Perfect Competition (MKM C4/68-9;
63-4) fully satisfies the following four
indistinguishable to producers.
Firms have no reason to favor one consumer over another.
The product of different firms is indistinguishable, one from
another, in terms of quality and there is no product differentiation.
Goods are 'homogenous'.
Consumers have no reason to prefer the product of one firm over
that of another, other than price.
ii - No Market Power
There is a
large number of both producers and consumers.
Sales or purchases by any buyer or seller are small relative to the
total volume of exchange. No
buyer or seller can affect price or quality, i.e., no one exercises market
power. All consumers and
producers respond and adjust only to market signals.
iii - Perfect Knowledge
producers possess perfect knowledge about price and quality. No firm can charge more, and no consumer can pay less than
the market equilibrium price.
iv - Free Entry & Exit
Entry and exit from the market is free for both consumers and
producers. There are no barriers to
entry or exit. There is an
unimpeded flow of resources between alternative uses i.e., resources are
mobile and move to the use with greatest advantage in terms of opportunity
costs. Firms exit if
they experience losses.
Thereby inefficient firms leave the market. Firms enter the market if they expect to earn economic
short-run, and/or, normal long run profits (
7th Ed Fig. 12.9; R&L 13th Ed
Fig. 9-9). On the other
side of the Marshallian scissors, Demand, there are many close substitutes
available to consumers who can easily switch if price, preference and/or
2. Profit Maximizing Output
these strict assumptions are satisfied then there is a perfectly
competitive marketplace and the firm is a 'price
taker'. The market sets the price. If a firm raises its price above
market price it loses all its business because of homogenous goods and the perfect knowledge of buyers.
Why pay a higher price for an identical product? If a firm
lowers its price below market it will, as will be seen,
sell less at a lower price earning smaller revenue and profit. To determine
profit-maximizing output we can use
(TR) less total cost (TC); and,
ii - marginal analysis.
Total Revenue less Total
(π) equals total revenue (TR) minus
total cost (TC). Under
perfect competition a firm sells every unit at market price. It is
a price taker. In Cartesian space (Quantity, Price/Cost) the TR
curve is a straight 45º line radiating from
the origin (0, 0). reflecting the fact that each unit sold earns the
same revenue. The TC curve, on
the other hand, begins above the origin on the y-axis reflecting fixed
costs that must be paid even if no revenue is earned. The changing
distance between TR and TC shows economic loss or profit (TR - TC
< 0 or > 0). Initially there is economic loss followed by profit followed by
loss with two points of ‘normal’ profit where TR - TC = 0 (P&B
7th Ed Fig. 12.2; R&L 13th Ed
Maximum profit occurs where the
distance between TR and TC is greatest.
ii - Marginal Analysis
Given an upward sloping marginal cost curve,
profit maximization occurs (under all forms of competition) where the
revenue earned on the last unit sold (marginal revenue) equals the cost
of the last unit sold (marginal cost), i.e., where MR = MC.
Under perfect competition, however, MR equals P (each unit sold at
market price) and profit maximization is where MR equals P equals MC.
is greater than MC then producing an additional unit adds more
revenue than cost. If MR equals MC then the firm experiences normal
profit with all factors of
production including entrepreneurship earning their opportunity cost.
If MR is less than MC then producing and selling another unit
results in a loss.
In effect the firm faces a perfectly
horizontal or elastic demand curve fixed by market price
7th Ed Fig. 12.3; R&L 13th Ed
MKM C14/Fig. 14.1).
An upward sloping marginal cost curve also
a perfectly competitive firm
will not lower its price below market price. If MR falls
profit maximization still occurs where MR equals MC and we slide down
the MC curve to equilibrium a smaller output, lower total revenue and
less profit. Why lower one's price if one earns a
higher profit by taking market price? It is more thus profitable
to be a 'price taker'.
There are five
possible outcomes in the short-run
i - point A shows a
loss with market price below shutdown (B). In this case the
firm earns enough to pay some variable costs but no fixed costs.
It minimizes losses (the flip side of profit maximization) by exiting
the industry. Given the market supply curve is an aggregate this
firm's exit will shift the market supply curve to the left raising
market price (R&L 13th Ed
ii - point B is the shut down point.
The firm earns enough to pay its variable costs but none of its fixed
costs. It opportunity cost is the same: if it stays it must pay
fixed costs out of pocket; if it exits it must pay fixed costs out of
pocket. This the starting point of the firm's supply curve.
It will not produce unless it receives at least P3;
iii - point C shows a loss with market price between shutdown
(B) and break even (D). In this case the firm earns enough to pay all
variable and some fixed costs. It minimizes losses by staying in
business in the short run. If it exits it must pay all fixed costs
without any revenue. In the long run, however, the firm must
decide if the exit of loss making firms in (i) will raise market price
to achieve normal profit or if economies of scale are available to
reduce marginal cost so that normal profit can be earned in the long run;
point D shows normal profit with market price at break even. In this
case the firm stays in business as all factors of production earn their
opportunity cost including normal profit for entrepreneurship; and,
point E shows economic profit
with market price above break even
(D). In this case excess profit is earned for
entrepreneurship, however, this in turn attracts new entrants wanting to
enjoy those profits.
