Perfect competition


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Perfect competition

  1. 1. PERFECT COMPETITIONPerfect competition in economic theory has a meaning diametrically opposite to the everyday useof the term. In practice, businessmen use the word competition as synonymous to rivalry. Intheory, perfect competition implies no rivarly among firms. Perfect competition, therefore, canbe defined as a market structure characterised by a complete absence of rivalry among theindividual firms.FEATURES1. Large number of buyers and sellersThere must be a large number of firms in the industry. Each individual firm supplies only a smallpart of the total quantity offered in the market. As a result, no individual firm can influence theprice. Similarly, the buyers are also numerous. Hence, no individual buyer has any influence onthe market price. The price of the product is determined by the collective forces of industrydemand and industry supply. The firm is only a price taker. Each firm has to adjust its output orsale according to the prevailing market price.2. Homogeneity of productsIn a perfectly competitive industry, the product of any one firm is identical to the products of allother firms. The technical characteristics of the product as well as the services associated with itssale and delivery are identical. The demand curve of the individual firm is also its averagerevenue and its marginal revenue curve. The assumptions of large numbers of sellers and producthomogeneity imply that the individual firm in pure competition is a price taker. Its demand curveis infinitely elastic indicating that the firm can sell any amount of output at the prevailing marketprice.3. Free entry exitThere is no barrier to entry or exit from the industry. Entry or exit may take time but firms havefreedom of movement in and out of the industry. If the industry earns abnormal profits, newfirms will enter the industry and compete away the excess profits. Similarly, if the firms in theindustry are incurring losses some of them will leave the industry which will reduce the supplyof the industry and will thus raise the price and wipe away the losses.4. Absence of government regulationThere is no government intervention in the form of tariffs, subsidies, relationship of productionor demand. If these assumptions are fulfilled, it is called pure competition which requires thefulfillment of some more condition.5. Perfect mobility of factors of productionThe factors of production are free to move from one firm to another throughout the economy. Itis also assumed that workers can move between different jobs. Raw materials and other factorsare not monopolised and labour is not unionised. In short, there is perfect competition in thefactor market.
  2. 2. 6. Perfect knowledgeIt is assumed that all sellers and buyers have complete knowledge of the conditions of themarket. This knowledge refers not only to the prevailing conditions in the current period but inall future periods as well. Information is free and costless. Under these conditions uncertaintyabout future developments in the market is ruled out.7. Absence of transport costsIn a perfectly competitive market, it is assumed that there are no transport costs.SHORT RUN EQUILIBRIUM OF THE FIRMThe firm is in equilibrium at the point of intersection of the marginal cost and marginal revenuecurves. The first condition for the equilibrium of the firm is that marginal cost should be equal tomarginal revenue. The second condition for equilibrium requires that marginal cost curve shouldcut the marginal revenue curve from below.The firm is in equilibrium only at e because only at e both the conditions are satisfied. At e the firm is not in equilibrium as the second condition is not fulfilled. The fact that the firm is inequilibrium in the short run does not mean that it makes excess profits. Whether the firm makesexcess profits or losses depends on the level of average total cost at the short run equilibrium.In figure 3. (A), the SATC is below the price at equilibrium; the firm earns excess profits.In figure 3. (B), the SATC is above the price; the firm makes a loss.In the short run a firm generally keeps on producing even when it is incurring losses. This is sobecause by producing and earning some revenue, the firm is able to cover a part of its fixedcosts. So long as the firm covers up its variable cost plus at least a part of annual fixed cost, it isadvisable for the firm to continue production. It is only when it is unable to cover any portion ofits fixed cost, it should stop producing. Such a situation is known as shut down point. The shutdown point of the firm is denoted by W. If price falls below P the firm does not cover its variablecosts and is better off if it closes down.154, 155The industry is in equilibrium at price P at which the quantity demanded and supplied is OQ.However this will be a short-run equilibrium as some firms are earning abnormal profits andsome incur losses as shown in figures 5. (B) and 5. (C) respectively. In the long run, firms that
  3. 3. make losses will close down. Those firms which make excess profits will expand and also attractnew firms into the industry. Entry, exit and readjustment will lead to long run equilibrium inwhich firms will be earning normal profits and there will be no entry or exit from the industry.Long-run equilibrium of the firmIn the long run firms are in equilibrium when they have adjusted their plant so as to produce atthe minimum point of their long run AC curve, which is tangent to the demand curve. In the longrun the firms will be earning just normal profits, which are included in the LAC. The long runequilibrium position of the firm is shown in figure below.At the price of OP, the firm is making excess profits. Therefore, it will have an incentive to buildnew capacity and hence it will move along its LAC. At the same time, attracted by excess profitsnew firms will be entering the industry. As the quantity supplied increases, the price will fall toPi at which the firm and the industry are in long run equilibrium. The condition for the long-runequilibrium of the firm is that the marginal cost tie equal to the price and to the long run-averagecost. LMC = LAC = PThe firm adjusts its plant size so as to produce that level of output which the LAC is theminimum. At equilibrium the short run marginal is equal to the long run marginal cost and theshort run average cost is equal to the long run average cost. Thus, in equilibrium in the long runSMC = LMC = LAC = SAC = P = MR. This implies that at the minimum point of the LAC theplant worked at its optimal capacity, so that the minimal of the LAC and SAC coincide.Long-run Equilibrium of the IndustryThe industry is in long run equilibrium when price is reach which all firms are in equilibriumproducing at the minimum point oft LAC curve and making just normal profits. Under theseconditions there is no further entry or exit of firms in the industry. The long run equilibrium isshown in the figure below.
