Perfect Competiton

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.