In the preceding posts, you have been introduced to the concept of market structure and the impact it has on the competitive behaviour of firms. You must have noted that the number and size of the firms is an important determinant of the structure of the industry and/or market.
Now we shall analyse the behaviour of a firm under two different market structures, namely, pure/perfect competition, monopoly, monopolistic and oligopoly markets. The crucial parameter is the size of the constituent firms in relation to the total industry’s output. In this post we analyze the case of Perfect competition. we go by the assumption that the firms are guided by profit maximisation.
CHARACTERISTICS OF PERFECT COMPETITION
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.
A perfectly competitive market has the following characteristics:
- There are a large number of independent, relatively small sellers and buyers as compared to the market as a whole. That is why none of them is capable of influencing the market price. Further, buyers/sellers should not have any kind of association or union to arrive at an understanding with regard to market demand/price or sales.
- The products sold by different sellers are homogenous and identical. There should not be any differentiation of products by sellers by way of quality, variety, colour, design, packaging or other selling conditions of the product. That is, from the point of view of buyers, the products of competing sellers are completely substitutable.
- There is absolutely no restriction on entry of new firms into the industry and the existing firms are free to leave the industry. This ensures that even in the long run the number of firms would continue to remain large and the relative share of each firm would continue to remain insignificant.
- Both buyers and sellers in the market have perfect knowledge about the conditions in which they are operating. Buyers know the prices being charged by different competing sellers and sellers know the prices that different buyers are offering.
- The distance between the location of competing sellers is not significant and therefore the price of the product is not affected by the cost of transportation of goods. Buyers do not have to incur noticeable transport costs if they want to switch over from one seller to another.
The characteristics of perfect competition are summarised in Table -1.
It is difficult to find a market that satisfies all the literary conditions of perfect competition. There are markets that come close to fulfilling these stringent conditions, but none that completely is in synchronization with all of them. You might well ask the rationale for studying this market structure if it does not exist in the real world. The answer is that perfect competition is the ideal market, and serves as a benchmark. We can use the outcomes of other markets to compare with outcomes that would have been achieved under perfect competition. For instance, if the market is competitive, prices would be lower and closer to costs, while if the market is monopolised then prices are likely to be higher. Another useful comparison relates to the concept of consumer’s surplus. Intuitively, consumer’s surplus can be thought of as the difference between the maximum amount the consumer is willing to pay for a product and the amount he actually pays. Think about your purchase of a big ticket item such as a camera. You have a price in mind that is the maximum you are willing to pay. The difference between this and the price actually paid is the consumer’s surplus.(Note that you will never pay more than maximum amount.)
In perfectly competitive markets, consumer’s surplus is the maximum, while in monopoly markets it is low. In fact, it is the endeavour of monopolies to capture as much of the consumer’s surplus as possible. When a perfectly competitive industry gets monopolised there is a transfer of surplus from the consumer to the producer. Or stated differently, the producer is able to increase his surplus (or profit) at the expense of the consumer. On the other hand, when a monopolised industry becomes competitive, there is transfer from producers to the consumers; i.e. consumers become better off when there is increased competition. An illustration of this can be gauged from the conduct of the automobile industry in India since it was deregulated in 1991. The consumers have benefited from competition in the sector and one can definitely assert that producer margins (or surplus) have declined to the benefit of the consumers.
PROFIT-MAXIMISING OUTPUT IN THE SHORT RUN
Having examined the rationale for studying perfectly competitive markets, let us analyse the profit-maximising output of a profitable competitive firm in the short run. As you already know, the short run is defined as a period of time in which at least one input is fixed. Often the firm’s capital stock is viewed as the fixed input.
Accordingly, this analysis assumes that the number of production facilities in the industry and the size of each facility do not change because the period being considered is too short to allow firms to enter or leave the industry or to make any changes in their operations.
