Microeconomics

5.0 Competition

5.1 Perfect Competition

1. Assumptions

Perfect competition fully satisfies the following four strict conditions:

(i) Anonymity
    Consumers are indistinguishable to producers.  Firms have no reason to favor one consumer over another.  The product of different firms is indistinguishable, one from another, in terms of price, quality and product differentiation.  They are 'homogenous'.  Consumers have no reason to prefer the product of one firm over that of another.

(ii) No Market Power
       There is a large number of both producers and consumers.  Sales or purchases by any buyer or seller are small relative to the total volume of exchange.  No buyer or seller can affect price or quality, i.e., no one exercises market power.  All consumers and producers respond and adjust only to market signals.

(iii) Perfect Knowledge
       Consumers and producers possess perfect knowledge about price and quality.  No firm can charge more, and no consumer can pay less than the market equilibrium price.

(iv) Free Entry & Exit
        Entry and exit from the market is free for both consumers and producers.  There is an unimpeded flow of resources between alternative uses i.e., resources are mobile and move to the use with greatest advantage in terms of opportunity costs.   Firms exit if they experience ‘economic’ loss.  Thereby inefficient firms are eliminated from the market.  Firms enter the market if they expect to earn economic short-run, and/or, normal long run profits. On the other side of the Marshallian scissors, there are many close substitutes available to consumers who can easily switch if price, preference and/or income changes.

2.  Market Demand Curve

Under perfect competition, market demand is calculated as the horizontal summation of individual consumer demand curves that are usually downward sloping. The Law of Demand also holds for the market demand curve: the higher the price the lower the demand, the lower the price the higher the demand, It is assumed that there are constant prices for all other commodities as well as constant consumer income and constant consumer preference amongst alternative goods and services or commodities. 

The consumer demand curves will shift, left or right - up or down, if any constant changes.  It will shift reflecting changes in the consumer income-consumption curve and/or changes in the marginal rate of satisfaction (preference) of consumers (please see: 2.1 Utility and 2.2 Demand Curve).  Thus, at any moment in the short-run, it is assumed the prices of all other commodities are constant as is consumer income.  The consumer demand curve will, therefore, shift or mutate (change in elasticity of price, income and/or substitutes/compliments) if any of these constants change. 

Market demand is thus not calculated from the producers’ perspective.  Rather, individual firms face a perfectly elastic or, horizontal demand curve. Each firm can sell as much as it likes, but only at the market equilibrium price as in (MBB not displayed; P&B 4th Ed. Fig 12.1; 5th Ed Fig. 11.1) (see 4.2 Equilibrium & Elasticity).  If any firm raises its price that firm immediately loses all its consumers; and, if it lowers its price, it can supply only a tiny part of the market and will sell even less at a lower price.  Further, Price (P) always equals Marginal Revenue (MR), i.e. if Revenue equals Price multiplied by Quantity - bought and sold or (Q) then MR equals the change in R divided by the change in Q equaling P.  Put another way, the additional revenue from the next sale tends to equal the market equilibrium price faced by each and every competitive firm.  This is a key characteristic of Perfect Competition.

3. Market Supply Curve

The market supply curve is calculated as the horizontal summation of the supply curves of all firms.  The cost function of the firm is used to determine the supply curve for each firm in three distinct time frames:

i - Very Short-Run Supply Curve:

during which the level of output cannot be changed  and therefore the output of each firm is fixed.  The very short-run supply curve is vertical, output is constant and does not depend on price.

ii - Short-Run Supply Curve:

during which the level of output can be changed but the size of plant cannot be varied. The short-run supply curve for a firm is identical to its short-run marginal cost curve above the intersection of the MC and AVC curves of the firm. The firm’s short-run supply curve is thus a function of costs. The market supply curve is the horizontal summation of the individual firm’s supply functions.

iii - Long-Run Supply Curve:

during which all factors are variable and long-run optimal output exists where P = LRMC.  The long-run supply curve is the portion of the long-run marginal cost curve above long-run average cost.

