Computer Science

PERFECT COMPETITION

DEFINITION:

Perfect competition is a market structure characterized by a complete absence of rivalry among the individual firms. Thus perfect competition in economic theory has a meaning diametrically opposite to the everyday use of this term. In practice businessmen use the word competition as synonymous to rivalry. In theory, perfect competition implies no rivalry among firms.

1. ASSUMPTIONS:

The model of perfect competition is based on the following assumptions.

Large members of sellers and buyers:

The industry or market includes a large number of firms (and buyers), so that each individual firm, however large, supplied only as a small part of the total quantity offered in the market. The buyers are also numerous so that no monopsonistic power can affect the working of the market. Under these conditions each firm alone cannot affect the price in the market by changing its output.

Product homogeneity:

The industry is defined as a group of firms producing a homogeneous product. The technical characteristics of the product as well as the services associated with its sale and delivery are identical. There is no way in which as buyer could differentiate among the products of different firms. If the product were differentiated the firm would have some discretion in setting its price. This is ruled out ex hypothesi in perfect competition.

The assumptions of large numbers of sellers and of product homogeneity imply that the individual firm in pure competition is a price taker, its demand curve is infinitely elastic, indicating that the firm can sell any amount of output at the prevailing market price. The demand curve of the individual firm is also its average revenue and its marginal revenue curve.

Free entry and exit of firms:

There is no barrier to entry or exist form the industry. Entry or exit may take time, but firms have freedom of movement in and out of the industry. This assumption is supplementary to the assumption of large numbers. If barriers exist the number of firms in the industry may be reduced so that each one of them may acquire power to affect the price in the market.

Profit maximization:

The goal of all firms is profit maximization. No other goals are pursued.

No government regulation:

There is no government intervention in the market (tariffs, subsidies, rationing of production or demand and so on are ruled out).

The above assumptions are sufficient for the firm to be a price-taker and have an infinitely elastic demand curve. The market structure in which the above assumptions are fulfilled is called pure competition. It is different from perfect competition, which requires the fulfillment of the following additional assumptions.

Perfect mobility of factors of production:

The factors of production are free to move from one firm to another throughout the economy. It is also assumed that workers can move between different jobs, which implies that skills can be learned easily. Finally, raw materials and other factors are not monopolized and labour is not unionized. In short, there is perfect competition in the markets of factors of production.

Perfect knowledge:

It is assumed that all sellers and buyers have complete knowledge of the conditions of the market. This knowledge refers not only to the prevailing conditions in the current period but in all future periods as well. Information is free and costless. Under these conditions uncertainty about future developments in the market is ruled out.

Under the above assumptions we will examine the equilibrium of the firm and the industry in the short run and in the long run.

EQUILIBRIUM OF THE FIRM:

MR = MC rule: A firm under perfect competition faces an infinitely elastic demand curve or we can say for an individual firm, the price of the commodity is given in the market. The firm while making changes in the amounts of variable factor evaluates the extra cost incurred on producing extra unit (MC). It also examines the change in total receipts which results from the sale of extra unit of production (MR). So long as the additional revenue from the sale of an extra unit of product (MR) is greater than the additional cost (MC) which a firm has to incur on its production, it will be in the interest of the firm to increase production. In economic terminology, we can say, a firm will go on expanding its output so long as the marginal revenue of any unit is greater than its marginal cost. As production increases, marginal cost begins to increase after a certain point. When both marginal revenue and marginal cost are equal, the firm is in equilibrium. The firm at this equilibrium point is either ensuring maximum profit or minimizing losses. This is shown with the help of a diagram below:

Fig

In the figure quantity of output is measured along OX axis and marginal cost and marginal revenue of OY axis. The marginal cost curve cuts the marginal revenue curve at two points K and T. the competitive firm is in equilibrium at both these points as marginal cost equals marginal revenue. The firm will not produce OM quantity of good because for OM output, the marginal cost is higher than marginal revenue. Marginal cost curve cuts the marginal curve from above. The firm incurs loss equal to the black shaded area for producing 50 units (OM) of output.

As production is increased from 50 units to 350 units (from OM to OS) marginal cost decreases at early levels of output and then increases thereafter. The marginal cost curve cuts the marginal revenue curve from below at point T. The shaded portion between M to S level of output shows profit on production. When a firm produces OS quantity of output; it earns maximum profit. The point T where MR = MC is the point of maximum profit.

In case, the firm increases the level of output from OS, the additional output adds less to its revenue than to its cost. The firm undergoes losses as is shown in the shaded area.

Summing up, profit maximum normally occurs at the rate of output at which marginal revenue equals marginal cost. As regards the absolute profits and losses of the firm, they depend upon the relations between average cost and average revenue of the firm Which are being discussed in the next pages.

CRITICISM

i. Large