Perfectly
competitive markets are those in which all firms produce an identical product
and each is so small in relation to the industry that its production decisions
have no effect on the market price. New firms can enter the industry if they
perceive a potential for profit, and existing firms can exit if they start
losing money.
STRUCTURE OF
PERFECTLY COMPETITIVE MARKET.
The assumptions
of such a market structure are as follows:
1. There are
infinite number of buyers and sellers in the industry or market.
Clearly supply
quantity of an individual firm is negligible amount in respect of the total
supply of the market. Hence individual
firm fails to influence market price of the product by changing its own supply
quantity. Similarly demand quantity of an individual consumer is negligible
amount in respect to market demand for the product. Therefore individual
consumer fails to influence market price by creating excess demand or supply
sufficiently through its own demand quantity. In this respect, market price is
given to the individual firm and individual consumer.
2. There is
free entry and exit. Free entry and exit implies that there is no cost to the
newcomers or to leave the industry. This assumption is necessary for the
infinite number of buyers and sellers. If entry is blocked and initially there
is only one firm then we cannot have infinite number of buyers and sellers.
Perfect competition breaks down. If number of firms is not infinitely large
then supply quantity of an individual firm can create excess supply or demand
significantly by changing its own supply and hence individual firm can
influence the market price.
3. Products are
homogeneous among the firms in both real and apparent sense. Products are homogeneous in the real sense
implies that there is no quantitative difference of the product among the
firms. Products are homogeneous in apparent sense implies that there is no
selling activity (i.e. brandname, goodwill, advertising etc). Hence there is no apparent qualitative
difference of the products among the firms. Hence consumers fail to distinguish
products among the firms. Hence none of the firms operate as a single seller of
a product and has no monopoly power in this respect and therefore individual firm
fails to influence market price in this respect.
If there is
qualitative difference of the products among the firms in real sense then
individual firm has some degree of monopoly power as a supplier of a particular
quality of the product.
Thus perfect competition
is inconsistent if there is selling activity such as brand name, goodwill, and
advertising expenditure. Thus we can also infer that there is no selling cost
or advertising cost to the firm in perfect competition.
4.There is perfect knowledge or complete information.
If there is
complete information then none of the firms can create product differentiation
by suppressing information. Hence none of the firms can influence market price
in this respect.
5. Firm’s
objective is to maximise profit.
A market
structure characterised by the above assumptions is called a pure competition.
The above assumptions are sufficient for the firms to be a price taker and have
an infinitely elastic demand curve.
Market price is
given to the individual firm. Hence demand curve to the individual firm is
horizontal as the firm can sell any quantity at this existing price. However
the market demand curve is downward sloping as market price is not constant in
the industry.
Total revenue
is defined as TR = P.q. Hence average revenue is given by AR = TR / q = P. q /q
= P.
Change in TR
due to one unit change in q is known as marginal revenue (MR).
Here MR = dTR /
dq = d (P.q) / dq = P.
Hence AR = MR =
P >0 and constant.
So demand curve
to the individual firm is the MR as well as AR curve which is a horizontal
straight line. Intuition is that as q increases one unit, TR increases by P
units. So MR = P as P is given to the individual firm.
6. Factors are
homogeneous and perfectly mobile.
Factor prices
are given to the individual firm (not in the market) i.e. w and r are fixed to
the individual firm. The factors of production are free to move from one firm
to another throughout the economy.
7. Production
is such that output (q) is rising function of inputs and quasi-concave. Hence
isoquants are convex to the origin.
Implication of
the last two assumptions: When input prices w and r are given to the firm and
production function is quasi-concave and rising function of input, so cost is
rising function of output and it is strictly convex. Hence MC = d C /dq > 0
and d(MC)/ dq> 0 . MC is positive and upward sloping.
SHORT RUN
EQUILIBRIUM OF THE FIRM and DERIVATION OF SHORT RUN SUPPLY CURVE.
Short run profit
function of individual firm is given by:
Π = TR –
TC = P.q + ø (q) – F .....................
(a)
Where TR = P.q
and TC = ø (q) + F
F is the
fixed cost. Therefore it is given to the firm. P is also given to the
individual firm as individual firm is price taker. Clearly firm maximises
profit by choosing q. Then from F.O.C. of profit maximisation we get,
dπ / dq = P – ø’(q) = 0
From this equation one can determine optimum output
supply in terms of the parameter P ; q = q(P) ...............(c)
S.O.C. for π
maximisation requires,
d ^ 2 π / d q ^2 = - d ø’(q) / dq < 0 which requires
d ø’ / dq = d(MC) / dq > 0 , i.e. at the point of P=
MC. MC must be rising which is satisfied by the assumptions that production
function is quasi concave and input prices are given to the firm.
