IB Economics: Perfect competition

IB Economics: Perfect competition

For all the market structures, the IB syllabus requires you to describe with examples the assumed characteristics of it. Keep in mind that they are all theoretical models, and some may not occur in real life, but it provides economists with a valuable tool for evaluting the resource allocation and efficiency of more realistic market models.

There are 4 main types of market structures, the perfect competition model obviously being part of the perfectly competitive market; while the monopolistically competitive, oligopolistic and monopolist model are imperfectly competitive markets.

By definition, a market is perfectly competitive if there are a large number of firms producing identical products facing identical costs of production and in which there are no barriers to entry or exit.

Assumptions of the perfect competition model:

• A very large number of firms
• Selling identical, homogenous products (the products are not differentiated meaning that they are perfect substitutes for each other) with similar prices due to sellers having no market power
• There is freedom of entry and exit, i.

  e. low or no barriers to entry

• Perfect information
• Perfect resource

First lets familiarise ourselves with an example: watermelon trucks in Shanghai, China during October. The trucks flood in from rural areas where the fresh watermelons are picked in thousands, each oaded with freshly harvested watermelons. Due to the sudden surge in supply, the prices of the watermelons will be lower than the other 11 typical months. As a result, during this brief period of time, the watermelon market in Shanghai becomes effectively perfectly competitive.

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Although examples of such market structure are rare, markets with some of the listed characteristics do exist in certain industries, e.g. certain aggricultural commodities, low-skilled labour… they are all markets in which there are many firms producing nearly identical products or millions households supplying an identical resource.

The individual firms produce a very small proportion of the overall supply of the product that altering their own output has no influence/ any significant impact over the market price of the product. In this regard, the sellers in such an industry/ market are price-takers. This means that they find it difficult or impossible to alter the price: raising the charges higher than the market equilibrium price would mean losing consumers to competitors while offering their output at a lower price would also be unsuccessful since competition, forces the prices of the producers, down to a minimum/ lowest average total cost.

Assuming there are no spillover effects in both the product and consumption of the product, perfectly competitive markets result in the most socially optimal level of output and price when compared with the other market structures. The market is in the state of the Pareto Optimal in which shortages or surpluses are non-existent as the market is allocatively efficient. This is because the high level of competition ensures that the marginal social benefit align with the social marginal cost and neither too much or too little will be produced. It achieves perfect efficiency, and provides evidence that efficiency decreases as markets become less competitive. The price-making power of less competitive firms result in a level of output that is lower than and a price that is higher than that achieved under perfect competition, market-wise.

A perfectly competitive firm seeking to maximize profits must examine both its short-run costs and revenues. The revenue a firm in a perfectly competitive market earns depends on 2 factors: the price its output are sold for and the quantity of output it sells. Since they are price-takers, the price they sell at is the market equilibrium prices determined by the market, graphically there is a perfectly elastic demand line as drawn out horizontally from the equilibrium price.

Since production is only possible in the short run (refer to notes previously), it is only possible for perfectly competitive firms to make an economic profit in the short run. TR is maximized when MR=0. While following the profit-maximization rule, producing at the level where MC=MR, although it doesn’t guarantee maximized profits, but if a firm is at loss, it minimizes the loss. Assume at quantity Q1, profits are maximized. At any level of output below Q1, MR (in the case of a perfectly competitive firm, it is the market equilibrium price) would > MC hence the firm’s total profits would increase if an additional unit is produced. Beyond Q1, the MC > MR, the last unit produced costs the firm more than it adds to revenue and since the firm is earning losses on the margin, it would need to reduce its losses by reducing its output back to Q1. Whether a profit is made depends on the firm’s average total cost of production, i.e. a profit is obtained when P (AR) > ATC. The profit or loss can be calculated from the area of the rectangle: Q1* (difference between market equilibrium price and the price corresponding to ATC by Q1)