<2.11.2 PERFECT COMPETITION>

--THINK AHEAD--

"Imagine you operate in a market of hundreds of small firms that produce exactly the same product that consumers all know is identical in quality to every other firm's. You can't get any competitive advantages; you produce exactly the amount of units that maximize your profits, which is just enough to stop you from leaving and doing your second highest-paying job, and you can sell out at the market price every day."

"Do you have any market power?"

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"No! If they raise their price, they will lose all their customers to a rival, and lowering their price would be irrational, as they can sell out at the market price."

--DEFINITION--

'PERFECT COMPETITION' as the name suggests, refers to a MARKET STRUCTURE, in which an individual firm has NO PRICE SETTING ABILITY at all. For this to be true, the following assumptions need to be made:

--ASSUMPTIONS--

"To understand this type of market in action, let's apply the assumptions of the model to the 'ride-hailing market' and see how this impacts the market power of an individual driver."

--LARGE NUMBER OF FIRMS--

"Can you think why having a large number of buyers and sellers reduces market power?"

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"Not sure?" "Think about what a large supplier like OPEC (a supplier of 40% of the world's crude oil production) can do to the market price that a tiny insignificant supplier can't?"

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"That's right! If a firm's output is a significant portion of the total market supply (like OPEC in the market for petroleum), then by reducing or increasing supply, they can in fact impact the market price; hence, they would have market power. HOWEVER, in this model, they are so INSIGNIFICANT IN SIZE that their supply decisions have no noticeable impact on market supply; hence, they have no market power.

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--TASK--

Now apply this to the ride-hailing driver scenario

"A ride-hailing driver operates in a (relatively) perfectly competitive market and thus has no market power, firstly because the ride-hailing market is made up of a huge number of buyers and sellers, in the form of the numerous people who want a taxi at all times of the day and the vast number of drivers who are offering their vehicles for hire on the apps. This fact means that a single driver only has a tiny market share and therefore cannot reduce their services and influence market supply and alter price."

--ALL PRODUCTS ARE IDENTICAL--

"Can you think why all firms producing identical products ('homogenous goods') reduces market power?"

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"Not sure?" "Think about what a large brand like Nike can do to the price it receives for its simple cotton t-shirts?"

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"That's right! As in the case of Nike, they are able to DIFFERENTIATE themselves from their rivals, by offering slightly different styles and varieties and therefore produce HETEROGENOUS products, which gives them a UNIQUENESS that allows for some loyalty and market power; whereas, if the goods are identical, then any attempt to raise the price will result in all demand disappearing to an identical and cheaper rival; hence, they have no market power.

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--TASK--

Now continue to apply this to the ride-hailing driver scenario...

"...furthermore the fact that all cars are identical means..."

--NO BARRIERS TO ENTRY & EXIT--

"Can you think why having 'very low barriers to entry and exit' reduces market power?"

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"Not sure?" "Why do you think certain tech and pharmaceutical companies can dictate their prices for many years without anyone challenging them?" "Why is it that when avocados became a popular 'superfood,' they started to be sold by everyone?"

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"That's right! In the case of tech firms, they hold intellectual property rights that prevent others from entering and 'competing away' their profits so they can keep prices high; however, in the case of avocados, it would be relatively easy for rival stalls, or even new entrants, to also start selling avocados, which would eventually 'compete away' the extra profits, and the price would fall back to a more competitive level; hence, they have no market power.

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--TASK--

Now continue to apply this to the ride-hailing driver scenario...

HINT: "Think about what actually happens when there is 'surge pricing.' How do other drivers react?"

"...in addition, the fact that the barriers to entry into the hail-riding market are so low means.."

--PERFECT RESOURCE MOBILITY--

"Can you think why having 'perfect factor mobility' reduces market power?"
HINT: "It's related to the last assumption."

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"Not sure?" "Think about why the avacado sellers can easily enter the market, in term sof their factor sof production, eg their labour, and the caital equipment they own.
HOW DOES THIS REDUCE MARKET POWER? As mentioned above in the wet market example, firms that were previously not selling watermelons saw the potential profitability and immediately entered, which implies their factors of production were perfectly mobile and able to switch seamlessly between whatever they were doing previously, however, how realistic is it that a law firm can jump into the market for international schools, if they notice higher earning potential?

--PERFECT INFORMATION--

Perfect information means that all firms and all consumers have complete information regarding products, prices, resources and methods of production.
HOW DOES THIS REDUCE MARKET POWER? CONSUMER-SIDE: One of the big factors that give a firm market power is the imperfect information that the consumer holds regarding the prevailing prices and quality of goods and their rivals, which is often created through branding and advertising. For example, perfect awareness of an identical substitute for a MacBook would render all BRANDING and ADVERTISING by apple pointless as consumers would not be fooled by the sleek images and their attempts to appear superior.
PRODUCER-SIDE: On the producer-side, perfect information about the costs of raw materials, etc, means no single firm is able to get a cost advantage over another and offer a discounted price, furthermore each firm can produce its goods or services at exactly the same rate and with the same production techniques as another one in the market.

