4. Competition (cont'd)
4.2 Perfect Competition
Perfect competition fully satisfies the following four strict conditions:
(ii) No Market Power
(iii) Perfect Knowledge
(iv) Free Entry & Exit
Under perfect competition, market demand is calculated as the horizontal summation of individual consumer demand curves that are usually downward sloping. The Law of Demand also holds for the market demand curve: the higher the price the lower the demand, the lower the price the higher the demand, It is assumed that there are constant prices for all other commodities as well as constant consumer income and constant consumer preference amongst alternative goods and services or commodities.
The consumer demand curves will shift, left or right - up or down, if any constant changes. It will shift reflecting changes in the consumer income-consumption curve and/or changes in the marginal rate of substitution (preference) of consumers. Thus, at any moment in the short-run, it is assumed the prices of all other commodities are constant as is consumer income. The consumer demand curve will, therefore, shift or mutate (change in elasticity of price, income and/or substitutes/compliments) if any of these constants change.
Market demand is thus not calculated from the producers’ perspective. Rather, individual firms face a perfectly elastic or, horizontal demand curve, i.e., the price established for market equilibrium is taken by each firm and equated with its own MC curve determining how much it will be willing to supply while maximizing its profits. Each firm will sell the quantity corresponding to the intersection of the market determined price and its MC curve. If any firm raises its price that firm immediately looses all its consumers; and, if it lowers its price, all competitors immediately follow. Further, Price (P) always equals Marginal Revenue (MR), i.e. Revenue equals Price multiplied by Quantity - bought and sold or (Q) and MR equals the change in R divided by the change in Q equaling P.
Put another way,
the additional revenue from the next sale equals the market
equilibrium price faced by each and every competitive firm.
This is a key characteristic of Perfect Competition. It
is this sense that the perfectly competitive firm is a 'price taker' , not
a 'price maker'.
It is this sense that the perfectly competitive firm is a 'price taker' , not a 'price maker'.
The market supply curve is calculated as the horizontal
summation of the supply curves of all firms.
The cost function of the firm is used to determine the supply curve
for each firm in three distinct time frames:
i - Very Short-Run Supply Curve:
during which the level of output cannot be changed and therefore the output of each firm is fixed. The very short-run supply curve is vertical, output is constant and does not depend on price.
during which the level of output can be changed but the
size of plant cannot be varied. The short-run supply curve for a firm is
identical to its short-run marginal cost curve above the intersection of
the MC and AVC curves of the firm (M&Y 10th
Fig. 9.3 &
9.4; M&Y 11th Figs 8.4 & 8.5; B&B Fig. 9.2; B&Z Fig. 9.5) The firm’s short-run
supply curve is thus a function of costs. The market supply curve is the
horizontal summation of the individual firm’s supply functions (M&Y 10th
Fig. 9.5; M&Y 11th Fig. 8.6; B&B not displayed; B&Z not
during which all factors are variable and long-run optimal
output exists where P = LRMC.
The long-run supply curve is the portion of the long-run marginal cost
curve above long-run average cost (M&Y 10th
Fig. 9.9; M&Y 11th Fig. 8.12; B&B Fig. 9.14; B&Z 9.9).
To determine profit-maximizing output of a firm under perfect competition, one can use two methods:
total revenue less total cost; and,
(i) Total Revenue less Total
Profit equals TR – TC (M&Y 10th Fig. 9.1; M&Y 11th Fig. 8.2; B&B Fig. 9.1; B&Z 9.2). By plotting TR and TC curves one can see the changing relationship: initially there is a section of economic loss followed by economic profit followed by economic loss with two points of ‘normal’ profit points.
Marginal revenue (MR)
can be compared with average cost (AC). Firm must sell at MR = P = MC (M&Y
Fig. 9.2; M&Y 11th Fig. 8.3; B&B Fig. 9.1b; B&Z Fig. 9.2).
But if MR > AC producing an additional unit output will add more revenue
than cost, i.e. economic profit earned in the SR.
If MR = AC then ‘normal profit’ earned, i.e. all factors of
production paid their opportunity cost value.
If MR < AC producing another unit with result in a loss .
Three possible outcomes are possible for the firm in the short-run:
normal profit, economic profit or economic loss.
