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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.

Characteristics
A 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.
Price Price

(a) The industry (b) The firm


Fig. 19.1

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,

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 equilibrium 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/
revenue revenu
M e M
C C
A
C

Q Quantity 0 Q Quantity
O
(a) Firm A (b) Firm B

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

Costs
/ XZ= Short-run
Price supply curve

revenue YZ= Long-run


supply curve

Costs/
reven
ue

Fig.
19.9

(b) The firm


(a) The
industry
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.