Given the market supply curve is an aggregate a firm's entry will
shift the market supply curve to the right lowering market price in the
In the long run firms suffering losses with
market price below shut down exit the industry shifting the market
supply curve to the left raising market price. Similarly, firms
that suffer losses with market price between shut down and break even
and that do not expect market price to rise sufficiently due to the exit
of other loss making firms or cannot benefit from economies of scale
also exit. This process will continue until all loss making
firms exit and market price reaches break even for all remaining firms.
economies of scale in the
long-run, firms suffering losses with market price between shut sown and
break even adjust the size of plant creating a series of
short-run average and marginal cost curves. The long-run average
cost curve is an envelope of short-run average cost curves.
At some point the
most efficient plant size is achieved (minimum optimum scale) where LR average cost is lowest.
At this size the short-run
marginal cost curves becomes the long-run marginal cost curve
P&B 4th Ed.
12.9; R&L 13th Ed
MKM Fig. 13.6). This will continue until all firms achieve
minimum optimum scale and market price reaches break even for all
If economic profit is being earned in the
long run new entrants shift the supply curve to the right lowering
market price. Entry will continue until market price eliminates
excess profits and reaches break even for all remaining firms.
But what of the demand curve faced by the
perfectly competitive firm? Market price rules as the demand
curve. If Firm A raises its price above market - given homogenous
goods and perfect knowledge - consumers will not buy from Firm A but
rather from other firms at market price. What if Firm A lowers its
price below market? Given profit maximization occurs where MC = MR
and MC is upward sloping
7th Ed Fig. 12.3)
the reduction in price (MR) means
output decreases. Firm A is left with lower sales (total revenue)
and lower profit than if it simply accepted market price. Hence we
call a perfectly competitive firm a 'price taker' in that to maximize
profit it must accept market price. The perfectly competitive firm
does not face the market demand curve but rather market price like a
perfectly horizontal demand curve.
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.
There are also what can be called enabling or transformative innovations
outside the economy itself in the form of scientific breakthroughs or
within the economy through the spreading of new techniques such as
'just-in-time' inventory systems or communications innovations such as
the internet or
Furthermore, such external effects may be ambiguous, that is they
may increase the cost of some and decrease the cost to other firms.
There are also the external economies available to
firms due to location as in what Marshall called industrial districts
but today are so-called 'clusters'
such as Silicon Valley.
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 it 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
addition to external economies, changes in taste and production technology
itself can change
equilibrium. Taste is symbolized by
the f in preference function U = f (x, y) while technology
is symbolized by the g of the production function Q = g
(K, L). 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) (
7th Ed Fig. 12.10;
MKM Fig. 4.4). Similarly, technological change can reduce costs and shift
the supply curve to right, or, if knowledge is lost, shift the supply
curve the the left.
This may be the case with 'de-industrialization'
resulting from automation and offshore production.
6. Allocative Efficiency
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:
MUx/Px = MUy/Py (MKM C7/150-4)
ii - Producer Efficiency: when firm cannot reduce cost by
shifting input mix:
MPK/PK = MPL/PL
iii - Exchange Efficiency
(MKM C7/159-65): when all gains from trade have been
exhausted. Gains from trade
to the consumer are called consumer surplus that is the difference
between what consumers are willing to pay and what they actually pay for a
total quantity of a good or service at market price.
It is the geometric space from the market price up to the demand curve.
Gains from trade to the producer are called producer surplus
which measures the difference between what producers are willing to accept
and what they actually receive for providing a market equilibrium level
of supply. It is the space from the market price down to
the supply curve (P&B
7th Ed Fig. 12.12;
The Holy Grail
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. Various theories
have been suggested to explain the 'value' of a good or service.
These include: (i) scarcity; (ii) utility (as usefulness); (iii) input cost
especially the labour theory of value shared by all classical economists
including Marx; and, (iv) whatever the market will bear. In this
sense, there is a distinction in economics between 'value
theory' and 'price theory'.
competition is the most comprehensive statement of conditions under which such
‘a just price’ exists because it combines all of them in a deductively
logical and mathematically and geometrically demonstrable model.
It generates Bentham's greatest good for the greatest number. Unlike other social sciences in economics 'seeing is believing'.
It is a yantra
or a visual mantra that can be visually contemplated
and manipulated. 'X' marks the spot where:
no one exercises market power,
i.e. no consumer or producer can affect the price/quantity
all factors of
production are paid their opportunity cost and none earn economic profits
– in the long-run;
market price internalizes all relevant benefits in
consumption and costs in production;
consumer sovereignty reigns and producers adjust to market demand
subject only to changing cost constraints and the changing tastes of consumers;
output in the long run is at its lowest
average cost per unit;
there is no role for government, just as in 'perfect'
Deviations in the
‘real world’ from Perfect Competition is used to justify public intervention.
For example, cases of 'market failure or the failure to achieve the
above requirements of Perfect Competition, justify in the Standard Model
public intervention in the market in order to:
account for costs
and benefits external to market price through imposition of taxes as
well as user or producer
charges like carbon credits, or subsidize 'merit goods' such as higher
education and R&D;
create intellectual property rights to encourage production of
new knowledge which, as a public good, is subject to the free-rider
market to attain a price/quantity outcome approximating perfect competition; or,
market through anti-trust or anti-combines policies to achieve a better
approximation of perfect competition.
The price/output outcome of perfect competition provides the benchmark
against which performance of all other market structures are judged.
There is, however, serious questioning
about both the pedagogic as well as policy use and application of this
benchmark. The last ideology standing after the end of the
Market/Marx Wars - perfect competition - serves as the regulatory
foundation of the EU, NAFTA, WTO and other multilateral economic trade
agreements. It is also why economist
Kenneth Boulding rightly notes that economics is a 'moral' not a