Perfect competition is a type of market characterized by
- a very large number of small producers or sellers,
- a standardized, homogeneous product,
- the inability of individual sellers to influence price,
- the free entry and exit of sellers in the market, and
- unnecessary nonprice actions.
Examples of markets in
perfect competition are extremely rare.
Numerous markets in the retail, service and agricultural sectors approach perfect competition best. But, in the agricultural sector, government support price programs distort the market mechanism. Notwithstanding the lack of good examples, this form of market is important because of a general conviction among economists that it is the best form of market. |
PERFECT
COMPETITION NUMBER OF FIRMS
The very large number of firms in perfect competition implies
that each individual firm is very small in comparison to the
total market. Indeed, if one firm were to become significantly
large, it would dominate the market and competition would be
eliminated or at least diminished.
The very large number of firms in perfect competition implies
that each individual firm is very small in comparison to the
total market. Indeed, if one firm were to become significantly
large, it would dominate the market and competition would be
eliminated or at least diminished.
In
the milk production segment of agriculture, farms are usually
small. They are especially small compared to the size of the entire market for milk. Note that the milk distributors are occasionally large, but not the productive farms. |
PERFECT
COMPETITION STANDARDIZED PRODUCT
The product in perfect competition is said to be standardized
(or homogeneous). This means that it does not make any
difference to customers which specific firm sells the product:
it is absolutely identical. This is the main distinction
between perfect competition and monopolistic competition: once
some differences can be recognized by customers, firms acquire
power over these customers.
The product in perfect competition is said to be standardized
(or homogeneous). This means that it does not make any
difference to customers which specific firm sells the product:
it is absolutely identical. This is the main distinction
between perfect competition and monopolistic competition: once
some differences can be recognized by customers, firms acquire
power over these customers.
Milk
is a uniform and homogeneous product. It is not possible to
make a distinction between the milk of one farm and another. The government has indeed set standards of quality, fat content and cleanliness. |
PRICE TAKER
The firms in perfect competition have no power over price: they
have to sell at the going market price. The firms in perfect
competition are said to be price takers. Should a firm attempt
to raise the price by the smallest possible amount, customers
would not buy from it because they could buy the same product
from other firms. Lowering the price is also not necessary
because the firm can already sell all its output at the going
price.
The firms in perfect competition have no power over price: they
have to sell at the going market price. The firms in perfect
competition are said to be price takers. Should a firm attempt
to raise the price by the smallest possible amount, customers
would not buy from it because they could buy the same product
from other firms. Lowering the price is also not necessary
because the firm can already sell all its output at the going
price.
A
milk producer who would try to raise his/her revenues by
increasing the price for milk, would find the company collecting the milk in that region unwilling to buy his/her milk any longer. One individual farmer is thus unable to affect the price of milk in the entire market. |
PERFECT
COMPETITION ENTRY AND EXIT
There are no barriers to entry to or exit from a market in
perfect competition. This condition assures that no firm will
dominate the market and evict other firms. It also assures that the
number of firms (although changing) will remain large.
There are no barriers to entry to or exit from a market in
perfect competition. This condition assures that no firm will
dominate the market and evict other firms. It also assures that the
number of firms (although changing) will remain large.
Agricultural
production can start for most crops by simply
planting on a parcel of land. For instance, that is true for fruit trees and vegetables. (It is true. however, that for some products such as milk or tobacco, the government limits production because of the existing overproduction). |
PERFECT
COMPETITION NONPRICE ACTION
Nonprice actions such as advertising, service after sale or
warranty, are not necessary in perfect competition because
the firm can already sell all its output at the going price, and
incurring additional expense would only make it unprofitable.
(Nonprice action for the entire industry may however be useful).
Nonprice actions such as advertising, service after sale or
warranty, are not necessary in perfect competition because
the firm can already sell all its output at the going price, and
incurring additional expense would only make it unprofitable.
(Nonprice action for the entire industry may however be useful).
A
single milk producer cannot possibly influence the consumption
of milk at large, and needs not advertise. An association of milk producers or a large milk distributor may, however, be in a position to use advertisement effectively. |
PERFECT
COMPETITION DEMAND
The demand of firms in perfect competition is perfectly elastic
(i.e., the smallest possible price change results in a
virtually infinite quantity change). Such demand is represented
graphically by a horizontal demand curve: no matter what
quantity is sold, the price is the same, and it is the going
price in the market.
The demand of firms in perfect competition is perfectly elastic
(i.e., the smallest possible price change results in a
virtually infinite quantity change). Such demand is represented
graphically by a horizontal demand curve: no matter what
quantity is sold, the price is the same, and it is the going
price in the market.
Nationwide,
the demand for milk is likely to be downsloping, that
is inversely related to price. But for a single milk producer, it is given by the price the farmer can receive: the going market price. It does not change, no matter what quantity the farmer produces. Thus demand is horizontal. |
PERFECT
COMPETITION MARGINAL REVENUE
The horizontal demand curve is also the marginal revenue of a
firm in perfect competition. The marginal revenue, or
additional revenue from one more unit sold, is just equal to
the going price (which is shown graphically by the demand curve
itself). Note that the average revenue is also the demand curve
and total revenue is an upsloping straight line.
