19 Perfect Competition

Dr. Savita

  1. Learning Objectives

After completing this module, the students will be able to understand:

  • The concept of perfect competition
  • Various features of perfect competition
  • Difference between pure and perfect competition
  • Price determination under perfect competition

 

PERFECT COMPETITION

  1. Introduction

 

Perfectly competitive is the name given to a market for a commodity in which a large number of unorganized buyers and sellers compete with one another in the purchase and sale of a commodity without having any individual influence over the market price of the commodity. So it is a market structure in which there are large numbers of buyers and sellers, exchanging homogeneous product without any interference by the government.

 

According to Leftwitch, “Perfect competition is a market in which there are many firms selling identical products with no firm large enough relative to the entire market to be able to influence market price”. This definition tells us that perfectly competitive market is without any kind of monopoly element or any control from the buyers and sellers side.

 

Mrs John Robinson has defined perfect competition in terms of price elasticity of demand. According to her, “Perfect competition prevails when the demand for the output of each producer is perfectly elastic”.

 

In nutshell we can say that, perfectly competitive market is a situation where large number of buyers and sellers are buying and selling products. Products produced y all producers are homogeneous. All producers under perfectly competitive market have to accept price which is settled by two forces namely, demand and supply in the market. Golden principle, ‘one market, one price’ operates completely and continuously under perfect competition.

  1. Features or Conditions for Perfect Competition

 

Koutsoyiannis has used the word assumptions instead of characteristics or features. But the other economists have used the word features. A perfect competitive market has the following features:

 

1) Large number of buyers and sellers: Under perfect competition numbers of buyers and sellers are in a large numbers but each seller and buyer sells or buys a small quantity of the output. Individual sellers or buyers can not influence the supply or demand individually. Individual sellers is price taker, price is settled with the two forces of demand and supply by an industry in perfect competition.

 

2) Identical products of different sellers: The sellers in the perfectly competitive market are supposed to sell completely homogeneous products. There products must be considered to be identical by all the buyers in the market. There should not be any diffentiation of products by sellers by way of quality, variety, colour, design, packing or other selling conditions of the product. Thus, in a perfectly competitive market, buyers have no other basis of attaching to one seller or the other and purchasing a sellers product on any basis other than price.

 

3) Free entry and exit of firms: In perfectly competitive market every firm is free to join or leave the industry. There is free entry and exit of the firms in industry under perfect competition. Firm may enter to share profit and may leave to avoid losses. Firms are not legally or socially bound to enter or exit the industry. This condition must be satisfied especially for long period equilibrium of the industry.

 

4) Profit maximization: Under perfect competition, all the firms have a common goal of profit maximization. No other goal is being pursued by any firm.

 

5) Perfect knowledge among buyers and sellers about market conditions: Both buyers and sellers must be having perfect knowledge about the market conditions in which they are operating. Sellers must know the prices being quoted by other sellers in the market. Similarly, the buyers must know the prices being charged by different sellers so that they try to purchase from a seller charging the lowest price. Technically, it means neither the buyers nor the sellers can exploit of the party through misguiding.

 

6) Perfect mobility of goods and factors: There is perfect mobility of goods and factors under perfect competition between industries, one can sell goods at those places where these goods can fetch high prices, and similarly a factor can move to any industry where he can be paid more. No firm has a monopoly over price or factor of production.

 

7) Lack of transportation costs: Under perfect competition transportation costs will not influence the price of the product. There will not be any change in the price due to location of different sellers.

 

8) Lack of selling costs: There is no selling cost under perfect competition. A seller does not spend on advertisements to sell his product because all firms are producing homogeneous products.

 

9) No government intervention: There is absence of state or government in the market. It means government is not imposing any type of tariffs, subsidies on the demand of a commodity. So firm is a price taker.

 

10) Difference of firm and industry: A firm is a single unit which is engaged in the production of identical product where as an industry is a group of different firms producing same product. A firm is a price taker where as industry is a price maker under perfect competition.

 

In short, a perfectly competitive market is that model market in which there is only one price of the product for all the buyers and sellers. Nobody can do anything on his own to change the market determined price.

 

4. Pure and Perfect Competition

 

An American Economist Prof. E-Chamberlin has used the term pure competition. Pure competition is a narrow whereas perfect competition is a wider term. Prof. Chamberlin has included five features under pure competition that is, large number of buyers and sellers, homogeneous products, free entry and exit of firms, lack of selling costs and lack of transportation costs.

Prof. R.A.Bilas also distinguished perfect and pure competition as, “Perfect competition implies pure competition but also consider other characteristics. Pure competition implies one degree of perfection-the complete absence of monopoly. Generally, perfect competition will introduce the notion of perfect resources mobility and perfect knowledge”.

