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4.2 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 (M&Y10th
Fig. 9.8; M&Y 11th Fig. 8.10; B&B not displayed; B&Z not
displayed ). 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 substitution (preference) of
consumers. 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, i.e., the price established for market equilibrium is taken
by each firm and equated with its own MC curve determining how much it
will be willing to supply while maximizing its profits. Each firm
will sell the quantity corresponding to the intersection of the market
determined price and its MC curve.
If any firm raises its price that firm immediately looses all its
consumers; and, if it lowers its price, all competitors immediately
follow. Further, Price (P)
always equals Marginal Revenue (MR), i.e. Revenue equals Price multiplied
by Quantity - bought and sold or (Q) and MR equals the change
in R divided by the change in Q equaling P.
Put another way,
the additional revenue from the next sale equals the market
equilibrium price faced by each and every competitive firm.
This is a key characteristic of Perfect Competition. It
is this sense that the perfectly competitive firm is a 'price taker' , not
a 'price maker'.
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 (M&Y 10th
Fig. 9.3 &
9.4; M&Y 11th Figs 8.4 & 8.5; B&B Fig. 9.2; B&Z Fig. 9.5) 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 (M&Y 10th
Fig. 9.5; M&Y 11th Fig. 8.6; B&B not displayed; B&Z not
displayed).
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 (M&Y 10th
Fig. 9.9; M&Y 11th Fig. 8.12; B&B Fig. 9.14; B&Z 9.9).
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 (M&Y 10th
Fig. 9.1; M&Y 11th Fig. 8.2; B&B Fig. 9.1; B&Z 9.2).
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.
(ii) Marginal Analysis
Marginal revenue (MR)
can be compared with average cost (AC). Firm must sell at MR = P = MC (M&Y
10th
Fig. 9.2; M&Y 11th Fig. 8.3; B&B Fig. 9.1b; B&Z Fig. 9.2).
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 .
Three possible outcomes are possible for the firm in the short-run:
normal profit, economic profit or economic loss.
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.
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.
In the
long-run, firms can adjust the size of their plants creating a series of
short-run average and marginal cost curves (M&Y 10th
Fig. 9.7; M&Y 11th Fig. 8.9; B&B Fig. 9.14; B&Z Fig. 9.9). 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.
As previously noted, an industry may experience constant,
increasing or decreasing economies of scale. In a constant
cost industry the long-run supply curve is horizontal (M&Y 10th
Fig. 9.10; M&Y 11th Fig. 8.14; B&B not displayed; B&Z Fig. 9.11). In an increasing cost or
declining economies of scale the supply curve is positively sloped (M&Y
10th
Fig. 9.11;
M&Y 11th Fig. 8.15; B&B Fig. 9.21; B&Z Fig. 9.12). In a decreasing cost or
increasing returns to scale, the industry supply curve is negatively
sloped (M&Y 10th
Fig. 9.12;
M&Y 11th Fig. 8.16; B&B & B&Z not displayed).
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.
Furthermore, such external effects may be ambiguous, that is they
may increase the cost of some and decrease the cost to other firms.
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 firms 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 technology can change
equilibrium. 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).
Similarly, technological change can reduce costs and shift the
supply curve to right.
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.
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. ‘Perfect
competition’ is the contemporary statement of conditions under which such
‘a just price’ exists.
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No one exercises ‘market power’, i.e. no consumer, producer or
government can affect the price of a good or service.
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All factors of
production are paid ‘opportunity cost’ and none earn ‘economic profits’
– in the long-run.
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In effect,
‘consumer sovereignty’ reigns and producers adjust to market demand
subject only to their cost constraints.
Deviations in the
‘real world’ from ‘perfect competition’ conditions justify intervention by
government to:
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restructure the
market through anti-trust or anti-combines policies;
-
internalize
‘external costs’ or benefits through imposition of user or producer
charges; or,
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regulate the
market to attain price and quantity outcomes approximating those of
perfect competition.
The price/output outcome of perfect competition provides the benchmark
against which the performance of all other market structures are to be
judged.
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