4. Profit Maximizing Output

To determine profit-maximizing output of a firm under perfect competition, one can use two methods:

(i)   total revenue less total cost; and,
(ii)   marginal analysis.

(i) Total Revenue less Total Cost

Profit equals TR – TC.   By plotting TR and TC curves one can see the changing relationship: initially there is a section of economic loss followed by economic profit followed by economic loss with two points of ‘normal’ profit points (MBB 10th Ed Fig. 8.2; MBB 11th Ed. Fig. 7.2; P&B 4th Ed. Fig. 12.2; 5th Ed Fig. 11.2).

(ii) Marginal Analysis

Marginal revenue (MR) can be compared with average cost (AC). Firm must sell at MR = P = MC.  But if MR > AC producing an additional unit output will add more revenue than cost, i.e. economic profit earned in the SR.  If MR = AC then ‘normal profit’ earned, i.e. all factors of production paid their opportunity cost value.  If MR < AC producing another unit with result in a loss (MBB 10th Ed Fig. 8.3; MBB 11th Ed Fig. 7.3; P&B 4th Ed. Fig. 12.3; 5th Ed. Fig. 11.3).  Three possible outcomes are possible for the firm in the short-run: normal profit, economic profit or economic loss (MBB 10th Ed Fig. 8.8 & 8.9; MBB 11th Ed. Figs 7.8 & 7.9; ; P&B 4th Ed. Fig. 12.4; 5th Ed. Fig. 11.4).

In short-run firm will continue producing if at least all variable costs are covered even if the firm suffers a loss because it is not covering all of its fixed costs.  If all variable cost cannot be covered, the firm will shutdown (MBB 10th Ed Fig. 8.6; MBB 11th Ed Fig. 7.6; P&B 4th Ed. Fig. 12.5; 5th Ed. Fig. 11.5).  In the LR, firms suffering short-run losses either adjust their scale of production (assuming economies of scale are available) or they exit the industry.  Exit reduces supply (shifts SC to left) and raises price.  The LRAC curve is the envelop of minimum points of sequence of SRACs reflecting scale increases.

If some firms enjoy SR economic profits, new firms will enter increasing supply (shifting SC to right) and reducing price (MBB not displayed; P&B 4th Ed. Fig. 12.8; 5th Ed. Fig. 11.8).   

In the long-run, firms can adjust the size of their plants creating a series of short-run average and marginal cost curves.  The long-run average cost curve is made up of an envelope of the minimum points of the short-run average cost curves where SR average cost equals SR marginal cost.  At some point the most efficient plant size is achieved where LR average cost is lowest for a particular short-run situation.  At this size the short-run marginal cost curves, in effect, becomes, the long-run marginal cost curve (MBB 10th Ed. Fig. 8.12; MBB 11th Ed Fig. 7.12; P&B 4th Ed. Fig. 12.9; 5th Ed. 11.9).

5. External Economies, Changing Taste & Technology

To this point it has been assumed that cost is a function only of firm output but cost may depend upon the output of all firms in the industry.  For example, if industry output goes up, input costs to the firm may go down, i.e. an external economy to the firm’s production.   Or, if industry quantity goes up, factor costs to the firm may increase, i.e., an external diseconomy to an individual firm’s production.  There are also what can be called enabling or transformative innovations outside the economy self in the form of scientific breakthroughs or within the economy through the spreading of new techniques such as 'just-in-time' inventory systems or communications innovations such as the internet or QR Codes.  Furthermore, such external effects may be ambiguous, that is they may increase the cost of some and decrease the cost to other firms.  There are also the external economies available to firms due to location as in industrial districts or so-called 'clusters' such as Silicon Valley.

Firms base their behavior on their own marginal cost curve.  If all anticipate the same market equilibrium price and industry output is consistent with the summation of individual firm output there will be no further adjustment.  Otherwise, individual firm output may not equate with marginal cost and it will adjust in the next round of what is called tatonnement or a bidding process until there is no further adjustment.  The market supply curve should state optimal output as a function of price after all necessary adjustments. 

