Y2 13) Perfect Competition

Summary

The video explains the characteristics of perfect competition, a theoretical market structure. It covers how firms act as price takers, the absence of barriers to entry and exit, and the assumption of perfect information. The script details the short-run dynamics of supernormal and subnormal profits and why they cannot persist in the long run. It also evaluates efficiency in perfect competition, highlighting the achievement of allocative, productive, and X-efficiency but noting the absence of dynamic efficiency due to the lack of supernormal profits for reinvestment.

Takeaways

• 📚 A perfectly competitive market is a theoretical construct used to assess the efficiency of real-world market structures.
• 🏪 Characteristics of perfect competition include many buyers and sellers, homogeneous products, price takers, no barriers to entry or exit, and perfect information.
• 💰 Firms in perfect competition are price takers, meaning they cannot influence the market price and must accept it.
• 🔄 The long-run equilibrium in perfect competition is where firms make a normal profit, which is the benchmark for market stability.
• 📉 Supernormal profits in the short run attract new firms, increasing supply and driving prices down until only normal profit remains.
• 📈 Subnormal profits incentivize firms to exit the market, reducing supply and allowing prices to rise until normal profit is achieved.
• 📊 In long-run equilibrium, firms produce at the minimum point of the average cost curve, indicating productive efficiency.
• 💼 Perfect competition achieves allocative efficiency as the market price equals marginal cost, ensuring resources are allocated according to consumer demand.
• 🔄 X-efficiency is also achieved in perfect competition, with firms minimizing waste and operating at the lowest possible cost.
• 🚀 However, perfect competition lacks dynamic efficiency as firms do not earn supernormal profits to reinvest in innovation or technology.

Q & A

What is the primary purpose of studying perfect competition as a theoretical model?

The primary purpose of studying perfect competition is to assess the efficiency of real-world market structures as a benchmark. It helps in understanding market dynamics and the conclusions that can be drawn about market efficiency.

What are the key characteristics of a perfectly competitive market structure?

The key characteristics of a perfectly competitive market include a large number of buyers and sellers, firms selling homogeneous goods, price takers with no ability to set prices, no barriers to entry or exit, and perfect information for both consumers and producers.

Why are firms in a perfectly competitive market considered price takers?

Firms in a perfectly competitive market are considered price takers because they have no power to influence the market price. They must accept the price determined by the market and cannot set their own prices without losing all demand.

How does the entry of new firms affect the market in the long run?

The entry of new firms increases the supply in the market, which shifts the supply curve to the right. This causes the market price to fall until there is no more incentive for new firms to enter, i.e., until all supernormal profits are eliminated, and only normal profits remain.

What is the definition of long-run equilibrium in perfect competition?

In perfect competition, the long-run equilibrium is defined as the point where firms are making only normal profit. This is where there is no tendency for the market to change, as any supernormal or subnormal profits have been eliminated.

Why can't supernormal profits persist in the long run in a perfectly competitive market?

Supernormal profits cannot persist in the long run because they attract new firms to enter the market due to the potential for high profits. As new firms enter, the supply increases, causing the market price to fall until only normal profits are left.

How does the exit of firms affect the market when they are making subnormal profits?

When firms are making subnormal profits, they are incentivized to leave the market to avoid losses. As firms exit, the supply decreases, which shifts the supply curve to the left and drives the market price up until only normal profits are left.

What is allocative efficiency, and how is it achieved in a perfectly competitive market?

Allocative efficiency is achieved when the market quantity produced is such that the price equals the marginal cost. In a perfectly competitive market, allocative efficiency is achieved at the long-run equilibrium where price equals marginal cost, ensuring resources are allocated according to consumer demand.

What is productive efficiency, and how is it demonstrated in a perfectly competitive market?

Productive efficiency occurs when a firm operates at the lowest point on its average cost curve, fully exploiting any economies of scale. In a perfectly competitive market, productive efficiency is demonstrated when firms produce at the minimum point of their average cost curve.

Why are firms in a perfectly competitive market not dynamically efficient in the long run?

Firms in a perfectly competitive market are not dynamically efficient in the long run because they only make normal profits, which do not provide the extra capital needed for reinvestment into the company for innovation or cost reduction through new technologies.

