Market Power & Perfect Competition (HL IB Economics)

Revision Note

Market Power in Perfect Competition

  • Market power refers to the ability of a firm to influence and control the conditions in a specific market, allowing them to have a significant impact on price, output, and other market variables
     

ibdp-economics---levels-of-competition-and-concentration-in-different-structures

The level of market power is low in perfect competition
  

  • Firms in perfect competition have low market power, low market share and a low industry concentration ratio

  • There is little market failure in perfectively competitive industries

    • This is why governments try to encourage more competition in every sector in their economy
       

Diagrammatic Representation of Perfect Competition

  • In order to maximise profit, firms in perfect competition produce up to the level of output where marginal cost = marginal revenue (MC=MR)

  • The firm does not have any market power so it is unable to influence the price & quantity

    • The firm is a price taker due to the large number of sellers

    • The firm's selling price is the same as the market price, P1 = MR = AR = Demand

3-4-2-individual-firm-_-market_edexcel-al-economics

A diagram that illustrates how an individual firm in perfect competition has to accept the market/industry price (P1)

  • In the short-run, firms can make abnormal profit or losses in perfect competition

  • However, they will always return to the long-run equilibrium where they make normal profit

Abnormal Profit in Perfect Competition in the Short-run

  • Firms in perfect competition are able to make abnormal profit in the short-run

  • The MC curve is the supply curve of the firm
     

3-4-2-short-run-profit-maximisation_edexcel-al-economics

A diagram illustrating a perfectly competitive firm making abnormal profit in the short-run as the AR > AC at the profit maximisation level of output (Q1)

 

Diagram Analysis

  • The firms is producing at the profit maximisation level of output where MC=MR (Q1)

    • At this point the AR (P1) > AC (C1)

    • The firm is making abnormal profit equals space left parenthesis straight P subscript 1 space minus space straight C subscript 1 right parenthesis space cross times space straight Q subscript 1

Moving from Abnormal Profit in the Short-run to Normal Profit in the Long-run

  • If firms in perfect competition make abnormal profit in the short-run, new entrants are attracted to the industry

    • They are incentivised by the opportunity to make supernormal profit

    • There are no barriers to entry

      • It is easy to join the industry

3-4-2-moving-from-profit-to-lr-equilibrium_edexcel-al-economics

A diagram illustrating how new entrants shift the industry supply curve to the right (S1→S2 ) which changes the industry price from P1→P2. The firm can now only sell its products at P2 and abnormal profits are eliminated

Diagram Analysis

  • The firm is initially producing at the profit maximisation level of output where MC=MR (Q1)

    • At this level of output, the AR (P1) > AC (P2) & the firm is making abnormal profit

  • Incentivised by profit, new entrants join the industry & supply increases from S1→S2

    • Overall quantity in the industry increases from Q1→Q2

    • The industry price falls from P1→P2

  • The firm now has to sell its products at the industry price of P2

    • The output of the firm falls from Q1→Q2 as it now has a smaller market share of the larger industry

  • At the profit maximisation level of output (MC=MR) the firm is now producing at the point where AR= AC

    • The firm is making normal profit

  • In the long-run, firms in perfect competition always make normal profit

    • Firms making a loss leave the industry

    • Firms making abnormal profit see them slowly eradicated as new firms join the industry

Losses in Perfect Competition in the Short-run

  • Firms in perfect competition are able to make losses in the short-run
     

3-4-2-short-run-losses_edexcel-al-economics

A diagram illustrating a perfectly competitive firm making losses in the short-run as the AR < AC at the profit maximisation level of output (Q1) 

Diagram Analysis

  • The firms are producing at the profit maximisation level of output where MC=MR (Q1)

    • At this level of output, the AR (P1) < AC (C1)

    • The firm's loss is equivalent to space left parenthesis straight P subscript 1 space minus space straight C subscript 1 right parenthesis space cross times space straight Q subscript 1

Moving from Loss in the Short-run to Normal Profit in the Long-run

  • If firms in perfect competition make losses in the short-run, some will shut down

    • The shut down rule will determine which firms shut down

    • There are no barriers to exit, so it is easy to leave the industry
       

3-4-2-moving-from-losses-to-lr-equilibrium_edexcel-al-economics

A diagram illustrating how firms leaving the industry shift the industry supply curve to the left (S1→S2 ) which changes the industry price from P1→P2. The firm can now sell its products at P2 which returns it to a position of normal profit
 

Diagram Analysis

  • The firm is initially producing at the profit maximisation level of output where MC=MR (Q1)

    • At this level of output, the AR (P1) < AC (C1) & the firm is making a loss

  • Some firms leave the industry & supply decreases from S1→S2

    • Overall quantity in the industry falls from Q1→Q2

    • The industry price increases from P1→P2

  • The firm now has to sell its products at the industry price of P2

    • The output of the firm increases from Q1→Q2 as it now has a larger market share of the smaller industry

  • At the profit maximisation level of output (MC=MR) the firm is now producing at the point where AR= AC

    • The firm is making normal profit

  • In the long-run, firms in perfect competition always make normal profit

    • Firms making a loss leave the industry

    • Firms making supernormal profit see them slowly eradicated as new firms join the industry

Efficiency in Perfect Competition

  • Allocative efficiency occurs at the level of output where average revenue = marginal cost (AR = MC)

    • At this point, resources are allocated in such a way that consumers & producers get the maximum possible benefit

    • No one can be made better off without making someone else worse off

    • There is no excess demand or supply
       

  • Productive efficiency occurs at the level of output where marginal cost = average cost (MC=AC)

    • At this point average costs are minimised

    • There is no wastage of scarce resources & a high level of factor productivity
       

2-11-1-perfect-competition

A perfectly competitive market benefits from both productive and allocative efficiency in the long-run
   

Diagram Analysis

  • The firm produces at the profit maximisation level of output where MC=MR (Y)

  • The firm is productively efficient as MC=AC at this level of output

  • The firm is allocatively efficient as AR (P)=MC

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