The market system determines what, how and for whom goods and services are produced. The consumer determines what to produce. An increase in consumer demand will lead to a rise in price and producers will respond to higher price by raising production- to make more profits. Competition between producers determines how to produce- if they do not want to produce as cheaply as possible they will go out of business. For whom to produce is decided by prices in factor markets. Some people have high incomes because there skills are scarce and they can afford more resources.
Perfect competition (sometimes known as pure competition) is a theoretical type of market structure. It is primarily used as a benchmark in comparison with other market structures. The structure of a market determines the behaviour and performance of firms that sell in the market. A real life example could be that fishermen and farmers often operate in perfectly competitive markets. Main theories Assumptions of Perfect Competition o There are many firms each selling an identical product o There are many buyers o There are no restrictions on entry to the industry o Firms in the industry have no advantage over potential new entrants o Firms and buyers have complete information about the market o Price taker Since in perfect competition there are many firms selling a homogenous product no single firm can influence the market to a greater extent than any other, hence all firms must accept the market price for their product. They are price takers.
The Short Run and the Long Run The short run under perfect competition is the period during which there is too little time for new firms to enter the industry. o In the short run the number of firms are fixed. Firms could be making large or small profits, breaking even or making a loss. The long run under perfect competition is the period of time which is long enough for new firms to enter the industry. o In the long run the level of profit will affect the entry or exit of firms.
o Normal profit is the level of profit just sufficient to persuade firms to stay in the industry, but not high enough to attract new firms. This level of normal profit will vary from one industry to another. o Supernormal profit is any profit above normal profit. If economic profits are being made new firms will be attracted into the industry in the long run. This will have the effect of increasing supply and reducing price and profit for those firms already in the industry. Economic profits will be completed away.
Output - the firm is making a profit over the output range 4 to 12 (TR >TC). Profits will be maximized where marginal cost equals marginal revenue, this occurs at output 9. Whilst MR is greater than MC total revenue is increasing at a faster rate than total cost, thus profits will be increasing. After output 9 where marginal cost is greater than marginal revenue, total cost is increasing more quickly than total revenue and therefore profits are declining.
Profit - at the profit maximizing output average cost (which includes normal profit) is below average revenue and therefore the firm is making supernormal profits equal to the shaded area in the diagram. The firm's short run supply curve will be its (short run) marginal cost curve. A supply curve relates quantity to marginal cost. Long Run Equilibrium of the Firm In the long run if typical firms are making economic profits, new firms will be attracted into the industry or existing firms will increase the scale of their operations. The industry supply curve will shift to the right, leading to a fall in price. Supply will go on increasing and price falling until firms are only making normal profits.
This will be where the demand curve for the firm touches the lowest point of its average cost curve. This can be seen in the diagram below. In the long run if the price falls below the average cost of producing the good (P 2), then firms will make a loss and will leave the industry. If firms leave the industry supply will decrease and the price will rise until firms are just making normal profit - that is where the demand curve touches the lowest point of the average cost curve. Therefore under perfect competition output will always tend towards this long run equilibrium.
Long run equilibrium is therefore where AR = MR = MC = AC Shut Down Point We can find the short run break even price and the short run shut down price by comparing the price with average variable total costs. Profit maximization occurs where MC = MR. Since the average total costs (ATC) includes all the relevant opportunity costs, this equilibrium is the short run break even point where normal profits (zero economic profits are being made). As the price falls the firm will carry on producing but be making below normal profit. However, if the price falls below the average variable costs then it will not be worth the firm producing any longer as they will be making a loss larger than their fixed costs. The shut down point therefore comes when average revenue is equal to average variable cost..