In this topic the principles which guide firms in their price and quantity decisions will be set out in the short and long run. Perfect competition is defined. The demand and marginal revenue are derived. The equivalence between profit maximization and equality of marginal revenue and marginal cost is established. The long run equilibrium is studied. The economic effect of this market form is shown to be optimum for society.
Perfect competition is a type of market characterized by
- a very large number of small producers or sellers,
- a standardized, homogeneous product,
- the inability of individual sellers to influence price,
- the free entry and exit of sellers in the market, and
- unnecessary nonprice actions.
Examples of markets in perfect competition are extremely rare. Numerous markets in the retail, service and agricultural sectors approach perfect competition best. But, in the agricultural sector, government support price programs distort the market mechanism. Notwithstanding the lack of good examples, this form of market is important because of a general conviction among economists that it is the best form of market.
Number of firms
The very large number of firms in perfect competition implies that each individual firm is very small in comparison to the total market. Indeed, if one firm were to become significantly large, it would dominate the market and competition would be eliminated or at least diminished.
In the milk production segment of agriculture, farms are usually small. They are especially small compared to the size of the entire market for milk. Note that the milk distributors are occasionally large, but not the productive farms.
The product in perfect competition is said to be standardized (or homogeneous). This means that it does not make any difference to customers which specific firm sells the product: it is absolutely identical. This is the main distinction between perfect competition and monopolistic competition: once some differences can be recognized by customers, firms acquire power over these customers.
Milk is a uniform and homogeneous product. It is not possible to make a distinction between the milk of one farm and another. The government has indeed set standards of quality, fat content and cleanliness.
The firms in perfect competition have no power over price: they have to sell at the going market price. The firms in perfect competition are said to be price takers. Should a firm attempt to raise the price by the smallest possible amount, customers would not buy from it because they could buy the same product from other firms. Lowering the price is also not necessary because the firm can already sell all its output at the going price.
A milk producer who would try to raise his/her revenues by increasing the price for milk, would find the company collecting the milk in that region unwilling to buy his/her milk any longer. One individual farmer is thus unable to affect the price of milk in the entire market.
Entry and exit
There are no barriers to entry to or exit from a market in perfect competition. This condition assures that no firm will dominate the market and evict other firms. It also assures that the number of firms (although changing) will remain large.
Agricultural production can start for most crops by simply planting on a parcel of land. For instance, that is true for fruit trees and vegetables. (It is true. however, that for some products such as milk or tobacco, the government limits production because of the existing overproduction).
Nonprice actions such as advertising, service after sale or warranty, are not necessary in perfect competition because the firm can already sell all its output at the going price, and incurring additional expense would only make it unprofitable. (Nonprice action for the entire industry may however be useful).
A single milk producer cannot possibly influence the consumption of milk at large, and needs not advertise. An association of milk producers or a large milk distributor may, however, be in a position to use advertisement effectively.
The demand of firms in perfect competition is perfectly elastic (i.e., the smallest possible price change results in a virtually infinite quantity change). Such demand is represented graphically by a horizontal demand curve: no matter what quantity is sold, the price is the same, and it is the going price in the market.
Nationwide, the demand for milk is likely to be downsloping, that is inversely related to price. But for a single milk producer, it is given by the price the farmer can receive: the going market price. It does not change, no matter what quantity the farmer produces. Thus demand is horizontal.
The horizontal demand curve is also the marginal revenue of a firm in perfect competition. The marginal revenue, or additional revenue from one more unit sold, is just equal to the going price (which is shown graphically by the demand curve itself). Note that the average revenue is also the demand curve and total revenue is an upsloping straight line.
A firm must seek to sell a volume of output where its total revenue exceeds its total cost by the largest amount possible; that is, its profit is the maximum.
If a firm fails to derive a profit, it may nevertheless seek, in the short run, to produce at that level of sales where the difference between its cost and its revenue, i.e., its loss, is minimum.
Close down decision
If a firm has revenues that are insufficient to cover even its fixed costs in the short run, the firm must close down.