The horizontal demand curve is also the marginal revenue of a
firm in perfect competition. The marginal revenue, or
additional revenue from one more unit sold, is just equal to
the going price (which is shown graphically by the demand curve
itself). Note that the average revenue is also the demand curve
and total revenue is an upsloping straight line.
PROFIT
MAXIMIZATION
A firm must seek to sell a volume of output where its total
revenue exceeds its total cost by the largest amount possible;
that is, its profit is the maximum.
A firm must seek to sell a volume of output where its total
revenue exceeds its total cost by the largest amount possible;
that is, its profit is the maximum.
LOSS
MINIMIZATION
If a firm fails to derive a profit, it may nevertheless seek,
in the short run, to produce at that level of sales where the
difference between its cost and its revenue, i.e., its loss,
is minimum.
If a firm fails to derive a profit, it may nevertheless seek,
in the short run, to produce at that level of sales where the
difference between its cost and its revenue, i.e., its loss,
is minimum.
CLOSE DOWN
DECISION
If a firm has revenues that are insufficient to cover even its
fixed costs in the short run, the firm must close down.
If a firm has revenues that are insufficient to cover even its
fixed costs in the short run, the firm must close down.
BREAK-EVEN
POINT
The volume of output where total revenue is equal to total cost
is known as the break-even point. A firm must be beyond its
break-even point in order to be maximizing its profit.
The volume of output where total revenue is equal to total cost
is known as the break-even point. A firm must be beyond its
break-even point in order to be maximizing its profit.
MARGINAL
REVENUE MARGINAL COST RULE
Producing at the level of output where marginal revenue equals
marginal cost is equivalent to profit maximization. Indeed, if
one less unit were to be produced, profit would be smaller by the
excess of marginal revenue over marginal cost for that last
unit. If one more unit were to be produced, profit would also be
smaller, this time by the excess of marginal cost over marginal
revenue.
Producing at the level of output where marginal revenue equals
marginal cost is equivalent to profit maximization. Indeed, if
one less unit were to be produced, profit would be smaller by the
excess of marginal revenue over marginal cost for that last
unit. If one more unit were to be produced, profit would also be
smaller, this time by the excess of marginal cost over marginal
revenue.
MARGINAL
REVENUE MARGINAL COST
The marginal revenue = marginal cost rule is applicable to
loss minimization as well as profit maximization. However, if
marginal revenue intersects marginal cost below average
variable cost, it means that revenues are not sufficient to
cover fixed costs and the firm should close down.
The marginal revenue = marginal cost rule is applicable to
loss minimization as well as profit maximization. However, if
marginal revenue intersects marginal cost below average
variable cost, it means that revenues are not sufficient to
cover fixed costs and the firm should close down.
MAXIMUM PROFIT
The maximum profit is obtained by first determining the level
of output for which marginal revenue equals marginal cost (thus
profits cannot possibly be increased). Then determining
1- total revenue given by price multiplied by quantity,
2- total cost given by average total cost multiplied by
quantity,3- the difference between 1 and 2 above is the profit (or loss).
The maximum profit is obtained by first determining the level
of output for which marginal revenue equals marginal cost (thus
profits cannot possibly be increased). Then determining
1- total revenue given by price multiplied by quantity,
2- total cost given by average total cost multiplied by
quantity,3- the difference between 1 and 2 above is the profit (or loss).
MAXIMUM PROFIT
GRAPH
Since maximum profit is the excess of total revenue over
total cost, it is shown graphically as the area by which the
total revenue rectangle exceeds the total cost rectangle. The
height of total revenue rectangle is the price received by the
firm, and the width is the optimum quantity (where MR=MC). The
height of total cost rectangle is average total cost (on ATC
curve), and the width is the optimum quantity.
Since maximum profit is the excess of total revenue over
total cost, it is shown graphically as the area by which the
total revenue rectangle exceeds the total cost rectangle. The
height of total revenue rectangle is the price received by the
firm, and the width is the optimum quantity (where MR=MC). The
height of total cost rectangle is average total cost (on ATC
curve), and the width is the optimum quantity.
SHORT RUN
SUPPLY CURVE
The short run supply curve of firms in perfect competition is
the upsloping portion of the marginal cost curve (above the
average variable cost intersection). Indeed, a firm determines
its optimum volume of sales by taking the intersection of
marginal revenue and marginal cost. The marginal revenue is also
the price it receives. Thus supplier's price-quantity
combinations are given by the marginal cost upsloping portion.
The short run supply curve of firms in perfect competition is
the upsloping portion of the marginal cost curve (above the
average variable cost intersection). Indeed, a firm determines
its optimum volume of sales by taking the intersection of
marginal revenue and marginal cost. The marginal revenue is also
the price it receives. Thus supplier's price-quantity
combinations are given by the marginal cost upsloping portion.
