Perfect competition

In this part we look at the various market conditions under which prices are determined. We start by looking at the highest degree of competition .possible.

Definition

The economist's model of perfect competition is highly theoretical, but it does provide a useful tool of economic analysis and helps us to make some sense of real world conditions. The real world is much too complicated to understand all at once; it is necessary to examine one feature at a time. Economists are able to use their model of a perfect market as a means of assessing the degree of competition in real world markets. They set out the conditions necessary for a perfect market and then contrast these with the situations found in the markets for goods and services. The degree of competition in these real markets is based upon the extent to which they approximate to the model of perfect competition. It is necessary to point out that the competition referred to here is price competition. Firms are assumed to be engaged in a rivalry for sales which takes the form of underselling competitors.

In a market operating under the conditions of perfect competition, there will be one, and only one, market price, and this price will be beyond the influence of any one buyer or any one seller.

CharacteristicsA perfectly competitive market has a number of key characteristics.

All units of the commodity are homogeneous (i.e. one unit is exactly like another). If this condition exists, buyers will have no preference for the goods of any particular seller.

There must be many buyers and many sellers so that the behaviour of any one buyer, or any one seller, has no influence on the market price. Each individual buyer comprises such a small part of total demand and each seller is responsible for such a small part of total supply that any change in their plans will have no influence on the market price.

Buyers are assumed to have perfect knowledge of market conditions; they know what prices are being asked for the

commodity in every part of the market. Equally sellers are fully aware of the activities of buyers and other sellers.

There must be no barriers to the movement of buyers, from one seller to another. Since all units of the commodity are identical, buyers will always approach the seller quoting the lowest price.

Finally, it is assumed that there are no restrictions on the entry of firms into the market or on their exit from it.

We can now see why, in a perfect market, there will be one and only market pried which is beyond the control of any one buyer or any one seller. Firms cannot charge different prices because they are selling identical products, each of them is responsible for a tiny part of the supply, and buyers are fully aware of what is happening in the market.

The individual firm under perfect competition

Under conditions of perfect competition the firm is powerless to exert any influence on price. It sees the market price as 'given’, that is, established by forces beyond its control. For example, in most countries, the individual farmer has no influence on the prices at which he sells his, or beef, or milk, or vegetables. Any changes in the amounts of these things which he brings to market will have negligible effects on their s. The firm, under perfect competition, is a 'price-taker'. The demand curve for the output of the single firm; therefore, must be line at the ruling price; in other words, a perfectly elastic curve. No matter how many units the firm sells it cannot change the price. It can sell its entire output at the ruling market price. If it tries to sell at higher prices its demand will drop to zero, and there is obviously no. incentive to sell at lower prices. Again, we must against a common misunderstanding. The demand curve for the product of the firm will be perfectly elastic, but the market demand for the output of the industry will be of the normal shape (i.e. _ downwards from left to right). Market price will be determined total demand and supply curves. Figure 19.1 should make this clear.Figure 19.1 (a) shows the determination of the market price (OP) by the forces of market demand and supply. D1D1 is the demand curve facing the industry and SS is the total supply provided by all the firms in that Industry. Fig. 19.1 (b) we have the situation facing the individual firm, s price (OP) is externally determined and the firm sees the demand for its product as being perfectly elastic. In the two diagrams, the scales on the price axes will be the same, but the scales on the quantity axes will be very different, because the firm supplies a negligibly small part of the total output of the product.

Average and marginal revenues

When a firm faces a perfectly elastic demand curve, how does it determine its output? In theory it could sell an infinite amount at the existing market price, because no matter what quantity it sells, it has no influence on the price. The answer to the question is to be found in the shape of the firm's average and marginal cost curves. As explained earlier these curves are assumed to be U-shaped and, if increasing output eventually leads to rising unit costs, there must come a point where the cost of producing a unit of output will exceed its price. It should be apparel that a firm will continue to expand its output as long as the revenue it receives from additional output exceeds the cost of producing that additional output. This leads us to consider how a firm's revenue changes as its output changes. There are three ways of looking at a firm's revenues.

Total revenue (TR) is quite simply the money value of the total amount sold. Average revenue (AR) is another name for price because it is equal to

revenue per unit sold.

i.e. AR = Total Revenue/Number of Units sold

In economic theory, the demand curve or price line is often referred to as the average revenue curve.