Under perfect competition, since an individual firm cannot influence the market price by raising or lowering its output, the firm faces a horizontal demand curve, that is, the demand curve of any single firm is perfectly elastic – its elasticity is equal to infinity at all levels of output. If a firm charges a price slightly higher than the prevailing market price, demand for that firm will fall to zero because there are many other sellers selling exactly the same product. On the other hand, if a firm reduces its price slightly, its demand will increase to infinity and thus other firms will match the low price.
A firm under perfect competition is a price-taker and not a price-maker. Because an individual firm’s demand or Average Revenue (AR) curve is horizontal under perfect competition, the Marginal Revenue (MR) curve of the firm is also horizontal and coincides with the AR curve. In other words, AR and MR are constant and equal at all levels of output. You should satisfy yourself that if price (i.e. average revenue) is constant, marginal revenue will be equal to price.2 The price-output determination and equilibrium of the firm under perfect competition may be explained through a numerical example. Suppose the demand and supply conditions of a product are represented by the following equations:
Aggregate Demand: Q = 25 – 0.5 P
Aggregate Supply: Q = 10 + 1.0 P
The equilibrium price would be at a point where aggregate demand equals aggregate supply:
25 – 0.5 P = 10 + 1.0 P
or P = 10
Industry output at P = 10 is obtained by substituting this price into either the demand or supply function:
Q = 10 + 1.0 (10)= 20
Therefore equilibrium price, P = 10 and equilibrium output, Q = 20.
Figure-1 shows that when the market price is at P1, demand and marginal revenue facing the firm are D1 and MR1. The optimal output for the firm to produce is at point A, where Marginal Cost (MC) = P1, and the firm will produce Q1 units of output. At Q1 level of output, the Average Total Cost (ATC) is less than the price and the firm makes an economic profit.
Suppose the market price falls to P2, price equals MC at point C. Because at this level of output (Q2) average total cost is greater than price, total cost is greater than total revenue, and the firm suffers losses. The amount of loss is the loss per unit (CR) times the number of units produced (Q2).
At price level P2, demand is D2 = MR2, there is no way that the firm can earn a profit. This is because at every output level average total cost exceeds price (ATC > P). The firm will continue to produce only if it loses less by producing than by closing its operations entirely. When the firm produced zero output, total revenue would also be zero and the total cost would be the total fixed cost. The loss would thus be equal to total fixed cost. If the firm produces at MC = MR2 (point C), total revenue is greater than total variable cost, because P2 > AVC at Q2 units of output. The firm will be in a position to cover all its variable costs and still has CD times the number of units produced (Q2) left over to pay part of its fixed cost. This way the firm suffers a smaller loss when it continues production than it shut down its operations.
At market price P3, demand is given by D3 = MR3. The equilibrium output Q3 would be at T where MC = P3. At this output level, since the average variable cost of production exceeds price, the firm not only loses all its fixed costs but would also lose Rs. ST per unit on its variable costs as well. The firm could improve its earnings situation by producing zero output and losing only fixed costs. In other words, when price is below average variable cost at every level of output, the short-run loss-minimizing output is zero.
To reiterate, the profit maximising output for a perfectly competitive firm in the short run is to set P = MC. Since P = MR, this is equivalent to setting MR = MC. In the short run, as the above discussion shows, it is possible for the firm to make above normal or economic profit. On the other hand, it is also possible for the firm to make losses, as long as those losses are less than its total fixed costs. In other words, the firm will continue to produce as long as P>AVC in the short run, because this is a better strategy than shutting down. The firm will shut down only if P< AVC.
PROFIT-MAXIMISING OUTPUT IN THE LONG RUN
Now let us analyse the profit maximising 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 maximise 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 maximise 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 maximises profit by equating marginal cost and marginal revenue (MR = MC; as discussed above).
The firm’s long run average cost (LAC) and marginal cost (LMC) curves are shown in Figure 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 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 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 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 maximisation 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-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 maximisation 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.