Perfect Competition Market: Detail Explanation

Topics Entitled

01.    Define perfect competition market. What are the
characteristics of perfect competition market?
Explain.

02.    How does price and output determine in perfect
competition market during short-run and long-run
period? Explain.

Perfect Competition Market:

Perfect competition market is the world of price-takers. A perfectly competitive firm sells a homogeneous product [one identical to the product sold by others in the industry]. It is so small relative to its market that it cannot affect the market price; it simply takes the price as given.

Perfect competition market is a market under which no buyer or seller can affect unilaterally or, it is a situation where no buyer or seller can affect price.

Characteristics of Perfect Competition Market:

The main characteristics of perfect competition market are as follows:

01. Large Number of Buyers and sellers:
One condition of perfect competition is that there should be operating in the market a large number of buyers and sellers. If that is so, no single seller or purchaser will be able to influence the market price, because the output of any single firm is only a small proportion of the total output and of the total demand.

02. Homogeneous Product:
The second condition is that the commodity produced by all firms should be standardized or identical.

03. Free Entry or Exit:
There should be no restrictions, legal or otherwise, on the firms’ entry into, or exit from, the industry. In this situation, all the firms will be making just normal profit. If the profit is more than normal, new firms will enter and extra profit will be competed away; and if, on the other hand, profit is less than normal, some firms will quit, raising the profits for the remaining firms. But if there are restrictions on the entry of new firms, the existing firms may continue to enjoy supernormal profit. Only when there are no restrictions on entry or exit, the firms will earn normal profit.

04. Perfect Knowledge:
Another assumption of perfect competition is that the purchasers and sellers should be fully aware of the prices that are being offered and accepted. In case there is ignorance among the dealers, the same price cannot rule in the market for the same commodity. When the producers and the customers have full knowledge of the prevailing price, nobody will offer more and none will accept less, and the same price will rule throughout the market. The producers can sell at that price as much as they like and the buyers also can buy as much as they like.

05. Absence of Transport Costs:
If the same price is to rule in a market, it is necessary that no cost of transport has to be incurred. If the cost of transport is there, the prices must differ to that extent in different sectors of the market.

06. Demand Curve of Perfect Competition Market is Completely Horizontal:

Figure-01: Demand curve looks horizontal to a perfect competitor.

The industry demand curve on the left has inelastic demand at the market equilibrium at A. however, the demand curve for the perfectly competitive firm on the right is horizontal (i.e. completely elastic). The demand curve on the right is horizontal because a perfect competitor has such a small fraction of the market that it can sell all it wants at the market price.

Price and Output Determination in Perfect Competition Market during Short-run: We will explain how price and output are determined in a perfectly competition market under short run period.

The short-run has been defined as a period of time sufficient to allow the firm to adjust its output by increasing or decreasing the amount of variable factors of production, but during which fixed factors of production cannot be altered. Thus, in the short run; the size and kind of plant cannot be changed, nor can new firms enter the industry.

The above twin conditions of equilibrium ensure that profits have been maximized or losses minimized, but they do not tell about the firm’s absolute profit or loss position. In this connection there are three possibilities: [a] When the firm makes super normal profit or, economic profit; [b] When it makes only normal profit; and [c] When it incurs losses, but still does not shut down. Let us take them one by one.

[a] When The Firm Makes Supernormal Profits in the Short-run: In Figure-02, if the price is OP₁ ,the average- marginal revenue curve is P₁ L₁ and the firm is in equilibrium at point Q of output OM₁ .

Figure-02: Supernormal Profit at Short-run.

In this
case, average cost is M₁G, whereas price is OP₁ (=QM₁). Hence, profit per unit is GQ. The output is OM₁ (=GH).Hence, in this equilibrium position, the firm is making supernormal profits, which are equal to the area P₁QGH. As all the firms in the industry have identical cost curves with the firm represented in Figure-02, all would be making supernormal profits. There will be a tendency for the new firms to enter the industry to compete away these supernormal profits. But the short run is not a period sufficient for the new firms to enter; therefore, the existing firms will continue to earn supernormal profits at the price OP₁ in the short period.

Thus, with price OP₁, all the firms in the industry will be in equilibrium at Q but industry, as a whole, will not be in equilibrium as there will be a tendency for the new firms to enter the industry.