Outlines

00:00

📈 Perfect Competition Market Structure

This paragraph introduces the concept of perfect competition as a theoretical benchmark for assessing real-world market structures. It outlines the characteristics of a perfectly competitive market, including a large number of buyers and sellers, the sale of homogeneous goods, and the inability of firms to set prices (price takers). The paragraph also discusses the absence of barriers to entry and exit, perfect information among consumers and producers, and the assumption that firms aim to maximize profits by producing where marginal cost equals marginal revenue. The long-run equilibrium in perfect competition is defined as the point where only normal profit is made, which is the focus of the analysis.

05:01

🔄 Dynamics of Supernormal and Subnormal Profits in Perfect Competition

The second paragraph delves into the dynamics of supernormal and subnormal profits in a perfectly competitive market. It explains that supernormal profits attract new firms, leading to an increase in supply and a subsequent decrease in prices until only normal profits remain. Conversely, subnormal profits incentivize firms to exit the market, reducing supply and increasing prices until normal profits are restored. The paragraph emphasizes the importance of drawing diagrams in reverse order to accurately depict the long-run adjustments in the market. It concludes by illustrating how supernormal and subnormal profits are short-run equilibria that cannot persist in the long run due to the entry and exit of firms.

10:01

📊 Evaluating Perfect Competition Through Efficiency

The final paragraph evaluates perfect competition in terms of allocative, productive, and X-efficiency. It confirms that in the long-run equilibrium of perfect competition, allocative efficiency is achieved as price equals marginal cost, ensuring resources follow consumer demand optimally. Productive efficiency is also attained as firms operate at the lowest point on their average cost curve, fully exploiting economies of scale. X-efficiency is implied as firms minimize waste and costs. However, the paragraph points out that while static efficiencies are achieved, dynamic efficiency is lacking in the long run due to the absence of supernormal profits, which are necessary for reinvestment and innovation. The conclusion highlights the trade-off between static and dynamic efficiency in perfectly competitive markets.

Keywords

💡Perfect Competition

Perfect competition is a theoretical market structure where there are numerous buyers and sellers, all selling identical products, and no single entity can influence the market price. In the video, this concept is used as a benchmark to assess the efficiency of real-world market structures. It's important because it sets the stage for understanding how firms behave and how markets reach equilibrium in an idealized setting.

💡Homogeneous Goods

Homogeneous goods are products that are identical in every way, making them indistinguishable from one another. In the context of the video, this means that firms in a perfectly competitive market sell goods that are so similar that consumers do not differentiate between them, leading to firms being price takers rather than price setters.

💡Price Takers

Price takers are firms in a market that have no control over the price of their goods or services; they must accept the market price. The video explains that in perfect competition, every firm is a price taker because the market is so saturated with identical goods that any attempt to set a different price would result in losing all customers.

💡Barriers to Entry and Exit

Barriers to entry and exit refer to the costs or restrictions that prevent firms from freely entering or leaving a market. The video mentions that in perfect competition, there are no such barriers, allowing firms to enter or exit the market freely, which is a key factor in how the market reaches equilibrium.

💡Perfect Information

Perfect information in a market means that all participants have complete knowledge of prices, quality, and other relevant factors. The video emphasizes that in a perfectly competitive market, consumers and producers have perfect information, which contributes to the efficiency of the market by ensuring that decisions are based on complete knowledge.

💡Profit Maximization

Profit maximization is the economic concept where firms aim to produce at the point where marginal cost equals marginal revenue to achieve the highest possible profit. The video explains that firms in perfect competition are profit maximizers, producing where their marginal cost (MC) equals marginal revenue (MR).

💡Long-Run Equilibrium

Long-run equilibrium in a market occurs when no firm is making a supernormal profit, and all firms are earning a normal profit. The video discusses how in perfect competition, the long-run equilibrium is characterized by firms making only a normal profit, indicating that the market has adjusted to a stable state where no firm has an incentive to enter or leave.

💡Supernormal Profit

Supernormal profit is a profit that exceeds the normal profit, which is the minimum return that a firm expects to cover all its costs including a return on investment. The video uses the concept of supernormal profit to explain how new firms are attracted to a market when existing firms are making such profits, leading to an increase in supply and a decrease in prices until only normal profit remains.

