Perfect competition
50 marks: 12 multiple choice questions, a data response and an essay. Answers are at the end.
AQA: Question 14 would be a 25-mark question on your papers.
Edexcel: Question 14 would be a 25-mark question on your papers.
OCR: Question 14 would be a 25-mark question on your papers.
1A firm in perfect competition is a price taker because:
- A it is too small a part of the market for its output to affect the market price
- B it agrees prices with the other firms in the industry so that no firm undercuts the rest
- C the government fixes the price it may charge in order to protect consumers from exploitation
- D its product is differentiated from its rivals' products, so it must accept what customers will pay
2For a firm in perfect competition, average revenue and marginal revenue are equal because:
- A marginal cost rises as output increases
- B the firm earns only normal profit
- C the firm produces where average cost is lowest
- D every unit is sold at the same market price
3A firm in a perfectly competitive market is making abnormal profit in the short run. In the long run:
- A existing firms leave the industry, which reduces market supply and raises the price still further
- B the firm's demand curve becomes downward sloping as customers develop loyalty to its product
- C new firms enter, market supply rises and the price falls until only normal profit remains
- D the firm raises its price to protect its profit, because it has become a price maker in its market
4A firm in perfect competition is making a loss in the short run. It should continue to produce as long as:
- A price is above marginal cost at every level of output it could choose
- B price is at least equal to average variable cost
- C price is at least equal to average total cost at the chosen output
- D its fixed costs are zero and so the loss is confined to its variable costs
5In long-run equilibrium, a firm in perfect competition produces at the output where:
- A price is above marginal cost and average cost is falling
- B marginal revenue equals marginal cost and price is above average cost
- C average cost is falling and the firm earns abnormal profit
- D price equals marginal cost and average cost is at its minimum
6A perfectly competitive industry in long-run equilibrium is allocatively efficient because:
- A the government sets price equal to average cost, so no firm can earn more than normal profit
- B price equals marginal cost, so the value placed on the last unit equals the cost of making it
- C each firm produces a different variety, so every consumer can find a product that suits their taste
- D firms earn abnormal profit, which they invest in new products that consumers value more highly
7Which of the following is an assumption of the model of perfect competition?
- A each firm faces a downward-sloping demand curve and so has some control over its own price
- B firms spend heavily on advertising in order to differentiate their products from those of rivals
- C buyers and sellers have perfect information about prices and products
- D there are significant barriers to entry, which protect existing firms from new competition
Use the information below for questions 8 to 9.
A firm in a perfectly competitive market has the costs shown in the table. The market price is £14.
| Output (units) | Total cost (£) |
|---|---|
| 4 | 40 |
| 5 | 50 |
| 6 | 62 |
| 7 | 75 |
| 8 | 91 |
8The profit-maximising output is:
- A 7 units
- B 5 units
- C 8 units
- D 6 units
9At the profit-maximising output, the firm's profit is:
- A £22
- B £23
- C £14
- D £98
10A criticism of perfect competition as a benchmark is that firms earning only normal profit:
- A cannot cover their variable costs, so they are forced to leave the industry in the long run
- B are always productively inefficient, because they produce where average cost is still falling
- C have little retained profit to fund research and development
- D must raise prices to survive, which drives their customers to rival firms in the industry
11Firms in a perfectly competitive industry are making losses. In the long run:
- A all firms leave the industry, because none of them can cover its costs at the current market price
- B the losses continue indefinitely, because firms in perfect competition are unable to leave the industry
- C firms collude to raise the price above the competitive level in order to restore their profits
- D some firms leave, market supply falls and the price rises until the remaining firms earn normal profit
12A fall in market demand in a perfectly competitive industry will, in the short run:
- A lower the market price and each firm's output, so some firms make losses
- B leave the price unchanged, because firms are price takers who cannot change what they charge
- C cause new firms to enter the industry in order to take advantage of the spare capacity available
- D raise the market price, because fewer units are sold and each must bear more of the fixed costs
13Cut flowers are sold at daily auctions in the Netherlands, where thousands of growers from several countries sell to hundreds of buyers at prices that change minute by minute. A grower cannot influence the price and sells whatever it brings to market at the going rate. Table 1 shows the position of one grower of a standard variety of rose. Figures are illustrative.
