If real world markets can be made to resemble more closely the model
of perfect competition, economic efficiency will improve. Explain why
Perfect competition is generally regarded as economically more efficient?
"If real world markets can be made to resemble more closely the model
of perfect competition, economic efficiency will improve."
a) Explain why Perfect competition is generally regarded as
economically more efficient? (20 marks)
The model of perfect competition describes market where there is a
high degree of competition. The word "perfect" does not mean that this
form of competition produces ideal results or maximises economic
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One that might is agriculture. In
agriculture there is a large number of farmers supplying the market,
none of whom is large enough to influence price. It is easy to buy a
farm and set up in business. It is equally easy to sell a farm and
leave the industry. Farmers on the whole possess perfect knowledge.
They know what prices prevail in the market, for instance from the
farming press. Finally farmers produce a range of homogenous products.
King Edwards's potatoes from one farm are indistinguishable from King
Edwards's potatoes from another. In Europe and in many countries
around the world, farming is in certain instances not a perfectly
competitive market. This is because governments may interfere in the
market, buying and selling to fix a price.
Perfect competition is generally regarded as economically more
efficient. There are a number of reasons for this; some are an
expansion of the points I outlined above.
It is an assumption of the model of perfect competition that there is
a large number of sellers in the market. If one of thee firms decides
to double its output then the industry supply curve will shift to the
right. However the shift will be very small, because the firm is very
small, so the resulting change in price and demand will be so small it
will be impossible to determine the effect the change has had. This is
shown by the diagram below.
Using the example again of farming, if one farmer were to double his
wheat output, it would have little effect on price and demand. If all
the farmers where to double their output, the price of wheat would
collapse. In other words, a firm in perfect competition can therefore
expand or contract its output without changing price. Put another way,
the firm cannot choose to raise its price and expect to sell more of
its product. It can lower its price there is no advantage to this
since it can sell its entire output at the higher market price. The
demand curve for the individual firm is therefore horizontal.
Therefore, the market is efficient, because the price and quantities
in the market are very stable.
In the short run, a firm will not necessarily shut down if it makes a
loss. It will only cease production if its revenue fails to meet its
average variable cost. This is shown on the diagram below.
In perfect competition it is assumed that firms are short run profit
maximisers. So the firms will produce at a level of output where
marginal cost equals marginal revenue. The price it charges is fixed
by the market because the individual firm is a price taker. The
diagrams below show this situation. Fig3 shows the firm producing at
its profit maximising equilibrium level of output OG where MC=MR.
Because AR is greater than AC, it makes an abnormal profit of EFGH.
Fig 4 show the firm producing at its profit maximisng equilibrium
level of output OQ where MC=MR. In this case, because AR is less tan
AC, it will make a loss shown by EFGH.