that's how super normal profit is only a short run equilibrium it doesn't last in the long run we have to get to normal profit in the long run because there is tendency for new firms to enter until the Super normal profit is taken away what about for subnormal profit let's go the same way so firms that price take is we have to draw the market on the left so we're going to draw supply and demand where the two meet we have an equilibrium price and quantity firms are price takers so we're going to take that price across that's going to be the revenue curves for this firm of A1 mr1 and D1 but now a loss is is going to be made a subnormal profit so average cost has to be drawn above average revenue to look something like that that will be lovely marginal cost has to cut average cost at its lowest point so let's do that next something like that is great this firm is a profit maximizer so let's get that quantity producing what MC is equal to Mr so we'll call that quantity here Q2 and at quany Q2 we need to get our subnormal profit now what do we do we have to compare average revenue and average cost well average revenue is at the Red Dot here average cost is much higher so if we go up here average cost is way up there that is the unit loss average cost higher than average revenue that's the unit loss if we take that point across and call it C1 multiplying that unit loss by all of the units being produced and sold we get the total loss being made by firms we'll call that the subnormal profit that box represents the area of subnormal profit being made the loss total loss that's the short run position but this will not last in the long run let's look at the theory first why won't this last because firms will be incentivized to leave the market and to produce that opportunity cost instead why would you continue if you're making a loss right so go and produce your opportunity cost and make profits that's the idea why can they leave the market well because there are no barriers to exit so it's free it's costly for them to leave the market as they leave the market supply is going to shift left the price is going to be driven up in the market and that's going to keep happening until there is no more incentive to leave I.E until there is normal profit left that's a theory how do we draw the diagram not in that order because it's difficult to draw the diagram correct in that order draw it backwards we know the long run position is going to be there so we can draw our Revenue curves first again so let's draw Revenue curves first and that's going to be at the higher price so we'll call that R2 equal MR2 = D2 so we know they're going to be our Revenue curves that's because the price is going to be higher let's call it P2 we know that the price would have come from the market so let's take it to the market there and we know that that price would have been driven up because Supply would have shifted left in which case it must have cut demand there so we're going to draw a new supply curve shifting left parallel so we have to draw it to look something like that and now we just need to add on our quantities so quantity of Q3 in the market and the profit Max quantity here at Q4 and that is going to show guys that a quantity Q4 at profit Max here normal profit is being made that's the process simple stuff and that's how to get the diagram nailed every single time so we can clearly see why the long run position for firms in perfect competition is going to be over here it's very clear now to understand the diagram I had on before let's now look analyze and evaluate perfect compet comptition using efficiency well let's focus on allocative efficiency knowing that here at Q2 is our long run equilibrium position is that quantity being produced by perfectly competitive firms allocatively efficient when we need to see whether price is equal to marginal cost well there's our price over here there's price and it is equal to marginal cost at quantity Q2 absolutely price is equal to marginal cost so allocative efficiency is being achieved what does that mean it means that resources are perfectly following consumer demand very very important it means that prices are low consumer surplus is high quantity is high choice is high consumers are benefiting from resources following their demand in the exact way that they desire them to is there productive efficiency well at quantity Q2 is the firm operating at the lowest point on that average cost curve well quite clearly yes they are aren't they and that means full exploitation of any economies of scale that there might be in this market so yes productive efficiency is being attained is there efficiency is this firm producing on their average cost curve well by definition if they're productively efficient they must be X efficient as well minimizing waste minimizing cost so we can see here that both allocative and productive are occurring but also of course X efficiency is occurring that means all the three static efficiencies are occurring in perfect competition and all of them have to be achieved because of the nature of competition such intense competition if firms deviate away from these efficiencies they are not going to survive in the market they have to be statically efficient because of the nature of competition but what's clear to see is that in the long run there is no super normal profit and therefore these firms cannot be dynamically efficient they don't have the profit in the long run to reinvest back into the company and therefore consumers may not see brand new Innovative products over time new technologies um producers will not be able to lower their cost through newer Technologies over time so we see uh the market not really progressing forward through Innovation because of a lack of dynamic efficiency so statically efficient but not dynamically efficient that covers perfect competition guys this is a quite simple conclusion there is a video later in this playlist where we discuss competitive markets in far more detail it's very important you watch that video to elaborate on everything we've learned here so make sure you watch that as that video comes in this playlist thank you so much for watching guys I'll see you all in the next video