[b] The Firm Just Makes Normal Profit in the Short-run: Now suppose that the ruling price in the market is OP.PL will then be the average-marginal revenue curve and the firm will be in equilibrium at the point R. At the point R, besides marginal cost

Figure-03: Normal Profit at Short-run.

being equal to marginal revenue and MC curve cutting MR curve from below, average revenue or price is also equal to average cost. Hence, with OP price and at the equilibrium point R or equilibrium output OM, the firm in Figure-03, and hence all the firms in the industry, will be making only normal profits (normal profits are included in average cost curve). Since all the firms in the industry are making only normal profits, there will be no tendency either for the new firms to enter or for the existing firms to quit the industry.

[c] The Firm Incurring Losses in the Short-run: If the short-run price in market were OP_2, instead of OP₁ and OP, the firm will be in equilibrium at point S, since with price OP₂, only at S the marginal cost is equal to marginal revenue or price OP, and MC curve cuts MR curve P₂L₂ from below. But, at S or output OM₂, the

Figure-04: Incurring Losses at Short-run.

firm is incurring losses, (Average revenue SM₂ is less than average cost EM₂ at the point S or output OM₂). The total losses in this situation are equal to the area P₂SEF. This is the smallest loss that a firm can incur under the given price-cost situation, if it is to produce at all. Given the price OP₂ in the market, the loss of the firm would be grater if it tries to produce at a point other than S.

Thus, we see that equating marginal cost with marginal revenue is optimal (when the second condition is also satisfied) even though profits are negative, because in that way losses are kept at the minimum. Since all the firms of the industry have identical cost conditions with the firm of Figure-03, all would be incurring losses. The firms would have a tendency to quit the industry to go in search for normal profits elsewhere. But in the short run they cannot do so.

Thus, with price OP₂, all the firms would be in equilibrium at point S (though all will be incurring losses), but the industry, as a whole, will not be in equilibrium, since the firms will have a tendency to leave it.

Price and Output Determination in Perfect Competition Market during Long-run: The long run is a period of time long enough to permit changes in the variable as well as in the fixed factors. In the long run, accordingly, all factors are variable and none fixed. Thus, in the long run, firms can change their output by increasing their fixed equipment. They can enlarge the old plants or replace them by new plants or add new plants. Moreover, in the long run, new firms can also enter the industry. On the contrary, if the situation so demands, in the long run, firms can diminish their fixed equipments by allowing them to wear out without replacement and the existing firms can leave the industry.

Thus, the long run equilibrium will refer to a situation where free and full scope for adjustment has been allowed to economic forces. In the long run, it is the long run average and marginal cost curves which are relevant for making output decisions. Further, in the long run, average variable cost is of no particular relevance. It is average total cost which is of determining importance, since in the long run all costs are variable and none fixed.

Now we see price and output determination in perfect competition market during long-run by a diagram:

Figure-05: Price and Output Determination in Perfect Competition Market during Long-run

At the initial situation —

Price = P_e

Output = Q_e

If economic profit is attained new firm will enter in industry. The production will increase and supply curve shifts from SS to S^/S^/.

At E^/,

Price = P^/_e

Output = Q^/_c

At R^/,

AR = Q^/_cR^/

AC = Q^/_cT

At this situation economic profit is attained and firm will enter in the industry.

As a result supply curve shifts from S^/S^/ to S^//S^//.

At E^//,

Price = P^//_e

Output = Q^//_c

At R^//,

AR = R^//Q^//_c

AC = R^//Q^//_c

At, R^// normal profit is attained and industry is equilibrium at this point where price is P^//_e and output Q^//_c.

Name of Reference Books:

01. Modern Economic Theory

— K. K. Dewett.

[S. Chand and Company Ltd., Ram Nagar, New Delhi-110055]

02. Economics

—Paul A. Samuelson

And

William D. Nordhaus

[Tata McGraw-Hill Publishing Company Limited, New Delhi,

Eighteenth Edition.]

03. Microeconomic Theory

—Dominick Salvatore

[McGraw-Hill Publishing Company Limited, Third Edition.]

Prepared By: Chinmoy Kumar Ghosh (BBA Student)

Random Posts