Perfect Competition as the Ideal Market Structure

Perfect Competition

In order, a market to be described as perfect several factors must be satisfied. Therefore, I describe perfect competition as a market structure where there a large number of buyers and sellers such that no individual buyer or seller can influence demand, supply, or price, and no firm knows what the other firm is doing. Each firm’s production is minute as compared to total industrial production. All firms sell a homogeneous product that is each firm’s output is indistinguishable from any competitor’s product. Both buyers and sellers are price takers. A price taker is a firm or individual who takes the market price as given. In most markets, households are price takers – they accept the price offered in stores.

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There is perfect information that is Firms and consumers know all there is to know about the market – prices, products, and available technology. There is easy entry and exit from the market. If new producers can easily enter and exit the market, existing firms may behave as though there are more firms than there appear to be, because there are more potential competitors.

Perfect competition faces a perfectly price elastic horizontal demand curve, as shown in Figure 1(a). Marginal revenue (MR) equals average revenue (AR) which is also equal to price.

Monopoly

In this market, there are many buyers but only one seller or producer. There is low cross elasticity of demand between the monopolist’s product and any other product; that is no close substitute products. It is a price maker and can affect price or output but not both. There are substantial barriers to entry that prevents competition from entering the industry including (1) large capital requirements, exceeding the financial resources of potential entrants. (2) Legal exclusion of potential competitors (3) – Absolute cost advantages of the established firm. It faces a price inelastic demand curve, as shown in Figure 1(b). AR lies above MR. There is imperfect knowledge due to market failure. Strong barriers are also present.

Demand curve for PC Fig.
Figure 1(a) Demand curve for PC Fig.
Demand curve for a monopoly
Figure 1(b) Demand curve for a monopoly

Monopolistic competitive market

This market structure has a large number of firms operating in the industry but unlike a perfect competition market, there is product differentiation that each firm is selling a product that is differentiated in some way. There is no collusion among firms within the industry also like perfect competition there is a free entry and Exit industry. This means the most distinctive characteristic of monopolistic competition from the perfect competition is that the outputs of each firm are differentiated in some way from those of every other firm. The differentiation may be trade names, quality design, or color. The firms in this market structure face cross-elasticity of demand between the products of individual firms.

Oligopolistic market

In oligopolistic competition, there is a small number of firms unlike in perfect competition and the firms are interdependent of firms of each other. The products that are produced by oligopolists may be homogenous like in the cases of Perfect competition

The distinguishing factor of market structures is their economic production efficiency. Wealth is allocated efficiently when one cannot benefit without the other person is worse off. From society’s point of view, this occurs at the socially ideal level of output. Efficiency in the allocation of resources is known as Pareto optimality or Pareto efficiency. This can be attained when both productive and allocative efficiency is achieved.

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Productive efficiency requires that whatever output is being produced, it be being produced at the lowest possible costs. A firm is said to be productive efficient if it produces at the minimum point of its long-run average cost (LRAC) curve. Under this situation, there is efficient allocation of resources, all economies of scale are realized and all diseconomies of scale are avoided. When the firm allocates resources in the most efficient, manner possible, full productive efficiency is attained.

PC firms can achieve productive efficiency as they can produce at the P=AR=minimum point of LRAC=minimum point of short-run average cost curve at long-run equilibrium.

However, the monopolist can make supernormal profits in the long run. However, it can never achieve productive efficiency, as it can never produce at the minimum point of its LRAC. Instead, it always produces at the falling portion of LRAC, when it is making normal profits.

As mentioned at the beginning when a market has a large number of firms, free entry and exit, and a relatively homogeneous product, it can generally be modeled as perfectly competitive. The key condition for a competitive market, as discussed above is price taking. Every firm – and every consumer – must take the market price of the good as given. No one can unilaterally affect the price by his or her choice of how much to buy or sell. This means the individual firm will face a horizontal demand curve. It will be horizontal at the market price, established by supply and demand on the market as a whole. A perfectly competitive firm will maximize its profits by setting MC = p*. Because profit maximization for any firm means that a firm MC =MR, and for a perfectly competitive firm, MR = p*.)

Using the knowledge about profit maximization under perfect competition we can derive a firm’s supply curve. The supply curve shows how much quantity is produced at each price. A market supply curve shows how much quantity all firms together will produce at each price. An individual firm’s supply curve shows much quantity that the firm will produce at each price. Looking at the firm’s response to different market prices, we can draw a supply curve. Let me take three different prices, p1 < p2 < p3. For each of these prices, we can figure out the quantity that a perfectly competitive firm will produce.