💡Subnormal Profit

Subnormal profit, also known as a loss, occurs when a firm's total revenue is less than its total cost. The video explains that in perfect competition, subnormal profit leads to firms exiting the market, as they seek to avoid losses, which in turn reduces supply and increases prices until only normal profit is left.

💡Allocative Efficiency

Allocative efficiency is achieved when the allocation of goods and services in an economy is such that the marginal cost of producing an additional unit is equal to the price consumers are willing to pay. The video discusses how perfect competition achieves allocative efficiency because the market price equals marginal cost, ensuring that resources are allocated according to consumer demand.

💡Productive Efficiency

Productive efficiency occurs when a firm produces at the lowest possible cost. The video explains that in perfect competition, firms operate at the lowest point on their average cost curve, indicating that they are productively efficient, utilizing resources in the most cost-effective way.

💡X-Efficiency

X-efficiency refers to the efficiency of a firm beyond just producing at the lowest cost, including minimizing waste and maximizing productivity. The video suggests that firms in perfect competition are X-efficient because they must minimize costs to survive in such a competitive environment.

💡Dynamic Efficiency

Dynamic efficiency relates to a firm's ability to innovate and improve over time. The video points out that while perfect competition ensures static efficiency, it does not guarantee dynamic efficiency, as firms in the long run only make normal profits and may lack the resources to invest in innovation.

Highlights

Perfect competition is a theoretical extreme used as a benchmark for assessing real-world market structures.

In a perfectly competitive market, there are infinite buyers and sellers, leading to intense competition.

Firms in perfect competition sell homogeneous goods and services, making them price takers.

Price takers cannot set their own prices and must match the market price.

There are no barriers to entry or exit in perfect competition, allowing free movement of firms.

Perfect information exists, meaning consumers and producers are well-informed about market conditions.

Profit-maximizing firms produce where marginal cost equals marginal revenue.

Long-run equilibrium in perfect competition is defined by the presence of normal profit.

Supernormal profits in the short run attract new firms, leading to a shift in supply and a decrease in prices.

Subnormal profits incentivize firms to leave the market, causing supply to shift left and prices to rise.

Allocative efficiency is achieved when price equals marginal cost in perfect competition.

Productive efficiency is present when firms operate at the lowest point on their average cost curve.

X-efficiency occurs as firms minimize waste and costs to survive intense competition.

Perfect competition is statically efficient but lacks dynamic efficiency due to the absence of supernormal profits.

The lack of dynamic efficiency may hinder innovation and technological advancements in the long run.

Understanding perfect competition is crucial for evaluating the efficiency of real-world market structures.

