16. Perfect Competition (1) 1. Assumptions of Perfect Competition Read the following extract on the wheat market, and then decide between the answers provided for the characteristics of a perfectly competitive market, by circling the correct answer. ‘The wheat market is perhaps the best example of a competitive market. A large number of firms produce an almost identical good to an equally large number of buyers. Information provided is substantial, so it is difficult for any one firm to influence prices significantly. Over the past 30 years, a large number of new grain providers have emerged, particularly in the developing world, who see the industry as one in which they can compete strongly.’ 1.1 Number of firms Many Single supplier 4-5 big firms 1.2 Firms are price Makers Takers Inelastic 1.3 The goods produced are Luxuries Homogenous Differentiated 1.4 Knowledge within the market is Perfect Limited Purchased 1.5 Barriers to entry are Very high Very low Variable 1.6 Competition within the market is Non-existent Regulated Very high 2. Perfectly competitive? Given your findings above, do you think these markets are somewhere close to being perfectly competitive? Circle this which you think exhibit some of the characteristics you have identified. Banking Pharmaceuticals Supermarkets Street food vendors Taxi Services Computer software Foreign exchange providers Rice 3. Short-run Equilibrium The equilibrium position of a perfectly competitive firm is influenced heavily by the assumptions identified above. Due to the large number of firms present in the market, individual firms will face a perfectly elastic demand curve (any movement above the market price will see demand fall to zero as consumers switch to other producers). Remembering that firms are price takers, use the market diagram provided to produce a cost/revenue diagram for a firm under perfect competition (ensure that the lowest part of the AC curve is below the AR curve). 3.1 Where will the firm maximise profits? Label this point on your diagram, and define the profit maximising level of output for the firm. ______________________________________________________________________________________ ______________________________________________________________________________________ 3.2 What area represents total revenue for the firm? What area represents total cost for the firm? ______________________________________________________________________________________ ______________________________________________________________________________________ 3.3 Shade the area of abnormal profit for the firm. ______________________________________________________________________________________ ______________________________________________________________________________________ 3.4 Given that the firms in this market are making abnormal profit, what incentive does this provide? ______________________________________________________________________________________ ______________________________________________________________________________________ www.a-zbusinesstraining.com 16. ANSWERS: Perfect Competition (1) 1.1 Number of firms Many Single supplier 4-5 big firms 1.2 Firms are price Makers Takers Inelastic 1.3The goods produced are Luxuries Homogenous Differentiated 1.4 Knowledge within the market is Perfect Limited Purchased 1.5 Barriers to entry are Very high Very low Variable 1.6 Competition within the market is Non-existent Regulated Very high 2. Banking Street food vendors Pharmaceuticals Supermarkets Taxi Services Foreign exchange providers Computer software Rice 3. MC AC E X C O Q1 3.1 The firm will maximise profits when MC=MR (point E on diagram). This defines the profit maximising level of output at Q1. 3.2 Total revenue is the area OP*E Q1. Total cost is equal to the area OXC Q1. 3.3 The area of abnormal profit is XP*EC (shaded in diagram). 3.4 Abnormal profit in this market will attract new firms to enter the market. This is made possible by the lows barriers to entry and perfect knowledge that exists in this market. Abnormal profit will not be retained in the longrun, as new firms enter to erode it away. www.a-zbusinesstraining.com