Perfect competition

It is common practice that we divide industries into categories pertaining to the level of competition in that industry. The spectrum of competition ranges from one extreme of perfect competition to the other extreme of monopoly. Other market structures such as monopolistic competition and oligopolies fall in between. It is these market structures which determine the behavior of the firm in that industry.

Perfect competition is on one extreme of the spectrum. Although it may not exist in our world today it plays an important role as a model to study when analyzing levels of competition (Bamford et al.2002).

The model of perfect competition is based upon four assumptions.

Firstly the firms are price takers. There are so many firms in the market that and single firm does not produce enough of the whole to be able to influence the market price. Therefore, they are considered as price takers where the price has already been determined at the market forces of demand and supply. There are no barriers of entry or exit for the firms. There are no stopping firms who wish to enter or leave the market. The existing firms have no role in this process. All firms are producing homogenous products. This means that the products of all firms are identical and as a result there can be no marketing in terms of names of brands. All the producers and consumers have perfect information regarding the prices of the products. (Sloman,2006)

Very few firms or industries come close to this model in the real world. We may see such conditions temporarily in the agricultural industry but, these do not exist in the long run.

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In perfect competition as stated in the assumptions above it is assumed that there are many small firms and that they cannot do anything to influence the market price. The firm’s contribution to the industry and market is so small that even if it changes its output it will have no effect on the market price of the product. Thus, the firm can produce any quantity hoping to sell all of it at market price. Considering this it is derived that the demand curve is perfectly elastic and thereby, marginal revenue earned for each additional output sold is same throughout. Therefore, the marginal revenue is equal to average revenue (Bamford et al 2002.).

Thus, considering that the individual firms do not affect the market price the only real decision which they have to make is the level of output to be produced. This decision can be taken by taking into account the costs of production. Considering the basic objective of the firm is to maximize profits it will produce at the point where marginal costs equals marginal revenue (MC=MR). (Bamford et al. 2002)

The first thing which needs to be understood is the difference between the short run and the long run. During the short run the number of firms in the industry is fixed. This means that no new firms will be entering the market in the short run. The existing firms will have the chance to earn abnormal profits in the short run. However, in the long run there will be other firms entering the market. Firms will enter the market if there will be signs of abnormal profits. On the other hand, if there are losses some firms may also leave the industry. (Sloman,2006)

The total revenue to be earned by the firm will be equal to the price multiplied by the quantity sold. If the total cost of producing this specified number of units is lesser than the total revenue then it can be said that the firm is making abnormal profits. This will actually be an incentive for the firm to keep producing at the current rate.

However, if total revenue equals total coast (TR=TC), then the firm is barely making it to the breakeven point. It is this point where the firm is earning normal profits.

On the other hand, it is plausibility that the total cost is greater than the total revenue. If the costs are greater, the firm may exit the industry altogether. This may not be the case at all times. If the total revenue is greater than the average variable cost then the firm may continue producing because it is at least covering the variable costs. This is known as the shutdown price. As long as the firm is able to cover the variable costs it will keep working and continue production. It will be making a loss equaling the fixed costs.

Loss making firms in the short run will first look to cover the variable costs and then look forward for the increase in the market price of the good. If this does not happen it will look to reduce its costs. But, if these two solutions do not work then it has no alternative but to shut down and leave the market. Thus, many firms simultaneously leave the market as they are no longer able to cover their costs. When this happens the overall supply of all the firms in the market falls considerably. The fall in supply results in an increase in the market price of the product allowing the remaining firms to benefit from the profit making opportunities.

In the long run, the situation will be entirely the different. The firms will not supply unless their costs are covered by the revenues and the firm is at least making normal profits. The minimum supply for the firms in the perfect competition long run will be the optimum output.

When in perfect competition the market price will be same for all suppliers. However, the only reason behind varied profits can be due to their different cost structures. The question which comes here is that how is it possible that firms making the same product with the same ingredients have different cost structures. The answer is pretty simple. The firms can reduce their average costs by increasing productivity and by reducing the variable costs as low as possible. In this way they will be able to boost the profits and make sure that the firm is able to keep up with the level of competition that exists.

For firms in any market structure the most important aim is always profit maximization. They are always looking forward to earn supernormal or abnormal profits. In the perfectly competitive market the abnormal profits are just a feature of the short run. This happens because the abnormal profit acts as an incentive for the firms to enter the industry in order to benefit from the profits. As we have already discussed that the perfectly competitive industry has no barriers to entry and exit. With the absence of barriers the firms will easily enter the market and this in turn will increase the overall supply in the market. With the increase in supply the market price will go downwards thereby, ending all opportunities for abnormal profits for the firms.

The entering firms in the long run cause the possibility of abnormal profit to be removed. The existing firms will no longer earn these profits and will have to carry on with the normal profits. In a perfectly competitive market only those firms who are the most efficient ones will survive and only making normal profits.

There are quite a few reasons why perfect competition is extremely rare or even nonexistent in the world today. One reason behind this is the economies of scale. For perfect competition to exist firms have to be extremely efficient meaning that they have to achieve economies of scale.

This poses a couple of problems. Firstly, it is very difficult for a small firm to achieve the economies of scale. It is usually the larger firms who actually achieve this. As the theory of perfect competition states that there are a large number of small firms this cannot actually happen. Secondly, those firms who achieve the economies of scale become larger in size and instead of this leading to perfect competition it leads away from it. This happens because the bigger the firm gets it starts to experience economies of scale. As the costs start to get lower the firm washes out the customers from other competitive firms. In this way they expand the influence and instead of moving towards perfect competition they move towards making a monopoly.

Competitive markets provide the best means of ensuring that the economy’s resources are put to their best use by encouraging enterprise and efficiency, and widening choice. Where markets work well, they provide strong incentives for good performance – encouraging firms to improve productivity, to reduce prices and to innovate; whilst rewarding consumers with lower prices, higher quality, and wider choice. By encouraging efficiency, competition in the domestic market – whether between domestic firms alone or between those and overseas firms – also contributes to our international competitiveness. (www.dti.gov.uk)

The long run of perfect competition, therefore, exhibits optimal levels of economic efficiency. But for this to be achieved all of the conditions of perfect competition must hold – including in related markets. When the assumptions are dropped, we move into a world of imperfect competition with all of the potential that exists for various forms of market failure.

The next diagram shows how when price and output is not at the competitive equilibrium, the result is a deadweight loss of economic welfare. The competitive price and output is P1 and Q1 respectively.

For social efficiency Marginal Social Benefit should be equal to Marginal Social Cost. Economists argue and explain that under certain circumstances there will be social efficiency. The two major conditions mentioned are that there should be perfect competition and there should be no externalities. Absence of externalities will mean that there will be no external costs and this will in turn ease the pressure and bring about social efficiency in the economy.

As it has been mentioned earlier that the perfectly competitive market is just a theoretical extreme it does not exist in the real world. However, it is ideal and acts as a means for comparison with other market structures. In such markets firms are forced to produce at the lowest point on their average cost curve in order to survive.

Many economists claim that apart from being efficient in production perfect competition may on some instances also lead to social efficiency.

Considering efficiency first we need to understand the concept of choice and the rational consumer. In each and every case a person benefits when the marginal benefits exceed marginal costs. If it is the opposite then the situation suggests that the activity should be stopped. Only when marginal benefit is equaled with marginal cost the point of efficiency is achieved. If MC=MB for a person then this situation is known as private efficiency.