Marginal revenue (MR) is the additional revenue obtained when sales are increased by one unit, or, more precisely, it is the change in total revenue when the quantity sold is varied by one unit. For example,

Price Price

(a) The industry (b) The firmFig. 19.1

Figure 19.2 shows a perfectly elastic demand curve of the type faced by the firm operating under perfect competition. In this case MR must always be equal to AR. As the quantity sold increases, the price remains unchanged so that each additional unit sold increases total revenue by an amount equal to its price.

The total revenue curve of a firm operating under conditions of perfect competition is a straight upward sloping curve as illustrated in Fig. 19.3.

The output of the firm under perfect competition

We assume that the firm is in business to make profits and that it will aim to maximize profits. As long as the price (AR) it receives for each unit exceeds the average cost of production, the firm will be making profits. Thus, in Fig. 19.4 when price = OP, the firm will be making profits in the range of output OQ to OQ2, because at all outputs in this range, AR is greater than AC.

We have to determine which output between OQ and OQ3 yields the maximum profit. It should be apparent that output OQK will yield the maximum profit per unit, but firms seek to maximize total profit not profit per unit. We notice first that as output increases from OQ to OQ2, the firm's total profit will be increasing because for each additional unit

Revenue

Fig. 19.3

Revenue and costs (£)

Fig. 19.4

produced, the increase in total revenue (i.e. MR) is greater than the increase in total cost (i.e. MC). Remember that in this particular case, MR = AR.

As output is expanded beyond OQ2, total profit will be decreasing, because, for each additional unit produced, the increase in total revenue (i.e. MR) is less than the increase in total cost (i.e. MC).

Therefore since total profit is increasing up to OQ2 and falling beyond OQ2, profits must be maximized when output is at OQ2, that is, when Marginal Revenue = Marginal Cost. It is important that the explanation above is fully understood, because the relationship which has been derived, i.e. profits are maximized when output is at the point where MR = MC, applies to all firms, whatever market structure they are operating in.

In the case of the perfectly competitive firm illustrated in Fig. 19.4 demand is perfectly elastic so that AR - MR. Thus, in this particular case. we can say that maximum profits will be earned where AR = MR = MC.

Normal and abnormal (supernormal) profit

The economist takes the view that some level of profit, described as normal profit, should be regarded as a cost of production. Normal profit is the minimum level of profit which will persuade an entrepreneur to stay in business. It will vary from industry to industry depending upon the degree of risk involved. Since production will not continue unless this minimum level of profit is forthcoming, normal profit may be legitimately regarded as a cost of production. Normal profits, therefore, are included in the calculations which produce the AC curve. Therefore, when price exceeds average cost, the firm is said to be earning abnormal profits (or supernormal profits). Supernormal profit is illustrated by the shaded area in Fig. 19.4. When output is at OQ2, the cost per unit is equal to BQ2, but the price is equal to AQ2. Supernormal profit per unit, therefore, is AB. Total supernormal profit is equal to the area AB x OQ2 (i.e.. the shaded area). Supernormal profits arise when either costs fall or demand increases.

The elimination of supernormal profits

Although the firm in Fig. 19.4 is in equilibrium, the industry is not in equilibrium. There will be forces at work tending to change the size of the industry. One of the assumptions of perfect competition is freedom of entry. The situation depicted in Fig. 19.4 will not persist in the long run, because the supernormal profits being earned by the existing firms will attract other firms into this industry. As new firms come in, total supply will increase, market price will fall, and the process will continue until the supernormal profits have been 'competed away.' Figure 19.5 shows that the entry of new firms moves the industry's supply curve to the right and lowers price. This will cause firms to move into a position of long- run equilibrium.

Long-run equilibrium

The long-run equilibrium of the firm is shown in Fig. 19.6. The market price has fallen to OP1 arid the most profitable output is now OQ1, where AR = MR = MC. Note that price, or average revenue, is now equal to average cost so that the firm is making only normal profits. There is no

Fig. 19.5

incentive for firms to enter or leave the industry so that both the firm and the industry are in equilibrium. The long-run equilibrium of the firm, therefore, is to be found where,

AR = MR = MC = AC

In theory, the system of perfect competition produces a long-run equi-librium where all firms earn only normal profits and produce at minimum cost.

Costs/Revenue

Fig. 19.6

Subnormal profits

In the short run firms may experience subnormal profits (i.e. losses). This will mean that firms will be producing where average cost exceeds average revenue. Subnormal profits occur if either costs rise or demand falls. Figure 19.7 shows subnormal profit arising due to a decrease in demand.