| Spring | Winter | |
|---|---|---|
| Market price (£) | 320 | 180 |
| Average total cost (£) | 250 | 250 |
| Average variable cost (£) | 160 | 160 |
(a)Using Table 1, calculate the grower's abnormal profit per 1,000 stems in spring. [2]
(b)Using Table 1, explain whether the grower should keep producing in winter. [4]
(c)With the aid of diagrams, explain what happens in the market and to the grower if spring prices stay at £320 for several years. [6]
(d)Explain two reasons why the flower auction market may not be perfectly competitive. [6]
14Discuss the view that perfect competition is the most efficient market structure. [20]
Answers
Show the answers
| Answer | Why | |
|---|---|---|
| 1 | A | With many small firms selling an identical product, no single firm's output is large enough to move the market price. |
| 2 | D | The firm can sell any amount at the going price, so each extra unit adds exactly that price to revenue: AR = MR = price. |
| 3 | C | With no barriers to entry, abnormal profit attracts entrants; the market supply curve shifts right and price falls to the minimum of average cost. |
| 4 | B | Fixed costs are paid whether or not it produces; if price covers average variable cost, producing contributes something towards the fixed costs. |
| 5 | D | Entry and exit drive price to the lowest point of average cost, where it also equals marginal cost. |
| 6 | B | Allocative efficiency means resources are used where consumers value them most, which holds when P = MC. |
| 7 | C | Perfect information is one of the model's assumptions, along with many buyers and sellers, homogeneous products and free entry and exit. |
| 8 | A | Marginal cost is £10, £12, £13 and £16 for the 5th to 8th units. The 7th unit costs £13 and earns £14, so it is worth making; the 8th would cost £16, more than it earns. |
| 9 | B | At 7 units total revenue is 7 × £14 = £98 and total cost is £75, so profit is £23 (at 6 units it would be £22, at 8 units £21). |
| 10 | C | Normal profit leaves nothing over to finance innovation, so the model may deliver static efficiency at the cost of dynamic efficiency. |
| 11 | D | Exit shifts the market supply curve left, raising the price until the firms left can cover average cost. |
| 12 | A | The market demand curve shifts left, the price falls, and each price-taking firm moves down its MC curve to a lower output; some now sell below average cost. |
13 (a) Using Table 1, calculate the grower's abnormal profit per 1,000 stems in spring. [2]
- 320 − 250 (1 mark)
- £70 per 1,000 stems (1 mark)
13 (b) Using Table 1, explain whether the grower should keep producing in winter. [4]
- In winter the price of £180 is below average total cost of £250, so the grower makes a loss of £70 per 1,000 stems (1 mark)
- But the price is above average variable cost of £160, so each 1,000 stems earns £20 towards the fixed costs (greenhouses, heating contracts, land) (1 mark)
- Fixed costs must be paid whether or not it produces, so producing loses less than shutting down for the season (1 mark)
- Conclusion: keep producing in the short run; if winter prices stayed below £250 in the long run, when all costs become variable, it should leave the market (1 mark)
13 (c) With the aid of diagrams, explain what happens in the market and to the grower if spring prices stay at £320 for several years. [6]
- Diagrams: the market with demand and supply, and the firm with a horizontal AR = MR at £320 above a U-shaped AC, MC cutting AC at its minimum, output where MC = MR, abnormal profit shaded (2 marks)
- Abnormal profit, with no barriers to entry, attracts new growers (1 mark)
- Market supply shifts right and the price falls (1 mark); the firm's horizontal AR = MR line falls with it (1 mark)
- Entry continues until price equals the minimum of average cost, where the grower earns normal profit only, at a lower output than before (1 mark)
- Levels: 1 to 2 for a description with a partly correct diagram; 3 to 4 for correct diagrams with the entry mechanism; 5 to 6 for both diagrams linked, the new long-run position identified and the effect on the grower's profit and output stated.
13 (d) Explain two reasons why the flower auction market may not be perfectly competitive. [6]
- Products are not fully homogeneous: varieties, quality and freshness differ, so buyers may pay more for a trusted grower (1 mark for the reason, 1 for applying it; the model assumes identical products)
- Information is not perfect: buyers cannot know the quality of every lot and growers cannot know future prices, so decisions are made with uncertainty (1 mark for the reason, 1 for applying it)
- Also credit: entry is not free, since greenhouses, land and transport to the auction are large sunk costs; some large growers or buyers may have enough market share to influence prices; the auction house itself has market power over fees (1 mark for the reason, 1 for applying it)
- Maximum 6: two reasons, each explained and applied to the flower market, with the assumption it breaks identified.
14 Discuss the view that perfect competition is the most efficient market structure. [20]
Analysis
- Define perfect competition and its assumptions: many buyers and sellers, homogeneous products, perfect information, no barriers to entry or exit, price takers.
- Static efficiency in long-run equilibrium: price equals marginal cost, so the market is allocatively efficient; firms produce at the minimum of average cost, so it is productively efficient; competition and the threat of losses keep X-inefficiency out. Use the long-run diagram with P = MC = minimum AC.
- Compare with monopoly: price above marginal cost, output below the competitive level, a deadweight welfare loss and abnormal profit protected by barriers; so on static measures perfect competition is clearly more efficient.
- Dynamic efficiency: firms earning only normal profit have no retained profit to invest in research and development, and no incentive to innovate because any gain is competed away by entry; a monopoly or oligopoly with abnormal profit may deliver new products and lower costs over time (Schumpeter's argument).
- Economies of scale: many small firms cannot reach the minimum efficient scale in industries with high fixed costs; a single large firm may have lower average cost than any competitive firm, so a natural monopoly can be more productively efficient than competition.
- Real markets: perfect competition is a benchmark rather than a description; agricultural commodities, foreign exchange and some online markets come close, but most markets have differentiated products, imperfect information and barriers to entry.
Evaluation
- It depends on which efficiency: perfect competition wins on allocative and productive efficiency in a single period; concentrated structures may win on dynamic efficiency over time.
- It depends on the industry's cost structure: where minimum efficient scale is small (hairdressing, farming) competition is efficient; where it is large (water, rail track, semiconductors) a few large firms or one regulated firm is more efficient.
- It depends on contestability: a market with few firms but low barriers to entry can produce near-competitive prices without many firms.
- It depends on time horizon: consumers today gain from low prices under competition; consumers in the future gain from innovation funded by abnormal profit.
- Perfect competition assumes perfect information and homogeneous goods; relaxing either changes the result, so the model's efficiency is partly built into its assumptions.
Judgement
A supported judgement might conclude that perfect competition is the most efficient structure in the static sense and a useful benchmark, but not the most efficient in every industry or over time: where scale economies and innovation matter, a concentrated but contestable or well-regulated market can serve consumers better.
Marking
Top band (16 to 20): a range of points developed in full chains of reasoning, supported by accurate diagrams and real examples, with evaluation that weighs the arguments and reaches a judgement that depends on stated conditions. Middle band (9 to 15): some developed chains, a relevant diagram, evaluation that is present but one-sided or asserted. Bottom band (1 to 8): points listed or described, little use of theory or examples, judgement missing or unsupported.