Price and Output Determination under Perfect Market, Features of Perfect Competition Notes

Market

Market structure refers to economically significant features of a market, which affects the behavior and working of firms in the industry. According to Pappas and Hirschey, “Market structure refers to the number and size distribution of buyers and sellers in the market for a good or service.”

Characteristics of Markets

1.    Market is not confined to one particular place, but over an entire area where buyers and sellers of a product (or) the commodity is spread over.

2.    Buyers and Sellers must be present, though physical presence is not necessary. In modern times, we sell goods through various types of media: Telephonic Media, Electronic Shopping Markets, Websites, etc.

3.    There must be a commodity that is bought and sold.

4.    There should be free interaction between buyers and sellers so that both agree on one price of the commodity.

 

FORMS OF MARKET

Economists have classified markets based on:

a)    the number of buyers and sellers of the commodity.

b)    the nature of the commodity produced by the sellers.

c)     degree of freedom in the movement of goods and factors.

Based on these criteria, economists have distinguished between four basic forms of the market:

1.    Perfect competition

2.    Monopoly

3.    Monopolistic competition

4.    Oligopoly

 

Pricing Under Perfect Competition

A perfectly competitive market structure obtains when there are many firms in an industry, all producing a homogenous product. An individual firm must accept the price set by the forces of market demand and market supply. They can sell as much as they choose at the prevailing market price and have no power to influence the price. If any firm charges a higher price, it will find no buyer for its product, many other firms would be selling at the market price that buyers would go to them.

According to Bilas, “the perfect competition is characterized by the presence of many firms, they all sell the same product which is identical. The seller is the price-taker.”

 

Features of Perfect Competition

The important features of this type of market are summarized as follows:

1)    Large number of buyers and sellers: The number of buyers and sellers is so large that no individual buyer or seller can influence the market price.

2)    Homogeneous products: Different firms produce homogeneous or identical goods. Therefore, no firm can raise its price above the general price level.

3)    Free entry and exit of the firms: There is absolute freedom for firms to join or leave the industry. If the industry is making profits, new firms can enter the market to share these profits. Similarly, if the industry suffers losses, the individual firms can quit the industry.

4)    No government regulation: There is no government interference in the market in any form.

5)    Uniform price: At a particular time, the uniform price of a commodity prevails all over the market.

6)    Perfect knowledge of market conditions: Buyers and sellers should have full knowledge of the nature of the product, its availability, and the price of the goods in the market.

7)    Perfect mobility of the factors: Factors of production are free to move into any industry or occupation.

8)    Absence of selling and transportation costs: Selling and other promotional costs should not present in a perfect market.

Thus, perfect competition is an uncommon phenomenon in the real business world. However, the actual markets that approximate the conditions of the perfectly competitive model include the share markets, securities-and-bond-markets, and agricultural product markets.

In a perfectly competitive market, the main problem for a profit-maximizing firm is not to determine the price of its product, but to adjust its output to the market price so that profit is maximized.

Price Output Determination under Perfect Competition

Under the Perfect Competition Market, the market price of the product is determined by the interaction of demand and supply in the case of the industry. Alfred Marshall compared to supply and demand to the blades of a scissor. As both the blades work together to cut a piece of cloth, both supply and demand interact with each other to determine the market price at which exchange takes place. Both forces (Demand and Supply) play an equally important role. The firm is a price-taker (not a price-maker), so, all the firms will accept this price and adjust their output on the given price.

The equilibrium point of the Industry and the Firm under Perfect Competition:

 

Price	Demand	Supply	State of Market	Pressure on Price
10	500	100	D > S	P↓
20	400	200
30	300	300	D = S	Neutral
40	200	400	D < S	P↑
50	100	500

 

[Please refer to the given link for market equilibrium with demand and supply: Click here ]

In the above diagram, DD is Demand Curve and SS is Supply Curve. At point E, Demand and Supply are in equilibrium where both curves intersect. Where the equilibrium price is OP and the equilibrium output is OQ.