Three possible outcomes are possible for the firm in the short-run: normal profit, economic profit or economic loss.
In short-run firm will continue producing if at least all variable costs are covered even if the firm suffers a loss because it is not covering all of its fixed costs. If all variable cost cannot be covered, the firm will shutdown. In the LR, firms suffering short-run losses either adjust their scale of production (assuming economies of scale are available) or they exit the industry. Exit reduces supply (shifts SC to left) and raises price. The LRAC curve is the envelop of minimum points of sequence of SRACs reflecting scale increases.
If some firms enjoy SR economic profits, new firms will enter increasing supply (shifting SC to right) and reducing price.
In the long-run, firms can adjust the size of their plants creating a series of short-run average and marginal cost curves (M&Y 10th Fig. 9.7; M&Y 11th Fig. 8.9; B&B Fig. 9.14; B&Z Fig. 9.9). The long-run average cost curve is made up of an envelope of the minimum points of the short-run average cost curves where SR average cost equals SR marginal cost. At some point the most efficient plant size is achieved where LR average cost is lowest for a particular short-run situation. At this size the short-run marginal cost curves, in effect, becomes, the long-run marginal cost curve.
As previously noted, an industry may experience constant, increasing or decreasing economies of scale. In a constant cost industry the long-run supply curve is horizontal (M&Y 10th Fig. 9.10; M&Y 11th Fig. 8.14; B&B not displayed; B&Z Fig. 9.11). In an increasing cost or declining economies of scale the supply curve is positively sloped (M&Y 10th Fig. 9.11; M&Y 11th Fig. 8.15; B&B Fig. 9.21; B&Z Fig. 9.12). In a decreasing cost or increasing returns to scale, the industry supply curve is negatively sloped (M&Y 10th Fig. 9.12; M&Y 11th Fig. 8.16; B&B & B&Z not displayed).
External Economies, Changing Taste & Technology
To this point it has been assumed that cost is a function only of firm output but cost may depend upon the output of all firms in the industry. For example, if industry output goes up, input costs to the firm may go down, i.e. an external economy to the firm’s production. Or, if industry quantity goes up, factor costs to the firm may increase, i.e. an external diseconomy to an individual firm’s production. Furthermore, such external effects may be ambiguous, that is they may increase the cost of some and decrease the cost to other firms.
Firms base their behavior on their own marginal cost curve. If all anticipate the same market equilibrium price and industry output is consistent with the summation of individual firm output there will be no further adjustment. Otherwise, individual firm output may not equate with marginal cost and firms will adjust in the next round of what is called tatonnement or a bidding process until there is no further adjustment.
The market supply curve should state optimal output as a function of price after all necessary adjustments. In addition to external economies, changes in taste and technology can change equilibrium. A decline in taste for a commodity can permanently reduce demand (shift curve to right) lowering price. At the extreme, all firms exit and the industry collapses (hoola-hoops). Similarly, technological change can reduce costs and shift the supply curve to right.
Allocative efficiency implies all factors of production and all commodities demanded by consumers are in their best use and receive their opportunity cost. Further, it is assumed that there are no external cost or benefits, i.e. all external costs and benefits have been ‘internalized’. Three conditions must hold:
(i) Consumer Efficiency: when consumer cannot increase utility by reallocating budget;
(ii) Producer Efficiency: when firm cannot reduce cost by shifting input mix;
Exchange Efficiency: when all gains from trade have been
exhausted. Gains from trade
to consumer is called consumer surplus which measures difference
between what consumer are willing to pay and what they actually pay for a
total quantity of a good or service at market price.
Gains from trade to producers are called producer surplus
which measures the difference between what producer are willing to accept
and what they actually receive for providing a market equilibrium level of
Beginning with Thomas Aquinas through Adam Smith up to today when consumers are outraged about bank profits and ‘bitch’ at the gas pump, the ‘just price’ has engaged the hearts and minds of economic thinkers for almost a thousand years in the West. ‘Perfect competition’ is the contemporary statement of conditions under which such ‘a just price’ exists.
Deviations in the
‘real world’ from ‘perfect competition’ conditions justify intervention by
The price/output outcome of perfect competition provides the benchmark
against which the performance of all other market structures are to be