In this paper, I am going to give a discussion on the market trends of a manufacturing firm in a perfect competition market. For this discussion, I am going to consider a sugar-producing firm. Our model market is free from market imperfection and the invisible hand of demand and supply is left free to determine the trends in the market. We are also going to make several assumptions for the sake of our discussion: Firms are producing homogenous goods (in our case sugar). All the firms in this industry are producing similar types of goods only differentiated by branding and advertising. Secondly, the producer and the consumer have the same and perfect knowledge about the market. That is to imply that there is a free flow of information about both technical conditions and production factors as Lipsey (1989) observes.
Earlier on we assumed that prices are left free to be allocated by forces of demand and supply. In this regard, we also assume that no players can influence the market either by themselves or in a cartel. We also assume that the actions of the players are driven by economic motives. The implication here is that all the players in the sugar industry are rational; meaning that the consumers are driven by the urge to maximize utility while the producer is motivated by the desire to maximize profits. Lastly, we assume that there are no barriers to entry and exit from the market. Consumers and producers can enter and leave the market at their own will since their major motivating factor is utility and profits respectively.
Effects of entry of new companies into the market
Firms in a perfect competition produce at the level where marginal cost is equal to the marginal revenue. Since each unit of sugar being produced is sold at the same price, the price will be equal to the average revenue and marginal revenue. Before the entry of new firms, the average revenue of the firms is greater than the average cost and the firms are making super-profits. The large profits act as an incentive for new firms to enter the market in the short run. With the entry of new firms into the market, the supply curve will shift to the right, and equilibrium price will fall forcing the profits downwards. The trend continues with the entry of new firms until they reach a level in production where the average cost is greater than the average revenue. At this level, firms are making losses.
Since there is free entry and free exit, the stream of losses offers disincentives of firms to produce leading to an exit of some firms from the market. The exit causes readjustment of the supply curve upwards to the left to the level where average revenue is equal to the average cost. This exerts pressure on the marginal revenue to move back to the equilibrium where marginal revenue is equal to the marginal cost. At this level there are neither abnormal profits nor losses and firms are making just enough to keep them operating. Given these conditions there are no incentives neither for firms to enter nor to exit the market and this occurs in the long run.
In a perfect competition market, each producer is a price taker and must sell at the prevailing market rates. In the case of our sugar market, no one producer can dictate the price of sugar in the market. Producers are wary that whenever one increases his price, others may not follow which decreases demand for his sugar hence reducing his revenue. An increase in price in the normal circumstance leads to a decrease in quantity demanded which exerts upward pressure on the supply curve. The supply curve moves upwards to the right and a new equilibrium is achieved.
Technological inventions lead to efficiency in production leading to a reduction in the cost of production. It also has the effect of increasing the quality of products. If the decrease in cost is large enough, the result is usually a transfer of those benefits to the consumer in terms of reduction in prices. An increase in technology, therefore, shifts the supply curve downward to the right along the demand curve. This pushes the equilibrium curve downwards causing a reduction in price and an increase in total output.
All factors remaining constant, when increasingly more and more amount of variable output is applied over a fixed level of input, the result is a decline in the level of productivity. This is what is commonly referred to as diminishing marginal productivity (Black, 2009). That is to imply that so long as capital remains fixed; employing additional labor in the production of sugar will only lead to diminishing returns as the marginal productivity of each additional worker declines. This is caused by the tendency of the workers to start getting into each other’s ways. As the marginal cost of hiring each additional worker increases with increased output, it becomes economical to substitute capital for labor. Piana (2001) however notes that productivity is largely a factor of pricing and demand.
The cost structure in this industry is composed of fixed and variable costs. The fixed component is made of those costs that do not increase with the increase in output while the variable component is composed of those costs that vary with the change of output. Fixed costs here include expenditure on rent and salaries while variable costs include the cost of raw materials, advertisement, and transport among others. Others are Total cost which is obtained by summing up fixed cost and variable cost and average cost obtained by dividing total cost by each successive level of output. In addition, we have a marginal cost which is the amount of change in total cost per each unit change in output.
Wages and benefit
Wages and benefits increase the disposable incomes of consumers. This increases consumption of goods and services other factors held constant. According to O’Hara (1916), the increased level of consumption increases the aggregate demand for goods and services. This creates incentives for firms to produce more output in the short run To prop out their profit margins. Initially, the rising incomes cause short spurts in price increases but in the long run the market levels off to go back to equilibrium.
Price elasticity of demand
This is a measure of a proportionate change in quantity demanded as a result of a proportionate change in price.
- P = price
- Q = Quantity demanded
- ∆ = change
For normal goods, a significant increase in price leads to a fall in quantity demanded as Moffat (2009) notes. For example, an increase in the price of sugar as a result of a drop in output in the industry will depress its demand. If the proportionate change in quantity is larger than the proportionate change in price the demand is price elastic. On the other hand, if the proportionate change in quantity is less than that of price, then the demand is price inelastic. And when the proportionate change in quantity is equal to the proportionate change in price the demand is said to be price inelastic. For our discussion, sugar being a normal good has a price elastic demand. Therefore for the producer to maximize revenue, he reacts by reducing price which leads to an increase in revenue. If he were to increase the price, he would incur losses as a result of a sharp decrease in quantity demanded.
Competition in this industry is manifested in form aggressive marketing campaigns and promotions. Since the industries are dealing with homogenous goods, they differentiate their products through packaging and branding. This does not however alter the quality of the commodity and so competitors seek to invoke brand loyalty among their customers. Since each firm in the market is a price taker and can not increase the price on its own the campaigns only bear fruits in the short run as other firms catch with the strategy which levels off demand in the long run.
Demand and supply analysis
Holding other factors constant, variation in demand is a result of movement in prices of goods. Bearing in mind the same assumption, for a normal good the quantity demanded will rise with the fall in price and on the other hand will fall as price increases. In considering the sale of its products the firm will have to consider the relationship between price and quantity. The firm must accurately predict the likely effect of a change in price because any change in the quantity demanded will impact the total sales revenue of the company.
The price-quantity relationship is not a concern of the firms alone as the government uses it in determining its fiscal policies. For example in our model, any change in the tax imposed on sugar will affect the price of our commodity. The change in the price of sugar will impact the quantity of sugar demanded. On the other side, while increasing the value-added tax of a product, the government must be able to estimate reliably how much extra total revenue it can collect from the tax change. This emphasizes the importance of the price-quantity relationship.
Impact of government regulations
Although the industry is largely driven by the forces of demand and supply, some level of regulation is sometimes healthy especially when there are instabilities in the markets as a result of variations in supply caused by drought, flooding among other factors beyond the control of the producer. For example, when there are shortages in the supply of sugar in the market-leading to an upward spiral in prices, the government intervenes to control prices to bring back stability in the market. In such a scenario the government might ease tax on sugar imports hence allowing increased importation of the commodity which increase supply hence stabilizing the price of sugar. The government might also opt to subsidize farm inputs as an incentive for farmers to produce more.
However administration and regulation of these policies come at a cost to the economy and so the government must assess the benefits accruing from them to determine whether the cost is justified. It must also take caution not to discourage the supply of the commodity to the extent that its objectives become counterproductive or misplaced.
Black, K. (2009). What are diminishing marginal returns? Web.
Lipsey, R.G. et, al. (1989). Introduction to positive economics, Oxford, Oxford University Press
O’hara F. (1916). Introduction to Economics. The McMillan Company
Moffat, M. (2009). Price Elasticity of Demand. Web.
Piana, V. (2001). Productivity. 2009. Web.