Costs/Revenue

(a) The industry (b) The firm

Fig. 19.7

The area C1 x YP1 represents the area of loss that the firm is making. It is costing the firm C1 per unit to produce the good but the firm is receiving a price of only Pl so it is not covering all of its costs.

In this situation some firms will leave the industry but some will remain. Those that stay in the industry will be those that believe that they will be able to return to earning normal profits and that currently can cover their variable costs. If the price a firm is receiving is covering its average variable costs it will be covering the direct cost of production and may be making some contribution to average fixed costs. Whereas if the firm shut down it would not be able to cover any of the fixed costs that it would still have to meet. Figure 19.8 shows two firms making subnormal profits. Firm (a) is covering its average variable cost and will stay in the industry, at least in the short run, whilst firm (b) is not and will leave the industry.

Firms in perfect competition are usually assumed to have identical cost curves. However, this is not a very realistic assumption. This is because even if all units of land, labour, and capital were equally efficient and available to all firms on identical terms, it is most unlikely that all entrepreneurs will have the same outlook, the same ability, and the same

Costs/ Costs/ revenueM

CMC

C

P

AC

Q Quantity 0 Q Quantity

(a) Firm A (b) Firm B

revenue

O

Fig. 19.8

energy. It is the marginal firms (i.e. those with the highest costs) which will be the first to leave the industry when subnormal profits are being made and the last to enter when supernormal profits are experienced.

Long run adjustment to subnormal profits

As we discussed above the existence of subnormal profits will cause some firms to leave the industry. This will move the industry's supply curve to the left, raise price and return profits to the normal profit level. Figure 19.9 shows the industry and a firm returning to long-run equilibrium where there is no incentive for firms to enter or leave the industry and where firms are earning normal profit.

The firm's supply curve under conditions of perfect competition

The previous explanation of how a firm under perfect competition determines its output may be used to explain the shape of the individual firm's supply curve and the general shape of the total supply curve for the industry. It has been shown that firms attempt to set their outputs at the point

where MR = MC. For the firm in perfect competition, MR is always equal to AR (i.e. price) so that the individual firm will try to adjust its output so as to equate price and marginal cost.

In the conditions shown in Fig. 19.10 when the market price is OP the firm will produce output OQ. If the market price falls to OP1 the firm, in

Fig. 19.9

(a) The industry

(b) The firm

Costs/Price

revenue

XZ= Short-run supply curve

YZ= Long-run supply curve

Costs/ revenue

Trying to maximize profit, will reduce output to OQ}. The MC curve, therefore, is acting as the firm's supply curve, because it is determining the quantity supplied at any given price. If the market price falls to OP2, the firm will adjust its output to OQ2 (where price equals marginal cost)

At this point, however. Price = MC = AC so that the firm will be making no more than normal profits.

If market price falls below OP2, the firm will be making losses because, at all outputs, price will be less than average cost. Thus when price is OP3 the firm will be making losses, but at this price, OQ3 still represents the 'most profitable' output in the sense that it represents the output at which losses are minimized. In the short-run, the firm may still produce even when price is less than average total cost provided it is above average variable cost. So the short-run supply curve is that part of the MC curve which lies above the AVC curve. In the long run all costs have to be covered so the long-run supply curve is that part of the MC curve which lies above the AC curve. It slopes upwards from left to right because increasing output gives rise to increasing marginal cost.

The industry's supply curve under conditions of perfect competition

The total or market supply curve for a commodity is obtained by adding together the supply curves of all the firms producing that commodity This total supply curve is described as the industry supply curve. We must bear in mind, however, that the supply curve for an industry is affected by the movement of firms into and out of the industry. If market price rises, not only will existing firms produce more, there will also be new firms moving into the industry. Similarly, falling prices will cause existing firms to reduce output and some of the higher cost firms will be driven out of the industry.

Realism of the perfect competition model

Perfect competition is not to be found in the real world, although it is possible to point to some markets where there is some rough approximation to this 'ideal'. There are hundreds of thousands of wheat producers all over the world and not one of them is large enough to influence the world price of wheat. The world markets' for a number of agricultural products contain many of the features of a perfect market. There are many- producers and many buyers; modern methods of communication make knowledge of market conditions almost perfect, and the standardized grading of commodities means that the products in any one grade are regarded as homogeneous. Another, often quoted, example of a market which bears some resemblance to a perfect market is the Stock Exchange, the market in stocks and share.