Therefore equation (c) represents output supply function of individual firm.
Graphically:
Equilibrium of
the individual firm is shown in the following figure. From assumption 1 to 5 we
can say that P is given to the individual firm. AR is a horizontal straight
line which is equal to the MR curve. Here MC is positive and upward sloping
from the assumption 6 and 7. Thus at the point of interaction between MC curve
and MR curve we have P = MC at which MC is increasing, so for the corresponding
output q, π is maximised. Thus q is the equilibrium output supplied by the
individual firm which depends on the parameter P. thus output function of
individual firm is defined by equation (c).
Economic Interpretation:
We have already
explained that d TR / dq = MR = P > 0 and constant to the individual firm
and d TC / dq = MC > 0. Therefore P and MC represent rise in TR and TC due
to one unit rise in q respectively. Consider any output say q0 in the above
figure where P>MC holds, i.e., for any unit rise in q increase in TR is larger
than increase in TC. Thus (π = TR – TC) increases, so profit maximising firm
will induce to rise q in further. As q increases further 1 unit, P does not
change as it is given to the firm. But MC rises as d (MC) / dq > 0 by
assumptions 6 and 7. So gap between P and MC decreases. If some gap exists then
by similar logic it will keep on decreasing until P = MC holds. At this point
for one unit rise in q rise in TR is just offset by rise in TC. So profit does
not rise furthermore. Hence it reaches its maximum level. If initially P <
MC holds then by reverse logic as q decreases , profit increases and gap
between P and MC decreases as MC is rising. Clearly profit is maximised when P
= MC holds at which MC is rising.
If MC is not
rising , i.e. , suppose MC is falling, then at P = MC , profit is not maximised
since , if initially P > MC holds as q increases, π increases , so π
maximising firm will rise q further for which MC decreases, as MC is falling. P
is given to the firm so P becomes far larger than MC. So π again increases and
so on. This process will continue and gap between P and MC becomes larger and
larger and π is ever rising, it can’t be maximise. So when MC is not rising
i.e. production function is not quasi-concave i.e. convex then perfect competition
is incompatible.
At equilibrium
P = MC holds, we have marginal cost pricing. If P is not equal to MC i.e. if we
deviate from marginal cost pricing then market is not perfectly competitive.
Concept of
normal and supernormal profit.
r.k. is the
normal return to the capital which is known as Normal Price.
TC = w.l + r.k
Therefore TC
includes normal profit if π = TR – TC = 0 then TR = TC. Then firm must earn
(r.k) after paying labour cost (w.l). Hence firm earns just normal profit. If π
= (TR – TC) > 0, then TR > TC holds. So after paying labour cost (w.l)
and recovering (r.k) i.e. normal profit, firm retains something more. This is
the additional profit of the firm, over the normal profit level which is known
as supernormal or pure economical profit whose magnitude is π = ( TR – TC )
< 0 , then TR < TC holds. Firms fail to recover normal profit and hence
firm incurs loss.
COMPETITION IN THE LABOUR MARKET
Many people believe that perfect competition
doesn’t actually happen in the real world, that it is merely a theoretical idea
used to illustrate points in economics textbooks.
Examples of
perfect competition typically used in textbooks like wheat, soybean etc. Are
not really ideal examples because they are provided with public support in the
form of subsidies or protective tariffs.
In fact, few if
any goods are sold in perfectly competitive markets and firms seek to limit the
pressure of competition in any way they can.
One market
however in which perfect competition reigns supreme, where quality of one
seller’s product is essentially identical to that of any other seller and
number of sellers is very large. Competition forces price right down to the
good’s marginal cost, every time. Not only have that – this market is really
important – the fundamental building block of the economy – marketed for
unskilled labour. Unskilled labourers are those workers who are selling their
labour time, without any resources that would improve their bargaining power
such as union membership, government regulation or professional license.
In a perfectly
competitive market, π is maximised when P = MC.
What could this
mean in the case of labour? What is labour’s marginal cost?
Labour’s
marginal cost is essentially working another day instead of not working – the
unskilled labour has no better alternative. So while it is true that workers
engage in “profit maximising” behaviour, we must not forget that for most of
them “profit maximising” means working instead of starving.
Any wage higher
than mere subsistence will always be undercut by some other worker who is just
a bit more desperate. Marginal cost of unskilled labour is equal to
subsistence, which is the market clearing price.
-Riddhi
Mazumdar, Presidency University, Kolkata.