The volume of output where total revenue is equal to total cost is known as the break-even point. A firm must be beyond its break-even point in order to be maximizing its profit.
Marginal revenue marginal cost rule
Producing at the level of output where marginal revenue equals marginal cost is equivalent to profit maximization. Indeed, if one less unit were to be produced, profit would be smaller by the excess of marginal revenue over marginal cost for that last unit. If one more unit were to be produced, profit would also be smaller, this time by the excess of marginal cost over marginal revenue.
Marginal revenue marginal cost
The marginal revenue = marginal cost rule is applicable to loss minimization as well as profit maximization. However, if marginal revenue intersects marginal cost below average variable cost, it means that revenues are not sufficient to cover fixed costs and the firm should close down.
The maximum profit is obtained by first determining the level of output for which marginal revenue equals marginal cost (thus profits cannot possibly be increased). Then determining
- total revenue given by price multiplied by quantity,
- total cost given by average total cost multiplied by quantity,
- the difference between 1 and 2 above is the profit (or loss).
Maximum profit graph
Since maximum profit is the excess of total revenue over total cost, it is shown graphically as the area by which the total revenue rectangle exceeds the total cost rectangle. The height of total revenue rectangle is the price received by the firm, and the width is the optimum quantity (where MR=MC). The height of total cost rectangle is average total cost (on ATC curve), and the width is the optimum quantity.
Short run supply curve
The short run supply curve of firms in perfect competition is the upsloping portion of the marginal cost curve (above the average variable cost intersection). Indeed, a firm determines its optimum volume of sales by taking the intersection of marginal revenue and marginal cost. The marginal revenue is also the price it receives. Thus supplier's price-quantity combinations are given by the marginal cost upsloping portion.
Long run perfect competition equilibrium
The long run equilibrium for firms in perfect competition is where demand (and marginal revenue which is identical to it) is tangent to the minimum of average total cost (where marginal cost also intersects average total cost). At that point, there is no profit or loss for the firm. (Note that there is no pure or economic profit, but normal profit must still be covered).
Entry of firms in perfect competition
Should demand be above the minimum of average total cost, pure profit would exist for firms in perfect competition. This profit would attract new firms to the industry. Such entry of new firms is not impeded by any entry barriers in industries in perfect competition. The new firms would increase the total market supply and drive the price down. The lower price pushes the demand for each firm down toward or even below the equilibrium minimum average total cost point.
Exit of firms in perfect competition
Should the demand be below the minimum of average total cost, losses of firms would force some firms to leave the industry. As firms leave, a decreasing total supply pushes price back up. The increasing price lifts the demand curves for individual firms upward toward or even above the equilibrium point. Firms departure or entry will continue until the price settles to be just equal to minimum average cost.
Long run supply curve
The long run supply curve for an industry in perfect competition is perfectly elastic (that is horizontal) in constant-cost industries and upsloping in increasing-cost industries. Whether an industry is constant-cost or increasing-cost is determined by the presence of adequate or insufficient resources.
Perfect competition economic effect
Perfect competition is seen as an ideal or optimum form of market because of its very beneficial economic effect for society, which comes from
- allocative efficiency, and
- productive efficiency.
But there are a few shortcomings nevertheless.
The productive efficiency of perfect competition can be observed in the long run equilibrium point of all firms in the industry, which is at the minimum of average total cost. This means that all firms are forced to cut their costs and utilize the best available technology in order to have their minimum average total cost no higher than that of all the other firms in the industry. There is also no under or over utilized capacity.
The allocative efficiency in perfect competition comes from the fact that the quantity produced by each firm is just that for which the price paid by society is equal to the cost of additional resources (marginal cost). More could not possibly be obtained for a lower price. The resources are also the most efficiently allocated among industries since firms will bid for these resources up to the price consumers want to pay for them.
Perfect competition shortcomings
In spite of its beneficial economic effect, perfect competition fails to
- provide any correction for income distribution inequity,
- generate any public goods since there is not profit,
- stimulate technological progress because of lack of profits,
- offer diversity in products since these are standardized.