  4. 4. At the market price P the firms produce at their minimum cost, earning just normal profits. Thefirm is in equilibrium because at the level of output x. LMC = SMC = P = MRThis equality ensures that the firm maximises its profit. At the price P the industry is inequilibrium because profits are normal and all costs are covered so that there is no incentive forentry or exit.Price determination under perfect competition-Role of timePrice of a commodity in an industry is determined at that point where industry demand is equalto industry supply. Marshall laid emphasis on the role of time element in the determination ofprice. He distinguished three periods in which equilibrium between demand and supply wasbrought about viz., very short period or market period; short run equilibrium and long runequilibrium.Market periodPrice is determined by the equilibrium between demand and supply in market period. In themarket period, the supply of commodity is fixed. The firms can sell only what they have alreadyproduced. This market period may be an hour, a day or few days or even few weeks dependingupon the nature of the product. So far as the supply curve in a market period is concerned, twocases are prominent-one is that of perishable goods and the other is that of non perishabledurable goods.
  5. 5. For perishable goods like fish, vegetables etc. the supply is given and cannot be kept for the nextperiod; therefore, the whole of it must be sold away on the same day whatever be the price. Thesupply curve will be a vertical straight line.QS is the supply curve. OQ is the quantity of fish available. DD is the market demand curve. Theequilibrium price OP is determined at which quantity demanded is equal to the available supplyi.e. at the point where DD intersects the vertical supply curve QS. If demand increases from DDto D1D1 supply remaining the same price will increase from OP to OP1. On the contrary, if thereis a decrease in demand from DD to D2D2 the price will fall and the quantity sold will remainthe same. If the commodity is a durable good, its supply can be adjusted to demand. If thedemand for commodity declines the firms will start building inventories, while on the other hand,if demand goes up the firms will increase their supplies out of the existing stocks. The firm cankeep on supplying out of its existing stocks only upto the availability of stocks. If demandincreases beyond that level, the firm cannot supply any additional quantity of the good. Thus thesupply curve for the durable goods is upward sloping upto a distance and then becomes vertical.A firm selling a durable good has a reserve price below which it will not like to sell. The reserveprice, is influenced by the cost of production.
  6. 6. SRFS is the supply curve of the durable goods. OM1 is the total amount of stock available. UptoOP1 the quantity supplied varies will I price. At OS price, nothing is sold. It is the reserve price.At OP1 price, the whole stock is offered for sale. DD is the demand curve. Price ul determined atOP at which quantity demanded is equal to the quantity supplied. At this price OM quantity issold. If demand increases form DD to D1 D1 the price will increase to OP1 and the whole stockwill be sold. If the demand decreases from DD to D2D2 the price will fall to OP2 and the amountsold will fall to OM2.Short run equilibriumIn the short period the firm can vary its supply by changing the variable factors. Moreover, thenumber of firms in the industry cannot increase or decrease in the short run. Thus the supply ofthe industry can be changed only within the limits set by the plant capacity of the existing firms.The short period price is determined by the interaction of short period supply and demandcurves. The determination of the short run price is shown in figure below.DD is the demand curve facing the industry. MPS is the market period supply, curve and SRS isthe short run supply curve of the industry. If there is an increase in demand form DD to D1D1the market price will increase from OP to OP1. The supply of the commodity will be increasedby intensive utilisation of fixed factors and increasing the amount of variable factors. So in theshort run price will fall to OP3 at which new demand curve D1D1 intersects the short run supplycurve SRS. Thus OP3 is the short run price and quantity supplied has increased from OM toOM1.Long-run equilibriumIn the long run, supply is adjusted to meet the new demand conditions. If there is an increase indemand, the firms in the long run will expand output by increasing the fixed factors ofproduction. They may enlarge their old plants or build new plants. Moreover, in the long run newfirms can also enter the industry and thus add to the supplies of the product. The determination ofprice in the long run is shown in figure below.
  7. 7. LRS is the long run supply curve; MPS is the market period supply curve and SRS is the shortrun supply curve. DD is the market demand curve and OP is the market price. If there is anincrease in demand from DD to D1D1 the market price will increase from OP to OP1. In theshort run, however, the firms will increase output. Price in the short run will fall to OP2 at whichD1D1 intersects the short run supply curve SRS. In the long run new firms will enter theindustry. As a result output will increase and price will fall to OP3. Thus OP3 is the long runprice.