Perfect Competition

You are expected to explain/analyze (AO2) the characteristics of a perfect competition, draw (AO4) the perfect competition diagrams, and evaluate/examine (AO3) the effect it has on allocative efficiency (HL)

<-- Back to Micro

<- Back to 2.11

Rational Producer Behavior

Perfect Competition

Monopolistic Competition

Oligopoly

Monopoly

Strengths & Weaknesses

There are 4 different types of market structure the IB syllabus lists:

Characteristics of a Perfect Competition (AO2)

A market with perfect competition has the following characteristics:

Many firms
Undifferentiated products: The goods and services the firms offer are completely identical to one another, so customers can easily switch
No barriers to entry: It is free to enter the market as a new business
No market power: Each firm controls such a small amount of the market that they don't have any control
Firms are price takers: Because no firm has control, they are forced to take the equilibrium price determined by buyers and sellers (they can't just set their own price)

Perfect Competition Diagram (AO4)

The Perfect Competition diagram features various variables:

AR: Average Revenue: The average amount of money the sale of a product generates for the firm. It is the same as the price of the product, and works as the demand line on the diagram.
MR: Marginal Revenue: The extra amount of revenue the sale of one additional product brings.
AC: Average Cost: Pretty self-explanatory. Its slope is like a parabola, and its minimum is always where it intersects with MC
MC: Marginal Cost: The extra amount of costs the production of one additional product brings. Its slope is like a hockey stick, and intersects AC where it is at its minimum

There are three forms of the perfect competition diagram you need to know how to draw:

When the firm is making normal profit (Costs = Revenue)
When the firm is making a loss (Costs > Revenue)
When the firm is making abnormal profit (Costs < Revenue)

While it may look intimidating, here are the key things you need to remember:

MC is in the shape of a hockey stick
MR, D, and AR are all represented by the same horizontal line
Firms produce (Q) where MC intersects the MR line
AC is a parabola with an upwards concave
The height of AC at Q indicates how expensive the product is to make

In the short run, perfect competition may experience losses or abnormal profits

A loss is when the firm has higher costs (AC) than revenue (AR)
Abnormal profit is when the firm has higher revenue (AR) than costs (AC)

However, in the long run, these losses and abnormal profits correct themselves and revert back to "normal profit" (revenue = cost):

Allocative Efficiency (AO3)

Allocative efficiency occurs when all goods and services are optimally distributed
The output of goods and services match the social optimum amount
This occurs when P = MC
As seen in the main diagram above, this does occur in perfect competition, due to the abundance of firms, lack of market power, and non-existent barriers to entry
Hence, perfect competition is a desired scenario in many markets, as it means the amount of product produced will exactly match what is best for society, at the best price for both consumers and producers

However, not every market is a perfect competition, in fact, most are not. This leads to market failure, and is discussed on their respective pages (monopoly, monopolistic, oligopoly)

Google Sites

Report abuse