Price decision under perfect competition

Definition of Perfect Competition:

The concept of perfect competition was first introduced by Adam Smith in his book "Wealth of Nations". Later on, it was improved by Edgeworth. However, it received its complete formation in Frank Kight's book "Risk, Uncertainty and Profit" (1921).

Perfect competition is a form of market in which there are a large number of buyers and sellers competing with each other in the purchase and sale of goods, respectively and no individual buyer or seller has any influence over the price. Thus perfect competition is an ideal form of market structure in which there is the greatest degree of competition.Leftwitch has defined market competition in the following words: "Prefect competition is a market in which there are many firms selling identical products with no firm large enough, relative to the entire market, to be able to influence market price". According to Bllas: "The perfect competition is characterized by the presence of many firms. They sell identically the same product. The seller is a price taker".

Basic assumptions required for conditions of pure competition to exist:

Many small firms, each of whom produces an insignificant percentage of total market output and thus exercises no control over the ruling market price.

Many individual buyers, none of whom has any control over the market price – i.e. there is no monophony power

Perfect freedom of entry and exit from the industry. Firms face no sunk costs - entry and exit from the market is feasible in the long run. This assumption ensures all firms make normal profits in the long run

Homogeneous products are supplied to the markets that are perfect substitutes. This leads to each firms being passive “price takers” and facing a perfectly elastic demand curve for their product

Perfect knowledge – consumers have readily available information about prices and products from competing suppliers and can access this at zero cost – in other words, there are few transactions costs involved in searching for the required information about prices

No externalities arising from production and/or consumption which lie outside the market

Profit maximization. For perfect competition to exist, the sole objective of the firm must be to get maximum profit.

The characteristics of perfect competition are summarized in Table 1.1:

Table 1.1: Characteristics of Perfect Competition

Under perfectly competitive market price is determined by the interaction of the forces of demand and supply. Equilibrium price is established at the level which demand curve intersects the supply curve, or at which the quantity demanded, is equal to the quantity supplied.

The graph shows that the market price under perfect competition is determined at 45 level complying with the point of intersection of the market supply curve with market demand curve.

Market supply curveDemand Curve

Importance of Perfect Competition: Perfect competition model is hotly debated in economic literature. It is argued that the model is based on unrealistic assumptions. It is rare in practice. The defenders of the model argue that the theory of perfect competition has positive aspect and leads us to correct conclusions. The concept is useful in the analysis of international trade and in the allocation of resources. It also makes us understand as to how a firm adjusts its output in a competitive world.

Short Run Equilibrium of the Price Taker Firm:

Definition of a Short Run: By short run is meant a length of time which is not enough to change the level of fixed inputs or the number of firms in the industry but long enough to change the level of output by changing variable inputs. In short period, a distinction is made of two types of costs (i) fixed cost and (ii) variable cost. The fixed cost in the form of fixed factors i.e., plant, machinery, building, etc. does not vary with the change in the output of the firm. If the firm is to increase or decrease its output, the change only takes place in the quantity of variable resources such as labor, raw material, etc. Further, in the short-run, the demand curve facing the firm is horizontal. No new firms enter or leave the industry. The number of firms in the industry, therefore, remain the same. Under perfect competition, the firm takes the price of the product as determined in the market. The firm sells all its output at the prevailing market price. The firm, in other words, is a price-taker. Equilibrium of a Competitive Firm:                       The short-run equilibrium of a firm can be easily explained with the help of                   marginal revenue = marginal cost approach or (MR = MC) rule. Marginal revenue is the change in total revenue that occurs in response to a one unit change in the quantity sold. Marginal cost is the addition to total cost resulting from the additional of marginal unit. Since price is given for the competitive firm, the average revenue curve of a price taker firm is identical to the marginal curve. Average revenue (AR) thus is equal to marginal revenue (MR) is equal to price (MR = AR = Price).                    According to the marginal revenue and marginal cost approach or (MR = MC) rule , a price taker firm is in equilibrium at a point where marginal revenue (MR) or price is equal to marginal cost The point where MR = MC = Price, the firm produces the best level of output. From this it may not be concluded that the perfectly competitive firm at the equilibrium level of output (MR = MC = Price) necessarily ensures maximum profit. The fact is that in the short period, a firm at the equilibrium level of output is faced with four types of product prices in the market which give rise to following results: 

(i) A firm earns supernormal profits.  (ii) A firm earns normal profits. (iii) A firm incurs losses but does not close down. (iv) A firm minimizes losses by shutting down. All these short run cases of profits or losses are explained with the help of diagrams. 

