PERFECT COMPETITION The highest degree of competition possible.
DEFINITION Economists are able to use the their model model of a of a perf perf ect market arket a s a means eans of a of asse ssessing the the degree of world rld markets. arkets. The set out they perf ect market arket and the compe competition tition in real wo they conditions necessary ssary for for a perf then with situa arkets for ervice es. The degree compe contra contrast st the these with situations tions fou found in the the markets for goods and servic competition tition in arkets is bas based upon upon the extent to which they approxima the these real markets the ext they appro imate to the the model model of per of perf f ect ref erred erred to here is price compe competition. tition. It is necessary ssary to point out tha that the the compe competition tition ref is price competition. competition . Firms are ass assu umed to be eng enga aged in a ri rivalry for ales which takes akes the elling compe for sales the for form of u of under ndersselling competito titorrs. In a market arket operating perating under will be one nder the the conditions of per of perf f ect compe competition, tition, there there wi one, and only only one one, arket pric price e, and this pric price e wi will be beyond beyond the luence e of a eller . The pric price e is set market the inf luenc of any one one buyer or a seller. arket demand and supply. upply. thr through market
CHARACTERISTICS A
perf perf ectly ve market arket has a number of key eristics. ctly compe competiti titive of key chara charact cter istics. -
All
units units of th of the e commodity commodity are homoge homogeneous, tha that is one one unit unit is exact exactly ly li like anoth another er.. If this f this
happens, appens, the then the the buyers buyers will have no pref pref erenc erence e for for the the good of a of any partic particular ular seller. eller. -
There must be many buyers buyers and many sellers ellers so tha behavio aviorr of a any one that the the beh of any one one buyer or an one luence e on the arket pric price e. Each indiv es such a small part of seller has no inf luenc the market individual idual buyer compr compris ise small part plans will have no inf luenc luence e on the arket pric price e. total total supply tha that any cha change nge in the their plans the market
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Buyers Buyers are ass assu umed to have perf perf ect knowle e of m arket conditions; they know w wh what pric price es are nowledg dge of market they kno being being asked ked for part of th e market. arket. Equally ellers are f ully ully aware of th e for the the commodity commodit y in every part of the Equally sellers of the activ eller s. ctivitie ities of buyer of buyerss and other other sellers.
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There must be no barri barriers ers to the units the move movem ment of buyer of buyerss f rom one one seller to another nother.. Since ince all units of th of the e commodity commodity are ide identical ntical,, buyers buyers will always always appro approach the the seller quoting the the lo lowest west pric price e.
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Finally inally,, it is assu ssumed tha that there there are no barri barriers ers to entry ntry and and exit exit of fi of firrms into the the market. arket.
We can now why, in a perf perf ect market, arket, there will be one and only arket pric price e which which is beyond beyond now see wh there wi one and only one one market any one eller . Firms cannot char erent pric price es bec becaus ause they the the contr control of a of any one one buyer or an one seller. charg ge diff erent they are elling ide produ ucts, each each of th em is res responsible part of th e total upply, and buyers buyers are selling identical ntical prod of the onsible for for a tiny tiny part of the total supply, ully aware of w appening in the arket. f ully of what is happening the market.
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THE INDIVIDUAL FIRM UNDER PERFECT COMPETITION Under the conditions of perf ect competition the firm is powerless to exert any inf luence on price. It sees the market price as given that is, established by forces beyond this control. F or example, in most countries, the individual f armer has no inf luence on the prices at which he sells his wheat, or beef, or ilk, or vegetables. Any changes in the amounts of these things which he brings to the market will have negligible eff ects on their prices. The firm under perf ect competition is a price taker. The demand curve for the output of the single firm, therefore, must be a horizontal line at the ruling price; in other words, a perf ectly elastic demand curve. No matter how many units the firms sell it cannot change the price. It can sell its entire output at the ruling market price. If it tries to sell at higher prices its demand will drop zero, and there is obviously no incentive to sell at lower prices. Again we must guard against a common misunderstanding. The demand curve for the product of the firm will be perf ectly elastic, but the market demand curve for the output of the industry will be of the normal shape, sloping downwards f rom left to right.