In addition to external economies, changes in taste and production technology itself can change equilibrium.  Taste is symbolized by the f in preference function U = f (x, y) while technology is symbolized by the g of the production function Q = g (K, l).  A decline in taste for a commodity can permanently reduce demand (shift curve to right) lowering price.  At the extreme, all firms exit and the industry collapses (hoola-hoops) (MBB not displayed; P&B 4th Ed. Fig. 12.10; 5th Ed. Fig. 11.1).  Similarly, technological change can reduce costs and shift the supply curve to right, or, if knowledge is lost, shift the supply curve the the left.   This may be the case with 'de-industrialization' resulting from automation and offshore production.

6. Competition & Efficiency

Allocative efficiency implies all factors of production and all commodities demanded by consumers are in their best use and receive their opportunity cost.  Further, it is assumed that there are no external cost or benefits, i.e. all external costs and benefits have been ‘internalized’.  Three conditions must hold:

(i) Consumer Efficiency:  when consumer cannot increase utility by reallocating budget;

(ii) Producer Efficiency: when firm cannot reduce cost by shifting input mix; 

(iii) Exchange Efficiency: when all gains from trade have been exhausted.  Gains from trade to consumer is called consumer surplus which measures difference between what consumer are willing to pay and what they actually pay for a total quantity of a good or service at market price.  Gains from trade to producers are called producer surplus which measures the difference between what producer are willing to accept and what they actually receive for providing a market equilibrium level of supply (MBB 10th Ed Fig. 8.14; MBB 11th Ed not displayed;  P&B 4th Ed. Fig. 12.12; 5th Ed. Fig. 11.12).  

7.  The Holy Grail

    Beginning with Thomas Aquinas through Adam Smith up to today when consumers are outraged about bank profits and ‘bitch’ at the gas pump, the ‘just price’ has engaged the hearts and minds of economic thinkers for almost a thousand years in the West.  Various theories have been suggested to explain the 'value' of a good or service.  These include: scarcity; utility (as usefulness); input cost (for example, the labour theory of value shared by all classical economists including Marx); and, whatever the market will bear.  In this sense, there is a distinction in economics between what is called 'value theory' and 'price theory'.

Perfect competition is the most comprehensive statement of conditions under which such ‘a just price’ exists because it combines all of them in a deductively logical and mathematically and geometrically demonstrable model.   Unlike other social sciences in economics 'seeing is believing'.  It is a yantra or a visual mantra that can be visually contemplated and manipulated.  'X' marks the spot where:

•  no one exercises market power, i.e. no consumer or producer can affect the price/quantity outcome;

• all factors of production are paid their opportunity cost and none earn economic profits – in the long-run;

• market price internalizes all relevant benefits in consumption and costs in production;

• consumer sovereignty reigns and producers adjust to market demand subject only to changing cost constraints and tastes of consumers; and,

• there is no role for government, just as in 'perfect' Communism.

Deviations in the ‘real world’ from perfect competition is used to justify intervention by government in cases of 'market failure' in order to:

• account for costs and benefits external to market price through imposition of taxes as well as user or producer charges like carbon credits;

• create intellectual property rights to encourage production of new knowledge which, as a public good, is subject to the free-rider problem;

• regulate the market to attain a price/quantity outcome approximating perfect competition; or,

• restructure the market through anti-trust or anti-combines policies to achieve a better approximation of perfect competition. 

    The price/output outcome of perfect competition provides the benchmark against which performance of all other market structures are judged.   There is, however, serious questioning about both the pedagogic as well as policy use and application of this benchmark.  The last ideology standing after the end of the Market/Marx Wars - perfect competition - serves as the regulatory foundation of the EU, NAFTA, WTO and other multilateral economic trade agreements.  It is also why economist Kenneth Boulding rightly notes that economics is a 'moral' not a natural science.