Efficiency of Perfectly Competitive Economies
Efficiency of Perfectly Competitive Economies
When we talk about perfect competition we mean a market structure that leave firms in a unique brand of competition. In fact a firm does not actually compete under perfect competition, it reacts to the market conditions, taking price and other market factors as beyond its control. A market is a perfect competition if it meets four basic criteria. The product of all sellers must be identical. All participants in the market, buyers, sellers, must be small relative to the entire market. As a result there should be many firms and buyers in the market. There are no barriers to entry or exit to the market. Firms can enter and leave as they wish. Fourthly market participants have perfect knowledge of and access to technology and prices.
When a firm fulfils these criteria it can then be categorised as a price taker. Those firms who are unconcerned about there competitors, because there is nothing they can do to influence there own behaviour, that of their rivals or the final market outcome. As shown in Fig 1 the price takers demand curve is perfectly horizontal. At the market price Pm the firm can sell as much as it wants of a specific product. The firm has no incentive to lower prices as it can sell all it wants at the market price. Furthermore the firm as no ability to raise price as potential customers would buy the same product elsewhere. The firm there for has no alternative but to sell at Pm , at which it face an infinite price elasticity of demand.
The question asks what will happen in the long run when price exceeds short run average cost. We must first determine the objective of the firm, - profit maximisation. Any typical firm will set production where marginal revenue equals marginal cost. A perfectly competitive firm however, taking into account the relationship between marginal revenue and price will achieve profit maximisation by setting output where marginal cost equals price. The profit maximising firm in perfect competition will produce where P=MC We can see the firms production condition by showing marginal cost, average cost and variable costs curves on the firms demand curve. As depicted in Figure 2. The figure uses short run cost curves as production decisions occur in the short term.
It is important to realise that firms adjust differently...