Economics - Perfect Competitiion - Notes - Economics, Study notes of Economics

Download Economics - Perfect Competitiion - Notes - Economics and more Study notes Economics in PDF only on Docsity! PERFECT COMPETITION In the perfectly competitive market, a singly market price prevails for the commodity, and it is determined by the forces of demand and supply in the market. Under perfect competition, every participant (whether a seller or a buyer) is a price-taker, and no one is in a position to influence it. Characteristics of perfect competition: The main characteristics of perfectly competitive market are:- (a) Large number of buyers and sellers:- A perfectly competitive market is basically formed by a large number of actual and potential buyers and sellers. Their number is sufficiently large and the size of each seller and buyer is relatively small in terms of market. So, the individual seller’s buyer’s and supply and demand are negligible in terms of market supply and demand. Hence, individual seller and buyer do not have a control over supply and demand of the market. (b) Homogeneous Product:- The commodity supplied by each firm in a perfectly competitive market is homogeneous. This means that the product of each seller is virtually standardized. Since each firm produces an identical product, their products can be readily substituted for each other. Hence, the buyer has no specific preference to buy from a particular seller and his purchase from any particular seller is a matter of chance and not of choice. (c) Free entry and exit of firms:- New firms are not having any legal, technological, economic, and financial or any other barrier to their entry in the industry. Similarly, existing firms are free to quit the market. Thus, the mobility of firms ensures that whenever there is scope in the business, new entry will take place and competition will remain always stiff. Due to the natural stiffness of competition, inefficient firms would have to eventually quit the industry. (d) Perfect knowledge of market conditions:- Perfect competition requires that all the buyers and sellers must possess perfect knowledge about the existing market conditions such as market price, quantities and sources of supply and demand. The perfect knowledge ensures transactions in a perfectly competitive market at a uniform price. (e) Non-intervention of the Government:- A perfect competition also implies that there is no government intervention in the working of market economy. This means that there are no tariffs, subsidies, rationing of goods, control on supply raw materials and licensing policy. Government non-intervention is essential to permit free entry of firms and for automatic adjustment of demand and supply through the market mechanism. (f) Absence of transport costs element. It is essential that competitive position of no firm is adversely affected by the transport cost differences. Hence, it is assumed that there is absence of transport cost as all firms are closer to the markets. Price and Output determination under perfect competition Price for an individual firm under perfect competition is given. It cannot influence the price by its own action. Hence, the demand curve or average revenue curve facing a firm under perfect competition is perfectly elastic at the ruling price. Perfectly competitive firm can sell as much as it wishes without affecting the price, and the marginal revenue is equal to the price (average revenue) of the commodity. So, the average revenue (or demand) curve, (AR) and marginal revenue curve (MR) must coincide with each other for a firm under perfect competition. Y MC R E V E N U E (b) It makes only normal profits, and (c) It incurs losses. Let us explain them one by one. (a) When the firm makes supernormal profits in the short run:- In Fig 2, if the price is OP1, the average-marginal revenue curve is P1A1 and the firm is in equilibrium at point C1 of output OX1. The average cost is X1G, and price is OP1. Hence, profit per unit is GC1. The output is OX1. Hence, the firm is making supernormal profits, and it is equal to the area P1C1GH. As all the firms in the industry have identical cost curves with the firm represented in Fig.2, and all would be making supernormal profits. There will be a tendency for the new firms to enter the industry and it will compete away these supernormal profits. But the time period is not sufficient for the new firms to enter, the industry and hence the existing firms will continue to earn supernormal profits at the price OP1 in the short period. Y SMC SAC Q P1 A1 F E G P R A P2 S A2 Q OUTPUT X2 X X1 Q Fig.2 Firm’s Equilibrium: Short Run (b) The Firm just makes normal profit:- Let us assume that the ruling price in the market is OP. PA will then be the average marginal revenue curve and the firm will be in equilibrium at the point R. At the point R, besides marginal cost being equal to marginal revenue and MC curve cutting MR curve from below, average revenue (or price) is also equal to average cost, and the firms in the industry will be making only normal profits which included in average cost. Since all the firms in the industry are making only normal profits, the time period is not sufficient enough either for the new firms to enter or for the existing firms to quit the industry. (c) The Firm incurring Losses, but does not shutdown:- If the short-run price in the market were OP2, instead of OP1 and OP, the firm will be in equilibrium at point S, since with price OP2, only at S the marginal cost is equal to marginal revenue or price OP, and MC curve cuts MR P2A2 from below. But, at S or output OX2, the firm is incurring losses, The total losses in this situation are equal to the area P2SEF. This is the smallest loss that a firm can incur under the given price-cost situation, if it is to produce at all. Given the price OP2 in the market, the loss of the firm would be greater if it tries to produce at a point other than S. The important question arises are:- Why at all should the firms continue operating if they are incurring losses ? If they cannot leave the present industry, why do they not at least shut down to avoid losses? As mentioned earlier, the short run is a period in which firms cannot alter their fixed capital equipment. Hence, they will have to bear fixed costs in the short run even if they shut down. Only variable cost can be avoided by stopping production. Shut-down point: R E V E N U S by these supernormal profits, new firms will enter the industry and these extra profits will be competed away. When the new firms enter the industry, the supply of output of the industry will increase and hence the price of the output will be reduced. The new firms will keep coming into the industry until the price is depressed down to average cost, and all firms are earning only normal profits. On the other hand, if the price happens to be below the average cost, the firms will be incurring losses. Some of the existing firms will quit the industry. As a result, the output of the industry will decrease and the price will rise to equal the average cost so that the firms remaining in the industry are making normal profits. Thus the following two conditions must be satisfied. (i) Price = Marginal Cost (ii) Price = Average Cost. But if price equals both the marginal and the average costs then for the long-run equilibrium of the firm under perfect competition, we have a combined condition. Price = Marginal Cost = Average Cost. Now when average cost curve is falling, marginal cost curve is below it, and when average cost curve is rising, marginal cost curve must be above it. Hence, marginal cost can be equal to the average cost only at the minimum point of average cost curve. Therefore, it is at the point of minimum average cost curve that marginal cost curve intersects the average cost curve, and the two are equal. Thus, the conditions for long-run equilibrium of perfectly competitive firm can be written as: Price = Marginal Cost = Minimum Average Cost. The conditions for the long-run equilibrium of the firm under perfect competition can be easily understood from the Fig 4 where LAC is the long-run average cost curve and LMC is the long-run marginal cost curve. The firm under perfect competition cannot be in long-run equilibrium at price OP1 because though the price OP1 equal MC at Q but it is greater than the average cost at this output and, therefore, the firm will be earning supernormal profits.