Suppose, the price (OP2) is higher than the equilibrium price because of the excess supply. Competition among the sellers will bring it down to the equilibrium price where the supply is equal to demand. On the other hand, if the price (OP1) is lower than the equilibrium price because of the excess demand. Excess demand pushes up the price, this process will go on until the equilibrium is reached where supply becomes equal to demand.

Thus the industry is the price-maker or giver and a firm is a price-taker. The firms will follow this price.

The firm will sell or produce that level of output where its profit

is maximized, and profit is maximized where the following two conditions are satisfied:

1. MR = MC

2. MC curve cuts MR from below.

Short-run Firm Equilibrium under Perfect Competition:

In the short-run, the firm can change only the variable factors and fixed factors can not be changed.

there are three possibilities for a firm. These are –

 (a) A firm makes supernormal profits when AR > AC.

(b) It earns an only normal profit when AR = AC.

 (c) It incurs losses when AR<AC. Firms will operate till they are able to get variable costs.

They will shut down their business when they cannot earn even average variable costs of production.

1-    Short-run supernormal profit: A firm in the short run earns Super-normal profits when the market price exceeds the short-run average total cost (SATC).

In the above diagram, the output is measured along the OX axis and price, revenue, and cost on the OY axis. We assume here that the market price is equal to OP. A firm has to sell its entire output at this prevailing market price {OP}. The firm is in equilibrium at point E. Where MC = MR. The intersection of MC and MR determine the quantity of the commodity-producing by the firm.

 

The competitive firm will produce OQ quantity of output and sell at market price OP. The total revenue of the firm at the best level of output OQ is equal to OPEQ. Whereas the total cost of producing OQ quantity of output is equal to OP1FQ. The firm’s supernormal profits are equal to the green rectangle PP1EF. The per-unit profit is indicated by the distance PP1 or EF.

 

2-Zero Profit of a Firm:

 

A firm, in the short run, maybe making zero economic profit or normal economic profit when AR=AC. It is also known as the break-even point of the firm, a zone of no loss or no profit.

In the above diagram, OP is the prevailing market price. At point E, the MR, MC, and AC are all equal. The firm produces OQ output and sells at market price OP. The total revenue of the firm is equal to the area OPEQ. The total cost of producing OQ output also equals the area OPEQ. The firm is earning only normal profits.

 

3- Short-run loss of the firm:

 

The firm in the short run maybe in loss if the market price is lesser than the average total cost [SATC] but larger than average variable cost [SAVC].

In the above figure, the market price is OP. The firm is in equilibrium at point E where MR = MC. The firm's best level of output is OQ which is sold at unit price  OP. The total revenue of the firm is equal to the area OPEQ. The total cost of producing the OQ quantity of output is equal to OP1FQ. The firm is suffering a net loss equal to the red rectangle PP1EF.

The firm at price OP in the market is covering its full variable cost and a part of the fixed cost. So, in the short run, the firm will not go out of business for as long as SAVC is lesser than AR.

 

4-Short Run Shut Down:

A firm in the short-run minimizes losses by closing it down if the market price is less than average variable cost.

 

 In the above diagram, the assumed market price is OP. The firm is in equilibrium at point E where MR = MC. The firm produces OQ output and sells at price OP. The total revenue of the firm is equal to the area OPEQ. Whereas .the total cost producing OQ output is OP1FQ. The firm is suffering a net loss of total fixed cost equal to the area PP1EF. The firm at point E is just covering average variable costs.

In this case, E point is a shutdown point for the firm.

 

Long-run Firm Equilibrium under Perfect Competition:

 The firm in the long run, must cover its full costs and should earn only normal profits.

Hence, in the long run, the firm will be in the equilibrium where,

P=MR=MC=AR=AC

In the above diagram, E is the equilibrium point, where MR=MC, indicating OP as the equilibrium price and OQ as the equilibrium output. At the same point E, the minimum point of  LAC is tangent to LAR curve. Thus, at equilibrium point E,

P=MR=MC=AR=AC

 

Hence, in the long run, a firm earns only normal profits.

Dr. Swati Gupta

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