Price
Price
D
S D
S
D
Quantity
(a) Industry
Quantity
(b) Firm
The graph above shows that, when the industrys demand and supply curve is in equilibrium, the individual firm has its demand on the Market price of the industry. This proves that when a firm is in perf ect competition, it has to keep its price same as of the industrys equilibrium price, because if it does not do so, then the firm cannot survive and will have to f ace negatice consequences.
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PERFECT COMPETITION AND ECONOMIES OF SCALE A
perf ectly competitive firm having economies of scale is dependent on the size of the firm relative to
the size of the market. In most perf ectly competitive models, it is assumed that production takes place with constant returns to scale that means no economies. This means that the unit cost of production remains constant as the scale of production increases. When that assumption is changed, it can open up the possibility of positive profits and strategic behavior among firms. Because there are numerous ways to conceive of strategic interactions between firms, there are also numerous models and results that could be obtained. To avoid some of these problems, a number of models have been developed which retain some of the key f eatures of perf ect competition while allowing for the presence of economies of scale as well. Because there are numerous ways to conceive of strategic interactions between firms, there are also numerous models and results that could be obtained. To avoid some of these problems, a number of models have been developed which retain some of the key f eatures of perf ect competition while allowing for the presence of economies of scale as well.
LOCAL MARKET HAVING PERFECT COMPETITION The closest thing to a perf ectly competitive market would be a large auction of identical goods with all potential buyers and sellers present. By design, a stock exchange resembles this, not as a complete description (for no markets may satisf y all requirements of the model) but as an approximation. The f law in considering the stock exchange as an example of Perf ect Competition is the f act that large institutional investors (e.g. investment banks) may solely inf luence the market price. This, of course, violates the condition that "no one seller can inf luence market price". Karachi stock exchange, quite a valid example of perf ect competition where there are many stockholders and many buyers that mean many buyers and many sellers; this satisfies the condition of being a perf ectly competitive market. Also, KSE has numerous buyers and seller and none can create barriers of entry or exit in the stock exchange market. Another
example can be of vegetables and f ruit vendors, they are large in number and provide
homogeneous goods. There is a perf ect mobility of f actors, that is, buyer can easily switch f rom one seller to another. A
very noticeable perf ect competitive market in Pakistan is of street foods. In every street we can find
kiosks in which the sellers are selling their product, which are also homogeneously available. Any new entrant can enter this market and there are no barriers or any stoppage for them to enter this market.
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SHORT RUN PRICE AND OUTPUT FOR THE COMPETITIVE INDUSTRY AND FIRM In the short run the equilibrium market price is determined by the interaction between market demand and market supply. In the diagram shown above, price P1 is the market-clearing price and this price is then taken by each of the firms. Because the market price is constant for each unit sold, the AR curve also becomes the Marginal Revenue curve (MR). A firm maximizes profits when marginal revenue = marginal cost. In the diagram above, the profit-maximizing output is Q1. The firm sells Q1 at price P1. The area shaded is the economic (supernormal profit) made in the short run because the ruling market price P1 is greater than average total cost. price
price MS
MC AC
AR=MR
PROFIT MD Industry output
firms output
Not all firms make supernormal profits in the short run. Their profits depend on the position of their short run cost curves. Some firms may be experiencing sub-normal profits because their average total costs exceed the current market price. Other firms may be making normal profits where total revenue equals total cost (i.e. they are at the break-even output). In the diagram below, the firm shown has high short run costs such that the ruling market price is below the average total cost curve. At the profit maximizing level of output, the firm is making an economic loss (or sub-normal profits). MS
MC AC
LOSS AR=MR
MD Industry output
firms output
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REALISM OF THE PERFECT COMPETITION MODEL Perf ect competition is not to be found in the real world, although it is possible to point to some markets where there is some rough approximation to this idea. There are hundreds and thousands of wheat producers all over the world and not one of them is large enough to inf luence the price of wheat. There are any producers and buyers; modern methods of communication make knowledge of market conditions almost perf ect, and the standardized grading of commodities means that the products in any one grade is regarded as homogeneous.
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