4. Competition (cont'd)

4.2 Perfect Competition

1. Assumptions

Perfect competition 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 price, quality and product differentiation.  They are 'homogenous'.  Consumers have no reason to prefer the product of one firm over that of another.

(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
        Entry and exit from the market is free for both consumers and producers.  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 ‘economic’ loss.  Thereby inefficient firms are eliminated from the market.  Firms enter the market if they expect to earn economic short-run, and/or, normal long run profits (M&Y10th  Fig. 9.8; M&Y 11th Fig. 8.10; B&B not displayed; B&Z not displayed ). On the other side of the Marshallian scissors, there are many close substitutes available to consumers who can easily switch if price, preference and/or income changes.


2.  Market Demand Curve

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 consumersThus, 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'.


3. Market Supply Curve

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.

ii - Short-Run Supply Curve:

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 displayed).

iii - Long-Run Supply Curve:

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).


4. Profit Maximizing Output

To determine profit-maximizing output of a firm under perfect competition, one can use two methods:

(i)   total revenue less total cost; and,
(ii)   marginal analysis.

(i) Total Revenue less Total Cost

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.

(ii) Marginal Analysis

Marginal revenue (MR) can be compared with average cost (AC). Firm must sell at MR = P = MC (M&Y 10th 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.

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).


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.  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.  


6. Competition & Efficiency

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; 

(iii) 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 supply.  


7.  The Holy Grail

    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.  

  •  No one exercises ‘market power’, i.e. no consumer, producer or government can affect the price of a good or service.

  • All factors of production are paid ‘opportunity cost’ and none earn ‘economic profits’ – in the long-run. 

  • In effect, ‘consumer sovereignty’ reigns and producers adjust to market demand subject only to their cost constraints.

Deviations in the ‘real world’ from ‘perfect competition’ conditions justify intervention by government to:

  • restructure the market through anti-trust or anti-combines policies; 

  • internalize ‘external costs’ or benefits through imposition of user or producer charges; or,

  • regulate the market to attain price and quantity outcomes approximating those of perfect competition.

    The price/output outcome of perfect competition provides the benchmark against which the performance of all other market structures are to be judged.  

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