Question

4. Economists believe that competition promotes efficiency and that without competition, costs rise and resources are wasted.

a. Discuss the perfectly competitive model. What assumptions are made about the firms in the industry, the ease of entry and exit into the market and the degree of product specialization?

b. It is said that in the long run, in perfectly competitive markets, price will equal minimum average cost. Explain why this is so.

Answer 1

Perfect competition means that that the competition is impersonal.

a)

The features of perfect competition are:

1. Large Number of Sellers and Buyers: The number of buyers and sellers are large. No buyer or seller can influence the price. The producers are price takers.
2. Products are identical. The products are homogeneous.
3. Perfect information. The buyers have perfect information about the products being sold and prices charged.
4. Perfect mobility of resources like labor
5. Entry and exit from the industry happens freely.

b) It is said that in the long run, in perfectly competitive markets, price will equal minimum average cost. Explain why this is so.

In the long run, a competitive firm is in equilibrium when MR=MC=AC. It will produce that output where LMC=LAC. Because if P is less than AC, the firm is suffering a loss.

Long term equilibrium of the perfectly competitive firm promotes allocative and productive efficiency. Allocative efficiency because P=MC. Price is the willingness to pay by a consumer, which is the social benefit. MC is the cost to the producer, which is the social cost of producing the good. Allocative efficiency occurs when social benefit equals social cost. Allocative efficiency means that resources are used most efficiently in an economy.

Productive efficiency occurs in perfect competition, because P=minimum ATC. This means the goods are produced at the lowest cost. When a firm is producing at the lowest minimum ATC then the firm is earning normal profits. If P> minimum ATC, then firm is making economic profit and other firms will enter the industry. If P< minimum ATC, then the firm is incurring a loss in the long run. Firms will exit the industry.