Transcripts

hi everybody perfect competition a

theoretical extreme we're not trying to

say it's a realistic Market structure

but very important to assess the

efficiency of Real World Market

structures as a benchmark here so

therefore it's very important that we

understand this really well and we

understand the conclusions we get at the

end let's understand this Market

structure by looking at characteristics

first we'll then go to how firms behave

on diagrams will then evaluate using

efficiency at the end so what are the

characteristics of a perfectly

competitive market structure well there

are many buys and sellers in truth

infinite buyers and sellers very very

intense extreme competition here each

firm is selling homogeneous goods and

services that means identical goods and

services and for that reason firms are

price takers they have no ability to set

their own prices if a new firm enters

the market they have to charge the price

that's being charged by all other firms

in the market they take the price from

the Market here they can't set their

price if they try and raise the price

above the market price they're going to

lose all their demand no customers at

all if they reduce their price what a

silly thing to do they're going to lose

revenue and lose profit without gaining

anything in the process so firms are

price takers taking the price from the

market there are no barriers to entry

and exit so any firm that wants to enter

or exit the market can do so freely

without any cost whatsoever there is

perfect information of market conditions

what does that mean for consumers it

means consumers know about prices and

quality in the market and for producers

they know about prices they know about

technology and costs in the market very

important we also assume that firms that

profit maximizes meaning firms will

produce where MC is equal to Mr let's go

straight to the long run equilibrium in

perfect competition the long run in

perfect competition is defined as when

normal profit is being made any profit

outside of normal profit is a short run

equilibrium in perfect competition

normal profit is long run equilibrium

there is no tendency for the market to

change there and it looks something like

this right so we see that there is a

market on the left the firm on the right

the firm is taking the price from the

market and at quantity Q2 there is

normal profit being made right we don't

understand this at all right now what we

need to understand is how supernormal

profit and subnormal profit cannot last

in the long run why why are they only

short run equilibrium and therefore why

do we end up here in the long run very

interesting how firms behave let's

consider that now let's start by

understanding how super normal profit is

only a short run equilibrium not a long

run equilibrium in perfect competition

remember whenever we draw these perfect

competition diagrams we have to draw the

market on the left and the firm on the

right because these firms are price take

it so we have to show where these guys

are getting the price from so let's

start by drawing the market we're going

to have Supply and demand where the two

meet we have an equilibrium price and

quantity let's call it P1 and q1 firms

are price takers so we're going to take

that price of P1 across and that price

is going to be the average revenue curve

the marginal revenue curve and the

demand curve for this individual firm

absolutely now we have to show super

normal profit to show that we know that

average cost is going to be below

average revenue average revenue is going

to be higher than average cost and

that's how we're going to show super

normal profit so if we draw um average

cost quite far below the average revenue

curve like that marginal cost Cuts

average cost at its lowest point so

let's put that on next lovely great so

the crucial thing we have to get average

cost drawn correctly in this case below

AR this firm is a profit maximizer so

they're going to produce what MC is

equal to Mr so we have to go there to

get a profit maximization

quantity let's call that quantity Q2 and

at that quantity it should be clear to

see the super normal profit we need to

compare average revenue and average cost

well average revenue is up here at the

Red Dot average cost is down here

average revenue is greater than average

cost the vertical difference there is

the unit super normal profit multiply

that by quantity Q2 so we take this

point across let's call it C1 we're left

with a lovely box and we shade that box

in that box represents the total area of

super normal profit being made by The

Firm so there is the total supern normal

profit but as we've said this is only a

short run position for firms in perfect

competition this is not going to last in

the long run and why because of two

crucial characteristics this profit is

going to attract new firms into the

market new firms is going to think look

at all these wonderful juicy supernormal

profits I want a piece of that pie and

they can enter why can they enter

because there are no to entry and

because there is perfect information of

market conditions that's why they can

enter the market as they enter the

market what happens Supply is going to

shift to the right as Supply shifts to

the right the price is going to fall and

that's going to keep happening until

there is no more incentive to enter the

market I.E until all these super normal

profits are taken away and normal profit

is left at the end that's the theory

very simple to understand that logic the

Dynamics of competition but we don't

draw it in that order if we draw it in

that order things can easily go wrong so

the best way to draw this long run

adjustment is to go backwards we know

from the diagram I showed you before

that the long run position is going to

be down here right the long run position

is going to be there with quantity

produced right here you can just learn

it as the minimum point of average cost

that's going to be a long run quantity

there so we need to start backwards

let's put our Revenue curves on first so

our new Revenue curves are going to be

here aren't they they're going to be

here at that price so we'll call that a

R2

MR2 and

D2 that's going to be a lower price of

P2 and that lower price would have come

from the market here it would have come

from there and how would it have come

from there supplyer would have shifted

right to cut demand here so our new

supply curve has got to be parallel and

it's got to cut demand

there brilliant now we just have to add

on our quantities so there's our

quantity in the market q1 to Q3 and our