 

Thus, when we include two more features i.e. perfect knowledge and perfect mobility of factors of production along with the features of pure competition then it would be called perfect competition.

 

5. Is Perfect Competition is a Reality or Myth

 

It is questioned sometimes whether perfect competition is a reality or myth? Some economists said that it may be found in the case of agricultural commodities. Farmers compete with each other quite unconsciously because none of them is able to influence the price of products in the market. But we cannot say that the market for other commodities is also anywhere near perfect competition. We commonly find that in actual market conditions of perfect competition are being violated in one way or the other. This gives us the impression that perfect competition is a myth. The different violations of perfect competition are:

 

Products are differentiated through packing, colour, method of selling and advertisement. Some buyers or sellers even in the competitive market may be having individual influence. There are many problems to the mobility of labour.

 

Demand and supply of many commodities are regulated by the government.

 

Entry to many industries is blocked by economic, legal or institutional factors. So keeping in view the above factors, we can say that perfect competition is only a theoretical concept. It has no relevance to reality. Now the important question arises, if it has nothing to do with the reality then, why we study this market and its determination? Here are some reasons for the study of perfect competition.

 

Perfect competition is an ideal organization of the market that can serve as a good perspective to compare the actual allocation of resources with the ideal, what is and what ought to be. Study of perfect competition pricing has given birth to much of the present day welfare economics.

 

It is good simplification to start teaching price theory. Having done this we can go on to study more complicated and presumably more realistic analysis of price determination.

 

There  is  indeed  some  practical  utility  in  the  study  of  perfect  competition.  Perfect competition was a standard model of a market with the classical economists. Although some classical economists were aware of the non-existence of some of the assumptions of pure and perfect competition in the actual markets, they thought it better to take the standard form of the market and built up a theoretical structure on it rather than being held up in building economic theory by the existence of a few imperfections.

  1. 6. Price Determination under Perfect Competition

 

The price determination under perfect competition can be explained under three situations:

 

Market period price Short period price Long period price

 

Market Period Price

 

Market period is very short period in which supply cannot be increased or decreased. Market period demand is affected by temporary factors. In market period supply is perfectly inelastic. In case of perishable goods, whatever the supply is available that cannot be changed even with the increase or decrease in demand in the quantity. In case of durable goods, supply can be increased or decreased by bringing from the store. In case, demand decreases, some quantity can be put into stock whereas in case, demand decreases, supply can e increased by bringing the quantity from the store.

 

Market price is the price of a good which prevail at any given time. To study price determination in such a market, goods are divided into two parts i.e. perishable goods and durable goods.

 

Perishable goods: Perishable goods are those goods which perish very quickly and cannot be stored or kept back such as fish, vegetables, milk etc. they will go waste if stored. Therefore, the whole of the given stock has to be sold in the market at whatever price is available. So in market period supply curve is perfectly inelastic. It is parallel to Y-axis. It can be shown by following figure:

This diagram depicts the price determination of market period price. MS is the supply curve,

 

DD is the initial demand curve which intersects the supply curve MS at E. The equilibrium price is OP and the quantity demanded and supplied is equal to OM. Now due to a sudden rise in the demand for product shifted DD to D1D1, now the new equilibrium is at point E1 and the price increases to OP1. If demand decreases, the demand curve shifted D2D2, and the new equilibrium price becomes OP2. This shows that in case of perishable goods, price increase or decrease with change in demand, supply being perfectly inelastic.

 

Durable goods: In case of durable goods, supply up to some extent can be increased or decreased from stock but afterwards becomes perfectly inelastic. Supply of these goods can be increased even in market period but supply is restricted till the stock ends. In this case firm has some ‘minimum reserve price’ below which these firms would not be ready to sell these products. When price start to decrease below the ‘minimum reserve price’ firms stock the goods and wait till demand rises and price start to increase more than the level of minimum price. So supply can be increased and decreased even in market period but only up to the quantity lying in the stock. Market price of durable goods is determined with the forces of demand and supply. This can be shown in the following figure:

 

In this figure quantity is measured on ‘OX’ axis and price is taken on ‘OY’ axis. DD is the demand curve and TS is the total supply of durable goods in the market period. OM is the total supply of durable goods minimum price is set at OT. If the demand curve is D1D1, and it intersects the supply curve TES at point E1, the equilibrium price is OP1. A shift in the demand curve from D1D1 to DD shows an increase in demand, and along with it the new equilibrium price rises from OP1 to OP. Thus, the further increase in demand beyond DD will have only the effect of raising the price, and the quantity supplied remains unchanged

 

Short Period Price

 

Short period is that period in which supply is adjusted to the limited extent. It means supply is adjusted up to the existing production capacity. With the increase in demand, supply can be increased through overworking factors of production. In short period a producer can change only variable factors of production while fixed factor remain fixed.

