This article is about perfect competition. The article describes the characteristics of a perfectly competitive market and gives assumptions about perfect competition. It also explains how perfect competition is achieved.
It also describes short run equilibrium and long run equilibrium as well as explains how the short run equilibrium model and the long run equilibrium model evolve. You will be able to draw neat and accurate diagrams of the short run equilibrium and the long run equilibrium positions to identify the profit maximizing position in each.
What is perfect competition?
Perfect competition is a model used to show how efficiency can be achieved. It is unrealistic to assume that all of the conditions needed for perfect competition can exist at the same time. However, if only some of the conditions apply to a certain market, then factors suggested by the model can be acquired, more or less.
Assumptions about perfect competition
The rules of a perfectly competitive market include:
- There are a large number of small buyers and sellers. However, none are able to influence the price because the price is set by market forces – demand and supply. Therefore, sellers are said to be price takers. Price taker is a company with products that are insufficiently distinctive to stand out. If they raise the price, no one will buy the product from the company. Lowering the price is pointless since they can sell for the higher market price.
- All products are homogeneous which means that all products are identical. There is no product differentiation in the market. This means that all products within the market are perfect substitutes for each other. This is another cause of the price taker phenomenon and the perfectly elastic demand curve.
- All consumers within the market have perfect knowledge about prices and products within the market. The result is the consumer is king and has absolute consumer sovereignty over what is produced.
- Free market entry guarantees that companies are free to enter the market and can also easily leave it. This is because there are no barriers to entry or exit. Barriers to entry are obstacles which prevent a company from entering or leaving a market freely.
To summarize the points made above, Price Elasticity of Demand (PED) is perfectly elastic in perfect competition. The result is that companies must price their products at the same level as competitors. Setting the price too high would result in no one buying the product, causing the company to leave the market. It is also pointless to price lower than competitors because the market price has been decided (by the forces of demand and supply) allowing the company to benefit from that higher price level.
All businesses in the market with perfect competition are profit maximizers causing them to produce where Marginal Cost (MC) = Marginal Revenue (MR). This is important in a perfectly competitive market since profit maximization is required to survive for companies whose only means of attracting customers is price.
1. Short run equilibrium in perfect competition
None can affect the market price resulting in a perfectly elastic demand curve. If the company’s price is any higher than the price determined by market forces, demand will be zero. If the company’s price is any lower than the price determined by market forces, demand will be zero too.
If a company can never change the price, the market price is the same as the company’s, hence the Average Revenue (AR) and Marginal Revenue (MR) curves are also the demand curve.
Additionally, the Marginal Cost (MC) curve above the Average Cost (AC) curve is the supply curve. The shaded area shows short run profit.
The company is making abnormal profits (Average Revenue (AR) – Average Cost (AC))*Q) because the Average Revenue (AR) is greater than the Average Cost (AC).
The point where Marginal Cost (MC) = Marginal Revenue (MR) is profit maximization. This is also the equilibrium – the point where the market is in balance. As stated earlier, the demand curve is the same as the Marginal Revenue (MR) and the Average Revenue (AR) curve.
However, when the abnormal profits are made in the market, it attracts new companies. This is causing an increase in supply. The supply curve shifts to the right as there are more products supplied to the market pushing the price down.
Eventually the situation shown in the following diagram will occur – the loss will be made. The shaded area shows short run loss.
When the market is going through a period where the price is lower than Average Costs (AC), a firm can continue operating as long as it is covering its Variable Costs (VC). It is because there is still positive contribution towards paying Fixed Costs (FC).
If a firm is making losses when it must pay for Fixed Costs (FC), it will go out of business. Those companies who are the most resilient and can go the longest period without needing to pay for Fixed Costs (FC) will be the ones who emerge as survivors in the long run.
Firms being forced out of the market will cause the supply curve to shift to the left, as there are fewer producers on the market now, pushing the price up.
2. Long run equilibrium
In the long run, Average Cost (AC) = Average Revenue (AR) = Marginal Cost (MC) = Marginal Revenue (MR). It is because on the market with perfect competition, a firm can only expect to make normal profits.
The black point on the chart is the long run equilibrium position in the perfect competition situation. It is because making abnormal profit attracts entrants and increases supply. This increased supply will lower prices causing companies to make less and less profit. This will happen until eventually no abnormal profit is made.
Summary
Perfect competition is a model that is used to show why being efficient is beneficial to the competitiveness of a firm.
It highlights how being in control of Working Capital and having resilient Fixed Assets can improve a firm’s survivability in a price war situation.