profit Max position for the firm now is

over here and we ending up at a long run

position of Q4 and at that position of

Q4 we can see that normal profit is left

so new firms enter the market the price

will fall and this process will keep

happening until there is no more Super

normal profit left only normal profit

remains that's how super normal profit

is only a short run equilibrium it

doesn't last in the long run we have to

get to normal profit in the long run

because there is tendency for new firms

to enter until the Super normal profit

is taken away what about for subnormal

profit let's go the same way so firms

that price take is we have to draw the

market on the left so we're going to

draw supply and demand where the two

meet we have an equilibrium price and

quantity firms are price takers so we're

going to take that price across that's

going to be the revenue curves for this

firm of

A1 mr1 and D1 but now a loss is is going

to be made a subnormal profit so average

cost has to be drawn above average

revenue to look something like that that

will be lovely marginal cost has to cut

average cost at its lowest point so

let's do that next something like that

is great this firm is a profit maximizer

so let's get that quantity producing

what MC is equal to Mr so we'll call

that quantity here Q2 and at quany Q2 we

need to get our subnormal profit now

what do we do we have to compare average

revenue and average cost well average

revenue is at the Red Dot here average

cost is much higher so if we go up here

average cost is way up there that is the

unit loss average cost higher than

average revenue that's the unit loss if

we take that point across and call it C1

multiplying that unit loss by all of the

units being produced and sold we get the

total

loss being made by firms we'll call that

the subnormal profit that box represents

the area of subnormal profit being made

the loss total loss that's the short run

position but this will not last in the

long run let's look at the theory first

why won't this last because firms will

be incentivized to leave the market and

to produce that opportunity cost instead

why would you continue if you're making

a loss right so go and produce your

opportunity cost and make profits that's

the idea why can they leave the market

well because there are no barriers to

exit so it's free it's costly for them

to leave the market as they leave the

market supply is going to shift left the

price is going to be driven up in the

market and that's going to keep

happening until there is no more

incentive to leave I.E until there is

normal profit left that's a theory how

do we draw the diagram not in that order

because it's difficult to draw the

diagram correct in that order draw it

backwards we know the long run position

is going to be there so we can draw our

Revenue curves first again so let's draw

Revenue curves first and that's going to

be at the higher price so we'll call

that

R2 equal MR2 = D2 so we know they're

going to be our Revenue curves that's

because the price is going to be higher

let's call it P2 we know that the price

would have come from the market so let's

take it to the market there and we know

that that price would have been driven

up because Supply would have shifted

left in which case it must have cut

demand there so we're going to draw a

new supply curve shifting left parallel

so we have to draw it to look something

like that and now we just need to add on

our quantities so quantity of Q3 in the

market and the profit Max quantity here

at Q4 and that is going to show guys

that a quantity Q4 at profit Max here

normal profit is being made that's the

process simple stuff and that's how to

get the diagram nailed every single time

so we can clearly see why the long run

position for firms in perfect

competition is going to be over here

it's very clear now to understand the

diagram I had on before let's now look

analyze and evaluate perfect compet

comptition using efficiency well let's

focus on allocative efficiency knowing

that here at Q2 is our long run

equilibrium position is that quantity

being produced by perfectly competitive

firms allocatively efficient when we

need to see whether price is equal to

marginal cost well there's our price

over here there's price and it is equal

to marginal cost at quantity Q2

absolutely price is equal to marginal

cost so allocative efficiency is being

achieved what does that mean it means

that resources are perfectly following

consumer demand very very important it

means that prices are low consumer

surplus is high quantity is high choice

is high consumers are benefiting from

resources following their demand in the

exact way that they desire them to is

there productive efficiency well at

quantity Q2 is the firm operating at the

lowest point on that average cost curve

well quite clearly yes they are aren't

they and that means full exploitation of

any economies of scale that there might

be in this market so yes productive

efficiency is being attained is there

efficiency is this firm producing on

their average cost curve well by

definition if they're productively

efficient they must be X efficient as

well minimizing waste minimizing cost so

we can see here that both allocative and

productive are occurring but also of

course X efficiency is occurring that

means all the three static efficiencies

are occurring in perfect competition and

all of them have to be achieved because

of the nature of competition such

intense competition if firms deviate

away from these efficiencies they are

not going to survive in the market they

have to be statically efficient because

of the nature of competition but what's

clear to see is that in the long run

there is no super normal profit and

therefore these firms cannot be

dynamically efficient they don't have

the profit in the long run to reinvest

back into the company and therefore

consumers may not see brand new

Innovative products over time new

technologies um producers will not be

able to lower their cost through newer

Technologies over time so we see

uh the market not really progressing

forward through Innovation because of a

lack of dynamic efficiency so statically

efficient but not dynamically efficient

that covers perfect competition guys

this is a quite simple conclusion there

is a video later in this playlist where

we discuss competitive markets in far

more detail it's very important you

watch that video to elaborate on

everything we've learned here so make

sure you watch that as that video comes

in this playlist thank you so much for

watching guys I'll see you all in the

next

video