--SR PROFIT DIAGRAMS--

--A PC firm's AR and MR curves--

We can see that as the INDIVIDUAL FIRMS HAVE NO MARKET POWER they MUST ACCEPT THE INDUSTRY DETERMINED PRICE, hence they are referred to as 'PRICE TAKERS'.
In other words, if they raise their price they will lose ALL quantity demanded, and they have no reason to lower price as they can sell all their output at a higher price anyway.

--ECONOMIC. PROFIT in the SHORT-RUN--

In the SR it is possible for some firms to make abnormal profits. If we assume a fixed market supply in the SR, a rise in demand will lead to a rise in the market price, as we know in the SR FIXED FACTORS will PREVENT NEW FIRMS FROM ENTERING, hence existing firms with lower average costs can take advantage and earn abnormal profits. [AR>AC]

--NORMAL PROFIT in the SHORT-RUN--

--INDUSTRY-- --FIRM--

--LOSSES in the SHORT-RUN--

In the SR it is also possible for a firm to make losses. If we assume a fixed market supply in the SR, a fall in demand will lead to a fall in the market price, and in the SR FIXED FACTORS will PREVENT ANY FIRMS FROM EXITING, hence existing firms will have to suffer losses.

--INDUSTRY-- --FIRM--

--TO SHUTDOWN OR NOT?--

We have just seen that firms can be making losses in the SR and in many cases, they have fixed costs that must be repaid regardless of whether they shut down now or remain open until they can exit the market after paying off these obligations in the LR.
So do they simply shut down? Have you ever seen a shop that is usually empty remain open? Why do you think this is? Surely they are losing money right?

--THINK AHEAD--

"For ride-hail drivers (e.g., Uber drivers), whenever there is 'surge pricing' due to a rapid increase in demand, abnormal profits can be earned by the current logged-in drivers, but what eventually happens to these extra profits?"

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"That's right! All the other drivers who were not willing to provide their services at the lower prices see the higher rewards on offer on the app (perfect info) and then quickly offer their services (low barriers to entry), increasing supply, and eventually 'competing away' the higher surge pricing, resulting in a fall in price."

--LR PROFIT DIAGRAMS--

--SR Ab. PROFIT & LR NORMAL PROFIT--

In the long run, if an industry has opportunities for abnormal profits firms that are now able to make all their factors variable, will ENTER THE PROFITABLE MARKET, which will as a result INCREASE MARKET SUPPLY gradually LOWERING THE PRICE LEVEL. and competing away abnormal profits until all remaining firms earn only normal profits.

--SR LOSSES & LR NORMAL PROFIT--

As soon as loss-making firms are able to make all their factors variable they will EXIT THE MARKET, which will in turn DECREASE MARKET SUPPLY gradually RAISING THE PRICE LEVEL.
As the price level rises only firms that are able to cover their costs at the new price level and thus earn normal profits will remain.

--A PC firm in LONG-RUN EQUILIBRIUM--

--EFFICIENCY DIAGRAMS--

--ALLOCATIVE--

ALLOCATIVE EFFICIENCY occurs when firms produce the particular combination of goods and services that consumers mostly prefer. This is also known as the 'SOCIALLY OPTIMAL' level where supply (MC) = demand (AR)

--PRODUCTIVE--

PRODUCTIVE EFFICIENCY occurs when production takes place at the LOWEST POSSIBLE AVERAGE COST (ATC). This occurs where the ATC = MC.

--EFFICIENCY IN THE SR--

--INDUSTRY-- --FIRM--

--EFFICIENCY IN THE LR--

--INDUSTRY-- --FIRM--

--EVALUATION--

--INSIGHTS--

ALWAYS ALLOCATIVLY EFFICIENT as the profit max quantity is always where MC=AR, hence maximising social surplus w/o DWL.
LOW PRICES FOR CONSUMERS in the LR, once abnormal profits are competed away, the price falls.
NO INEFFICIENT FIRMS as all high cost producers are forced to leave the market.
Responds to consumer tastes in LR.

--LIMITATIONS--

UNREALISTIC ASSUMPTIONS, in the first place.
FIRMS ARE TOO SMALL TO TAKE ADVANTAGE OF ECONOMIES OF SCALE, which means they are unable to lower their average costs, which in turn leaves less chance of a price reduction for consumers.
LACK OF PRODUCT VARIETY, as all goods are homogenous.
UNABLE TO ENGAGE IN R&D to make new products as they are unable to make any abnormal profits.

--TASK--

--EXPLAIN WHY FIRMS IN PERFECT COMPETITION IS UNABLE TO SUSTAIN ECONOMIC PROFITS IN THE LONG RUN (DEFINITIONS, ASSUMPTIONS, AND DIAGRAMS NEEDED) [10 MARKS]--

--RELEVANT PAST-PAPER QUESTIONS--

--ASSESSMENT--

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https://www.investopedia.com/ask/answers/05/perfectcompetition.asp

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