Adapted

 Horizontal demand curve
Figure 2. Horizontal demand curve

Using the marginal cost down to the AVC, we can see that any price above the minimum point of the AVC will induce the firm to stay open and produce. However, for prices below the minimum AVC, the firm will shut down and produce q = 0. So it turns out the supply curve has two parts, like so. The upper part corresponds to when the firm stays open, while the lower part corresponds to when the firm shuts down.

Marginal cost down to the AVC
Figure 3. Marginal cost down to the AVC

To find the market supply curve I have to add up all the firms’ supply curves horizontally.

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The complete representation of a PC market has two side-by-side graphs, a market on the left and a typical firm on the right. As shown in the figure below.

PC market
Figure 4. PC market

In this short-run equilibrium, we have the firm making a profit. We could also have drawn it with the firm making a loss. In addition, there is no particular reason why all PC firms must be identical in the SR, because while they face the same technology, they may have made different capital choices and therefore be on different SRATC curves.

If demand increases or decreases, this will affect the choices and profits of all the firms in the market. Note that the price increase tends to increase profits or decrease losses.

The reverse would be true of a price decrease.

Perfect Competition in the Long Run

In the long run, entry and exit become possible. Because potential firms can buy fixed inputs and become actual firms. In addition, existing firms can sell off or stop renting their fixed inputs and go out of business. Firms will choose to enter the industry if the existing firms in the industry are making economic profits. The profits are an incentive to enter. If I add more firms, therefore, the market supply must shift to the right. However, it drives down the price on the market, thereby reducing the profits of each firm. This is shown by the graphs below

Perfect Competition in the Long Run
Figure 5. Perfect Competition in the Long Run

As I have, changes in demand in a perfectly competitive market create profits and losses for firms. In the short run, this has no effect on the supply curve; but in the long run, firms enter for profits and leave to escape losses, leading to supply curve shifts. We want to use this information to derive a long-run supply curve. A long-run supply curve, just like a short-run supply curve, shows the total quantity that will be supplied in a market at different prices; but unlike the long-run supply curve, it shows the quantity supplied after all long-term changes, including entry and exit of firms, have been taken into account.

Now we are going to use the same basic technique to trace out the long-run supply curve. We can do this by changing demand and then finding the equilibrium points after allowing long-run adjustments, including entry and exit. Start with an initial (short-run) supply and demand. If we are in long-run equilibrium, profits are zero. Now, let demand shift to the right. In the short run, price rises a lot. However, the higher price creates profits, and profits attract entry in the long run. So eventually supply shifts to the right as well, pushing the price back down (though possibly not as low as it was before). Once profits are back to zero again, you’re in a new long-run equilibrium. Do this all again to find a third long-run equilibrium, and then connect the dots to get the long-run supply curve.

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 Long-run equilibrium
Figure 6. Long-run equilibrium

The interpretation of the long-run supply curve is pretty much the same as the SR supply curve: it shows the willingness of producers to sell at each price. However, the LR supply curve measures this willingness in the broadest sense, including all firms that might potentially supply this product.

Notice that the long-run supply curve is flatter than the SR supply curve. This must be so since the long-run supply curve takes into account the quantity responses of all firms, not just the ones currently in the market, but potential firms as well. It is even possible that the long-run supply curve can be downward sloping.

In conclusion, perfect competition is often referred to as ideal market because no competitive structure will satisfy the conditions that are to be fulfilled in this competition. In real life as (1) the number of firms increases, the effect of any one firm on the price and quantity in the market declines. (2) If firms are vigorously trying to claim market share at each other’s expense, each firm will be more constrained in its choices thus affecting the market. (3) There are always differences in quality or other properties means that the products of different firms are not perfect substitutes for each other, and that means customers will absorb some price differences among firms. (4) If new producers can easily enter and exit the market, existing firms may behave as though there are more firms than there appear to be because there are more potential competitors.

There are always barriers to entry and exit from an industry, which includes:

  1. High start-up costs. These may cause it to take a very long time for new firms to enter the market, during which time the market is less competitive than it otherwise would be.
  2. Brand loyalty. If people are reluctant to consider new alternatives, the established firms in an industry face less of a threat from new competitors.
  3. Government restrictions. These restrict the ability of competitors to contest the market. Examples include licensing of electricians, plumbers, doctors, etc.; patents; protectionist tariffs and quotas; and absolute limits on the number of suppliers, such as NYC’s taxicab medallion system. Therefore, we cannot have a perfect market without restriction in the real world.

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