PC: Short-Run Equilibrium

Firm’s Demand Curve = Market Price = MRFirm’s Supply Curve = Marginal Cost

Where Marginal Cost > Average Variable Cost

Determining Profit from a Graph:                  (1) Profit Maximizing Position:

 A firm in the short run earns abnormal profits when at the best level of output, the market price exceeds the short run average total cost (SATC). The short run profit maximizing position of a purely competitive firm is explained with the help of a diagram. 

 In the figure (15.3), output is measured along OX axis and revenue / cost on OY axis. We assume here that the market price is equal to OP. A price taker firm has to sell its entire output at this prevailing market price i.e. OP. The firm is in equilibrium at point L. Where MC = MR. The inter section of MC and MR determine the quantity of the good the firm will produce.

 After having determined the quantity, drop a vertical line down to the horizontal axis and see what the average total cost (ATC) is at that output level (point N). The competitive firm will produce ON quantity of output and sell at market price OP. The total revenue of the firm at the best level of output ON is equal to OPLN. Whereas the total cost of producing ON quantity of output is equal to OKMN. The firm is earning supernormal profits equal to the shaded rectangle KPLM. The per unit profit is indicated by the distance LM or PK.

 It may here be noted that a firm would not produce more than ON units because producing another unit adds more to the cost than the firm would receive from the sale of the unit (MC > MR). The firm would not stop short of ON output because producing another unit adds more to the revenue than to cost (MR > MC). Hence, ON is the best level of output where profit of the firm is maximum.

 (2) Zero Profit of a Firm:

  A firm, in the short run, may be making zero economic profit or normal economic profit. It may here be remembered that although economic profit is zero, all the resources including entrepreneurs are being paid their opportunity. So they are getting a normal profit the case of normal profits of a firms at break even price is explained with the help of the diagram 15.4.

 

 We assume in the figure (15.4) that OP is the prevailing market price and PK is the average revenue, marginal revenue curve. At point K, which is the break even price for a Competitive firm, the MR, MC and ATC are all equal. The firm produces OM output-and sells at market price OP. The total revenue of the firm to equal is the area OPKM. The total cost of producing OM output also equals the area OPKM. The firm is earning only normal profits. It is a situation in which the resources employed by the firm are earning just what they could-earn in some other alternative occupations.            (3) Loss Minimizing Case:

 The firm in the short rue is minimizing tosses if the market price is smaller than average total cost but larger than average variable cost. The loss minimizing position of a price taker firm is explained with the help of a diagram.

 

 We assume in the figure (15.5) that the market price is QP. The firm is in equilibrium at point N where MR = MC. The firm's best level of output is OK which is sold at unit cost OP. The total revenue of the firm is equal to the area OPNK. The total cost of producing OK quantity of output is equal to OTSK. The firm is suffering a net loss equal to the shaded area PTSN.

 The firm at price OP in the market is covering its full variable cost and a part of the fixed cost. The loss of part of fixed cost equal to the shaded area PTSN is less than, the firm would incur by closing down. In case of shut down, the firm has to bear the total fixed cost ETSF. The firm thus by producing OK output and selling at OP price is minimizing losses. Summing up, in the short run the firm will not go out of business for as long as the loss m staying the business is less than the loss from closing down.

(4) Short Run shut Down (Short-run losses and the shut-down decision):        

 When the firm's average total cost curve lies above its marginal revenue curve at the profit maximizing level of output, the firm is experiencing losses and will have to consider whether to shut down its operations. In making this determination, the firm will take into account its average variable costs rather than its average total costs. The difference between the firm's average total costs and its average variable costs is its average fixed costs. The firm must pay its fixed costs (for example, its purchases of factory space and equipment), regardless of whether it produces any output. Hence, the firm's fixed costs are considered sunk costs and will not have any bearing on whether the firm decides to shut down. Thus, the firm will focus on its average variable costs in determining whether to shut down.

The case where the firm is incurring short-run losses but continues to operate is illustrated graphically in Figure 2 (a). At the market price, P1, the firm's profit maximizing quantity is Q1. At this quantity, the firm's average total cost curve lies above its marginal revenue curve, which is the flat, dashed line denoting the price level, P1. The firm's average variable cost curve, however, lies below its marginal revenue curve, implying that the firm is able to cover its variable costs. The firm's losses from producing quantity Q1 at price P1 are given by the area of the shaded rectangle, abcd. Despite these losses, the firm will decide not to shut down in the short-run because it receives enough revenue to pay for its variable costs. 

