Evaluate the usefulness a knowledge of perfect competition theory in analysing the behaviour of firms. [15]

Perfect competition is the most competitive market structure with many firms holding a small market share and no barriers to entry. There are no pure real-world examples of this market structure but some come close such as fruit and vegetable markets and online product markets on websites such as Amazon. An understanding of perfect competition theory can be useful in understanding the importance of long-run efficiencies. In the long run, perfectly-competitive markets are allocatively efficient which shows resources are being allocated as well as possible to maximise utility as price will equal marginal cost (P=MC) as well as productively efficient meaning production costs are minimised. These efficiencies combined create a state of Pareto optimality whereby no individual in this market could be made better off without compromising the utility of another. Fig. 1 illustrates these benefits by showing how at an equilibrium of (Qe,Pe) P=MC and the minimum point of the average cost curve for the firm. This results in a situation where resources are allocated as well as possible to solve the basic economic problem of infinite wants but scarce resources. However, the extent to which such an equilibrium will arise depends on the nature of the good or service being examined. For example, the market for online pen sellers is extremely saturated with a major level of homogeneity between products and this relative lack of differentiation means that the assumptions of perfectly competitive markets will be more applicable and hence for these types of low-cost, fairly simple product markets a knowledge of the long-run benefits of perfect competition theory is useful.

In contrast, the lack of super-normal profits (defined as profits above normal levels) in the long-run means that the theory is less helpful to firms trying to profit maximise as there is no room for continuous dynamic efficiencies. This is because (as seen in fig. 1) in the long-run firms operate at P=AC which is the price level that only normal profits are made. This limits investment in the product and hinders a business' ability to gain a competitive advantage through innovation. As illustrated in fig. 2 the existence of super-normal profits in the short - run encourages other firms to enter the market, taking advantage of the lack of barriers to entry to do so, and this squeezes the profits of all remaining firms. However, the extent that this lack of super-normal profit is an issue depends on the objectives of the firm. If they are a traditional profit maximising firm, then the tendency of perfectly competitive markets to become static in the long run would limit the usefulness of the theory to such a company, but if they are more focused on fulfilling their cooperate social responsibilities (CSR) then the lower prices in the long run and highly efficient outcome achieved in perfect competition markets would make an understanding of the theory much more helpful.