 

This diagram shows equilibrium of industry. Initially, demand and supply equalize on point E, determining OP price which will be taken y the firm as given and firms earn just normal profits. In case demand increases, demand curves shift upward to D’D’ resulting into change in equilibrium on point Q. Accordingly, firms average revenue and marginal revenue curve shift upward and firm will attain equilibrium on point Q earning excess profit. In case demand decreases, demand curve shift downward to D”D” resulting into equilibrium in the industry on point T. Accordingly, AR/MR of the firm shift downward. The firm attains equilibrium in (a) diagram. The firm undergoes loss but will continue as it fulfills the variable cost. Hence, it is proved that in short period, firm faces three possibilities: (a) earn excess profit, (b) earn normal profit, (c) loss.

 

Long Period Price

 

Long period is that period when fixed factor of production becomes variable. So in long run all factors of production become variable. The price which is settled in long period is known as normal price. In long period supply is fully adjusted to demand. In this period, equipments, plants, old machines can be replaced with new ones. There is free entry and exit of firms in long period under perfect competition. In long period, neither excess profit nor loss can occur. Only normal profits will occur. And price thus determined called, Normal price. So, normal price is a price which tends to prevail in the market. It is a probable but not a real price. In long period supply are in equilibrium at that point normal price will be determined.

 

In the long period, there is no tendency of new firms to enter into market and old firms to leave the industry. Industry attains equilibrium as usual where demand equalizes supply. In case of firm, if there is excess profit, new firms will enter into the market. If there is loss, some firms will leave the market. Only those firms will attain equilibrium which earns just normal profit. It means in a long period firm will attain equilibrium where three conditions satisfied. Firstly MC=MR, secondly MC cut MR from below and lastly MC=MR=AR=AC

 

In this diagram industry attain equilibrium where demand and supply are equal to each other. Firm attain equilibrium where all the three conditions are applicable. Firm earn just normal profit.

  1. Normal Price and Laws of Increasing Return: Normal price is also influenced by laws of returns. Whenever there is a change in demand, then there will also be a change in the supply of the product in long period. When there is a change in the supply, it affects the cost of production of a firm due to the operation of laws of returns to scale. Change in supply will bring a change both in long run marginal and long run average cost. Whenever cost change it will bring a change in the normal price. So in long period price is always equal to minimum average cost.
  2. Law of Increasing Return and Normal Price: It is also called law of diminishing cost. Under the law of Increasing Return the per unit cost that is average cost will start to fall with the increase in the volume of production. Marginal cost will also fall under this law.

In this diagram SS is supply curve which slopes downward. It shows that when producer increases the production, cost decreases. DD is a demand curve which intersects supply curve SS at point E. and OP is the equilibrium price, ON is a equilibrium output.

 

When demand increases, demand curve shifted to D1D1 and intersects supply curve SS at point E1. With increase in demand, prices will fall to OP1. So, we can say that under law of increasing returns, normal price would fall when demand increases and normal price would rise if demand falls.

  1. Normal Price and Law of Constant Return: Under the law of constant return long period supply curve is parallel to ‘OX’ axis or it is horizontal. This shows that per unit cost of production will remain the same as the volume of output id increased or decreased. When industry is operating under law of constant returns price will remain unaffected by an increase or decrease in demand. This can be shown by following diagram.

In this diagram quantity and price are measured on ‘OX’ and ‘OY’ axis. SS is the long period supply curve of constant cost industry. DD and SS intersect at point E. at OX quantity price is determined at when demand increases demand curve shift upward but price will remain unaffected. There will be no change in price under law of constant return.

  1. Normal Price and Law of Diminishing Return: It is also known law of increasing cost. An increasing cost industry is one in which external diseconomies are more powerful than external economies. Long period supply curve slopes upward when law of diminishing return or increasing cost operate. Per unit cost will increase as more output is produced. To meet the extra demand, cost of production increases. With the increase in cost of production, price also increases. This shows that price varies directly as the amount supplied varies. It can be shown by following diagram.

In this diagram SS is supply curve and DD is a demand curve. Both intersect at E and OP price is determined. When demand curve shifts to D1D1 with the increase in demand. It coincide supply curve at E1. To produce OQ1 more quantity, cost increases, price is raised to OP1 from OP. So it is observed that under law of Diminishing Returns with the rise in demand, price rises and with the fall in demand price falls.

  1. Summary: Perfect competition is an ideal market structure where the same price is quoted by every seller and accepted by all the buyers. The firm in the market is price taker. There is a perfect mobility of factors of production and is no barrier, legal or market related, on the entry of new firms into or exit of existing ones from the industry. There is no government intervention with the working of the market system. In short run, a firm in a perfectly competitive market may be in a position to earn economic profit. In long run no firm is in a position to earn economic profit, nor does any firm make losses. So there is only normal profit in long run.

 

References