Tuesday, 9 April 2013

Perfect Competition

Perfect competition is a very unrealistic market structure. We'll discuss the characteristics of it later, but for now we have to understand that it is a theoretical concept. If the world was perfect then in most cases we'd have markets operating 'perfectly'. The world isn't perfect and therefore actually seeing perfect competition in reality is a long shot. The major assumption we make is that firms are price takers. By this we mean that each firm alone has no influence over the market price because of their relative size. They take the price they can get as given and perceive it to be constant. Therefore the demand curve for a firm in perfect competition is horizontal - the can sell as much as they want but only at the market set price. Any higher and they wouldn't sell a thing, any lower and they'd make a loss in the long run.

Here we have a typical perfect competition scenario in the short run. On the left is the market where the market price is determined by the supply and demand for the good. The firm, on the right, takes the market price as given and as their price. Average revenue and marginal revenue is the same as the demand curve because we are looking at a constant price for the good. Production takes place at the point where MC = MR, anywhere before this point and more profit can be made, anywhere after this point and profit falls. If you look at the diagram, at the point MC = MR, the average cost is below the average revenue. This means profit is available, which is shown by the yellow area. In the short run the supernormal profit will be (AR-AC) x Qe.

Now, above I've just said that AR and MR are the same as demand because price is constant. You want proof I hear? Sure thing. Average revenue = Total revenue / Quantity. Total revenue is actually price x quantity. Therefore average revenue can be re-written as (price x quantity) / quantity. Quantity cancels out leaving price ~ average revenue = price. Marginal revenue = the change in total revenue / the change in quantity. Substituting in what total revenue actually is we have the change in (price x quantity) / change in quantity. The change in quantity cancels out leaving price ~ marginal revenue = price. Boom!

But, we have only discussed the short run. These supernormal profits don't go unnoticed - they attract new firms into the industry. Supply now shifts out.

The price falls due to the increase in supply. On the right diagram we can see that it's fallen to the point where MC = MR = AC. This means that supernormal profit is no longer being made, it has been competed away. At this point no more firms will enter the industry because there won't be the pull of supernormal profits. Therefore, in the long run there is no supernormal profit to be made in a perfectly competitive market.

It seems risky to the normal person, producing right on the point of breaking even. This is true to a certain extent. Shocks to the system could cause demand to fall, what would happen to the firm then?

Here we have the case of a fall in demand in the market causing a fall in price. The firm was initially producing where MC = MR = AC, but now the fall in price means that if they produce at MC = MR they will actually be making a super-normal loss. This point would be below average costs and therefore the enclosed area on the right hand diagram would be loss. Would they carry on producing? Surprisingly, yes, in this case the firm would. To understand this we have to look at the breakdown of the costs. In the short run we know capital is fixed and labour is variable. Therefore the average variable cost for the firm in a simple world would be labour costs / quantity. As long as the average revenue (demand curve) is greater than the average variable costs then the firm will continue producing. This means they can cover the costs of labour and make some contribution to the fixed costs. If they couldn't cover the average variable costs it would be better for the firm to stop producing, lay off all the workers and only lose the fixed costs.

Some other things we can state is that the short run supply curve for a firm in a perfectly competitive market is the marginal cost curve until the point where price equals average variable cost. As we said above, below that point the firm will stop supplying the market. In the long run the firms supply curve is horizontal at the minimum average cost.

All we need to do now is sum up whether perfect competition is a good thing. It definitely has its advantages, they are as follows:

·         It's efficient - production occurs at the lowest average cost which is the most efficient point.
·         Competition - competition in an industry forces firms to be more efficient.
·         Price is influenced by demand - the market is essentially run by consumers, it responds to their behaviour.
·         No supernormal profits in the long run.

It really has few disadvantages though. You could state the fact that it isn't realistic as a disadvantage, I guess. In real life it would be rare to find a market with freedom of entry/exit, identical products, price taking firms, etc. One point that could be made about the lack of super-normal profit is the lack of innovation. Innovation tends to be fueled by profit, without profit there is little room for firms to innovate. Innovation is one thing that can lead to a more efficient market, so in perfect competition once the efficient point is reached it will not be made any more efficient. Comprende?


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