Figure 2 (b) depicts a different scenario in which the firm's average total cost and average variable cost curves both lie above its marginal revenue curve, which is the dashed line at price P2. The firm's losses are given by the area of the shaded rectangle, abed. In this situation, the firm will have to shut down in the short-runbecause it is unable to cover even its variable costs. As a general rule, a firm will shut down production whenever its average variable costs exceed its marginal revenue at the profit maximizing level of output. If this is not the case, the firm may continue its operations in the short-run, even though it may be experiencing losses.

 

On the other way:

Long-Run Equilibrium of the Price Taker Firm:

Now let us analyze the profit maximizing output decision by perfectly competitive firms in the long run when all inputs and therefore costs are variable. In the long run, a manager can choose to employ any plant size required to produce the efficient level of output that will maximize profit. The plant size or scale of operation is fixed in the short run but in the long run it can be altered to suit the economic conditions. In the long run, the firm attempts to maximize profits in the same manner as in the short run, except that there are no fixed costs. All costs are variable in the long run. Here again the firm takes the market price as given and this market price is the firm’s

marginal revenue. The firm would increase output as long as the marginal revenue from each additional unit is greater than the marginal cost of that unit. It would decrease output when marginal cost exceeds marginal revenue. This way the firm maximizes profit by equating marginal cost and marginal revenue (MR = MC; as discussed above).

Quantity is set by the firm so that short-run:Price = Marginal Cost = Average Total Cost

At the same quantity, long-run:Price = Marginal Cost = Average Cost

Economic Profit = 0

Figure 12.2: Profit Maximizing Equilibrium in the Long Run

The firm’s long run average cost (LAC) and marginal cost (LMC) curves are shown in Figure 12.2. The firm faces a perfectly elastic demand indicating the equilibrium price (Rs. 17) which is the same as marginal revenue (i.e., D = MR =P). You may observe that as long as price is greater than LAC, the firm can make a profit. Therefore, any output ranging from 20 – 290 units yields some economic profit to the firm. In figure 12.2, B and B1 are the breakeven points, at which price equals LAC, economic profit is zero, and the firm can earn only a normal profit. The firm, however, earns the

maximum profit at output level 240 units (point S). At this point marginal revenue equals LMC and the firm would ideally select the plant size to produce 240 units of output. Note that in this situation the firm would not produce 140 units of output at point M, which is the minimum point of LAC. At this point marginal revenue exceeds marginal cost, so the firm can gain by producing more output. As shown in figure 12.2, at point S total revenue (price times quantity) at 240 units of output is equal to Rs. 4080 (= Rs. 17 * 240), which is the area of the rectangle OTSV. The total cost (average cost times quantity) is equal to Rs. 2,880 (= Rs. 12 * 240) which is the area of the rectangle OURV. The total profit is Rs. 1,200 = (Rs. 17 – Rs. 12) * 240, which is the area of the rectangle UTSR.Thus, the firm would operate at a scale such that long run marginal cost equals price. This would be the most profitable situation for an individual firm (illustrated in figure 12.2). Therefore, if the price is Rs. 17.00 per unit, the firm will produce 240 units of output, generating a profit of Rs. 1,200.00. This profit is variously known as above normal, super normal or economic profit. The crucial question that one needs to ask is whether this is a sustainable situation in a perfectly competitive market i.e. whether a firm in a perfectly competitive industry can continue to make positive economic profits even in the long run? The answer is unambiguously no. This result derives from the assumption that in a perfectly competitive market there are no barriers to entry. Recall that in a market economy, profit is a signal that guides investment and therefore resource allocation decisions. In this case, the situation will change with other prospective entrants in the industry. The economic force that attracts new firms to enter into or drives out of an industry is the existence of economic profits or economic losses respectively. Economic profits attract new firms into the industry whose entry increases industry supply. As a result, the prices would fall and the firms in the industry adjust their output levels in order to remain at profit maximization level. This process continues until all economic profits are eliminated. There is no longer any attraction for new firms to enter since they can only earn normal profits. By observing figure 12.2 you should try to work out the price that will prevail in this market in the long run when all firms are earning normal profit.

Analogous to economic profit serves as a signal to attract investment, economic losses drive some existing firms out of the industry. The industry supply declines due to exit of these firms which pushes the market prices up. As the prices have risen, all the firms in the industry adjust their output levels in order to remain at a profit maximization level. Firms continue to exit until economic losses are eliminated and economic profit becomes zero, that is, firms earn only a normal rate of profit.

Others example:

Global Competition:

Foreign Exchange Rate Price of a foreign currency in terms of the domestic currencyDepreciation of the Domestic Currency Increase in the price of a foreign currency relative to the domestic

currencyAppreciation of the Domestic Currency Decrease in the price of a foreign currency relative to the domestic

currency