Microeconomics

5.0 Competition

1. Assumptions

Perfect Competition (MKM C4/68-9; 63-4, 65-66; 59-60) fully satisfies the following four strict conditions:

i - Anonymity
    Consumers are 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
       Consumers and 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 (MKM C14/304-7; 286-87; 310-311; 289-291)
        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 (P&B 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 income changes.

2. Profit Maximizing Output (MKM C14/298-303; 280-85; 304-309; 283-287)

If 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 two methods:

i - total revenue (TR) less total cost (TC); and,

ii - marginal analysis.

i - Total Revenue less Total Cost (MKM C13/276-8; 257-59; 282-284; 262-264)

Profit (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 Fig. 9-4i).   Maximum profit occurs where the distance between TR and TC is greatest.

ii - Marginal Analysis (MKM C14/298-303; 280-85;304-309; 283-287)

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. 

If MR 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 (P&B 7th Ed Fig. 12.3; R&L 13th Ed Fig. 9-4ii; MKM C14/Fig. 14.1). 

An upward sloping marginal cost curve also explains why 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'.

3.  SR Equilibrium (MKM C14/298-303; 280-85;304-309; 283-287)

There are five possible outcomes in the short-run (graph below):

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 Fig. 9-10);

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;

iv - 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,

v - 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 long run.

P&B 4th Ed. Fig. 12.9

4. LR Equilibrium (MKM C14/304-9; 286-91; 310-312; 289-291)

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. 

Assuming 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. Fig. 12.9; R&L 13th Ed Fig. 9-12; MKM Fig. 13.6).  This will continue until all firms achieve minimum optimum scale and market price reaches break even for all remaining firms.

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 (P&B 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. 

5. 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 QR Codes.  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 necessary adjustments. 

In 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 left) lowering price.  At the extreme, all firms exit and the industry collapses (hoola-hoops) (P&B 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 (MKM C7/149-65; 138-54; 145-165; 131-151)

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: MUx/Px = MUy/Py (MKM C7/150-4)

ii - Producer Efficiency: when firm cannot reduce cost by shifting input mix:  MP_K/P_K = MP_L/P_L (MKM C7/154-8)

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; MKM Fig. 7.7).  

7.  The Holy Grail

Epithet

There are four classes of idols which beset men’s minds. To these for distinction’s sake I have assigned names—calling the first class Idols of the Tribe; the second, Idols of the Cave; the third, Idols of the Market-Place; the fourth, Idols of the Theatre.

Francis Bacon (1560–1626), Novum Organum, Aphorism 39 (1620).

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.  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'.  Please see my "Value without Price".

Perfect 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 outcome;

• 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; and,

• there is no role for government, just as in 'perfect' Communism.

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 problem;

• regulate the market to attain a price/quantity outcome approximating perfect competition; or,

• restructure the 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 natural science.