LONG RUN
PERFECT COMPETITION EQUILIBRIUM
The long run equilibrium for firms in perfect competition
is where demand (and marginal revenue which is identical to it)
is tangent to the minimum of average total cost (where marginal
cost also intersects average total cost). At that point, there
is no profit or loss for the firm. (Note that there is no pure
or economic profit, but normal profit must still be covered).
The long run equilibrium for firms in perfect competition
is where demand (and marginal revenue which is identical to it)
is tangent to the minimum of average total cost (where marginal
cost also intersects average total cost). At that point, there
is no profit or loss for the firm. (Note that there is no pure
or economic profit, but normal profit must still be covered).
ENTRY OF FIRMS
IN PERFECT COMPETITION
Should demand be above the minimum of average total cost, pure
profit would exist for firms in perfect competition. This profit
would attract new firms to the industry. Such entry of new
firms is not impeded by any entry barriers in industries in
perfect competition. The new firms would increase the total
market supply and drive the price down. The lower price pushes
the demand for each firm down toward or even below the
equilibrium minimum average total cost point.
Should demand be above the minimum of average total cost, pure
profit would exist for firms in perfect competition. This profit
would attract new firms to the industry. Such entry of new
firms is not impeded by any entry barriers in industries in
perfect competition. The new firms would increase the total
market supply and drive the price down. The lower price pushes
the demand for each firm down toward or even below the
equilibrium minimum average total cost point.
EXIT OF FIRMS
IN PERFECT COMPETITION
Should the demand be below the minimum of average total cost,
losses of firms would force some firms to leave the industry.
As firms leave, a decreasing total supply pushes price back up.
The increasing price lifts the demand curves for individual
firms upward toward or even above the equilibrium point. Firms
departure or entry will continue until the price settles to be
just equal to minimum average cost.
Should the demand be below the minimum of average total cost,
losses of firms would force some firms to leave the industry.
As firms leave, a decreasing total supply pushes price back up.
The increasing price lifts the demand curves for individual
firms upward toward or even above the equilibrium point. Firms
departure or entry will continue until the price settles to be
just equal to minimum average cost.
LONG RUN
SUPPLY CURVE
The long run supply curve for an industry in perfect competition
is perfectly elastic (that is horizontal) in constant-cost
industries and upsloping in increasing-cost industries. Whether
an industry is constant-cost or increasing-cost is determined by
the presence of adequate or insufficient resources.
The long run supply curve for an industry in perfect competition
is perfectly elastic (that is horizontal) in constant-cost
industries and upsloping in increasing-cost industries. Whether
an industry is constant-cost or increasing-cost is determined by
the presence of adequate or insufficient resources.
PERFECT
COMPETITION ECONOMIC EFFECT
Perfect competition is seen as an ideal or optimum form of
market because of its very beneficial economic effect for
society, which comes from
- allocative efficiency, and
- productive efficiency.
But there are a few shortcomings nevertheless.
Perfect competition is seen as an ideal or optimum form of
market because of its very beneficial economic effect for
society, which comes from
- allocative efficiency, and
- productive efficiency.
But there are a few shortcomings nevertheless.
PRODUCTIVE
EFFICIENCY
The productive efficiency of perfect competition can be observed
in the long run equilibrium point of all firms in the industry,
which is at the minimum of average total cost. This means that
all firms are forced to cut their costs and utilize the best
available technology in order to have their minimum average
total cost no higher than that of all the other firms in the
industry. There is also no under or over utilized capacity.
The productive efficiency of perfect competition can be observed
in the long run equilibrium point of all firms in the industry,
which is at the minimum of average total cost. This means that
all firms are forced to cut their costs and utilize the best
available technology in order to have their minimum average
total cost no higher than that of all the other firms in the
industry. There is also no under or over utilized capacity.
ALLOCATIVE
EFFICIENCY
The allocative efficiency in perfect competition comes from the
fact that the quantity produced by each firm is just that for
which the price paid by society is equal to the cost of
additional resources (marginal cost). More could not possibly
be obtained for a lower price. The resources are also the most
efficiently allocated among industries since firms will bid for
these resources up to the price consumers want to pay for them.
The allocative efficiency in perfect competition comes from the
fact that the quantity produced by each firm is just that for
which the price paid by society is equal to the cost of
additional resources (marginal cost). More could not possibly
be obtained for a lower price. The resources are also the most
efficiently allocated among industries since firms will bid for
these resources up to the price consumers want to pay for them.
PERFECT
COMPETITION SHORTCOMINGS
In spite of its beneficial economic effect, perfect competition
fails to
- provide any correction for income distribution inequity,
- generate any public goods since there is not profit,
- stimulate technological progress because of lack of profits,
- offer diversity in products since these are standardized.
In spite of its beneficial economic effect, perfect competition
fails to
- provide any correction for income distribution inequity,
- generate any public goods since there is not profit,
- stimulate technological progress because of lack of profits,
- offer diversity in products since these are standardized.
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