Perfect Competition is the most competitive market structure imaginable in which everybody is a price taker. Perfect competition is rare and may not even exist. It is so competitive that any individual buyer or seller has a negligible impact on the market price. Products are homogeneous. Information is assumed to be perfect.
Figure 1.1 Perfect Competition and the firm’s average and marginal revenues.
Under perfect competition, firm faces a perfectly horizontal elastic demand curve, thus it will also face perfectly elastic average revenue (AR) as shown in Figure 1.1. Firm earn only normal profit (marginal revenue, e.g. £10), the bare minimum profit necessary to keep them in business. If firms earn more than that (supernormal profits, e.g. £20) the absence of barriers to entry means that other firms will enter the market and drive the price level down until there are only normal profits to be made (Figure 1.2). Output will be maximised and price minimised.
Figure 1.2 Perfect Competition in the long-run.
Allocative efficiency implies all factors of production and all commodities demanded by consumers are in their best use and receive their opportunity cost (Figure 1.3). Further, it is assumed that there is no external cost or benefits.
Figure 1.3 An increase in firms’ costs and adjustment to long-run equilibrium.
A monopoly is a firm that is the only seller of a good or service for which there is no substitute. In the absence of government intervention, a monopoly is free to decide its price by equating its marginal revenue and marginal cost, and choose the price-quantity combination to maximize its profits. For monopoly to exist there must be a barrier to the entry of competing firms. In the case of natural monopolies, a firm whose average cost of producing the product reaches a minimum at an output sufficient to supply the entire market, the government creates that barrier. In some cases the barrier is...