Perfect Competition

Perfect Competition

Every time we look at a market structure, we will start with a section on assumptions. Although some of the market structures are more realistic than others, all of them are essentially models that only work if one adheres to a set of assumptions.

Perfect competition is probably the most unrealistic of the lot! As you will see from the assumptions below, the world we are creating is not very real at all! I hear you saying, 'So what's the point of it?' Good question. Economists have created these models as benchmarks from which the real world can be compared. The model of pure monopoly is fairly unrealistic as well, but one can learn about how firms in industries, which are similar to the model, act in real life. In the same way, no industry is perfectly competitive, but there are some that are fairly close, so studying this model helps us understand how these industries operate.

So, here are the assumptions that we have to make for the model of the perfectly competitive industry.

  1. Numbers: In a perfectly competitive market, there are many buyers and many sellers. In fact, the number of buyers and sellers is effectively infinite. All firms in the industry act independently of each other.
  3. Ease of entry: This one is about barriers to entry. We assume that there is total freedom of entry into and exit from the market. There are no barriers to entry or exit.
  4. Knowledge: In a perfectly competitive market, it is assumed that both buyers and sellers have perfect knowledge, about prices in particular. Buyers and sellers know the exact price of the product charged by all firms at all times. This means that there are no search costs for consumers (searching for the best price).
  5. Product: The product sold by the numerous firms in the market is homogenous, or identical.
  6. Maximising assumption: All firms aim to maximise their profits. That is their sole objective. Buyers aim to maximise their welfare through their purchases.
  7. Mobility of factors: It is assumed that all of the factors of production are perfectly mobile. If they are not being used as efficiently as they could, they will instantly move to where they will be best used without any restrictions.
  8. Price takers: Firms in perfectly competitive markets are price takers. This means that they have absolutely no control over the price they charge. There are so many firms that the actions of one firm will have no effect on the whole market. The price is derived from market supply and market demand, over which each firm has no power. Buyers also have no control over the market price. If one consumer increased his demand significantly, it would still be dwarfed by the cumulative demand from the other, infinite, consumers.

It is almost impossible to think of a perfect example of an industry, or market, that displays these characteristics. There are some that get close. Some say that the Stock Market is one. There are lots of buyers and sellers, few barriers to entry (especially with Internet stock broking) and the product is homogenous (for any one type of share, anyway). But although knowledge is meant to be perfect, I'm not sure that it is.

Is agriculture, there are lots of buyers and sellers, the product is homogenous (a potato is a potato, whichever farm you visit!) and prices appear to be determined by the market. But are they? In the European Union, prices are controlled via subsidies through the Common Agricultural Policy.

Before we can look at what actually happens in these markets, we need to look at the revenue and cost curves, from which we will derive the demand and supply curves for the market and each firm.

Here are the demand and revenue curves for the market and each firm:

Demand and revenue curves

Assuming that the good in question is normal, the market demand curve will be a normal looking downward sloping demand curve. Equally, there is no reason to believe that the market supply curve will be anything other than a normal looking upward sloping supply curve.

We said earlier that no one firm is big enough to affect the market price. Imagine that one firm doubled its supply. The industry supply curve would shift to the right, but the move would be so infinitesimally small (given that the firm is just one in a market of millions) that one would not be able to see it. Effectively the price is unchanged.

Hence, every firm is a price taker setting their price at the market price of P1. Each firms' demand curve is perfectly elastic. This means that they can sell as much as they want at the given market price. If one of the firms were to raise its price above P1, their sales would plummet to zero because the buyers would go to one of the other numerous firms selling the identical good at P1. I suppose a firm could lower its price below P1 to try and steal some market share from their competitors, but what's the point? Each firm can sell as much as they want at price P1.

Finally, notice that the firms' demand curve has also been labelled AR = MR. If you can't remember why the demand curve is the average revenue curve, or why average revenue = marginal revenue when AR is constant, then look back at the topic on 'Costs and revenues'.

We have already stated that the market supply curve is a normal looking upward sloping supply curve. But what about the firms' supply curve? The following diagrams will attempt to explain that each firm's supply curve is their marginal cost curve.

Cost curves

Assume that initially, D1 is the market demand curve, S the market supply curve, and so the given market price is P1. This means that each firm in the market has an individual demand curve of D1. This also represents their average revenue curve (AR) and their marginal revenue curve (MR).

One of the key assumptions we made earlier was that each firm tries to maximise profits. This occurs at the level of output where marginal cost = marginal revenue (MC = MR). If you do not remember why this is the case, look back at the 'Costs and revenues' topic under the Learn-It called 'Profit'.

Looking at the diagram for the firm on the right, when the price is P1, the condition MC = MR occurs at point A, giving an output of Q1. If there is a shift to the right of the demand curve in the market (due to increased real incomes, for example), the given price will rise to P2, and each firm will have an individual demand curve of D2. This time, MC = MR occurs at point B, giving output Q2. For a shift to the left in market demand, the given price is P3, MC = MR occurs at C and output for each firm is Q3.

From the analysis above, you can see that, effectively, if a firm wants to find out how much he should supply at any given price, he simply reads this amount off the marginal cost curve. The marginal cost curve is doing the job of a supply curve; it tells the firm its supply for any given price. Hence, the marginal cost curve is the firm's supply curve.

The shut-down point

So, a perfectly competitive firm's marginal cost curve is its supply curve. But as you will see, its supply curve is not the whole of the marginal cost curve.

The shut-down point

The two diagrams above are very similar to the two previous diagrams except I've added the firm's average cost and average variable cost curves (both are short run curves).

Let's assume that the given market price is P1. Does each firm make profit or loss? Well, given the information we have, it is probably best to compare average revenue and average cost (we don't have TR and TC). At P1, AR > AC, so the firm is making super normal profit.

At P2, AR = AC, so each firm is making normal profit, or, in other words, breaking even.

At P3, AR < AC, so each firm is making a loss. But, AR > AVC. This means that the revenue each firm receives, on average, is still higher than their variable costs. They can 'cover' their variable costs. They can still pay wages, pay for raw materials and pay for the power to run the machines. They can exist! The costs they can't cover are some of the fixed costs. Imagine this as being behind on the rent! A problem, but not the end of the world. The point is that the firm can keep operating.

Below point S, the shutdown point, the firm has to shut down even in the short run. For instance, at the given price P4, AR < AVC. The firm cannot even cover its variable costs of production. If a firm cannot even afford the raw materials or the labour to make enough of the product to minimise their losses, then they are in real trouble! They must shut down.

The implication of all this is that, although the firm's supply curve is the marginal cost curve, in the short run it is only that part of the MC curve that is above point S. The supply curve for a perfectly competitive firm in the short run is the part of the marginal cost curve above the average variable cost curve.