Chapter 6: The Firm in Perfectly Competitive Markets

Introduction

Markets foster economic interaction among buyers and seller. Perfect competition refers to a market in which there are many sellers and buyers of the same product, and they all have perfect information. In a perfectly competitive market, both firms and consumers are pricetakers. That is, their decision cannot affect the market price.

Market and Market Structure

The mode of exchange of goods and services has changed over time. Hence, the notion ‘market’ includes both the activities that are confined to a physical place and the ones that take place in a Web site, as well.

A market also creates a social relation since it brings people together and enables contact among them. Therefore, a market can be defined as an institution that facilitates and structures interactions among participants for buying and selling.

According to the characteristics of the market, the number of firms in the market, the degree of product differentiation and the ease of entry and exit of firms into and out of the market, there are four types of market structures as follows:

• Perfect competition: It is a market for the exchange of identical products, in which an enormous number of small firms serve many buyers, all of whom are well informed.
• Monopolistic competition: Monopolistic competition differs from perfect competition because the products sold in monopolistic competition are slightly differentiated.
• Oligopoly: It is a market structure in which a few large firms compete.
• Monopoly: A monopoly arises when there is only one firm which produces a good or service with no close substitute.

What is a Competitive Market?

In perfectly competitive markets, many firms produce and sell identical products to many consumers. In such markets, a single/representative firm cannot affect the market price of the good or service it produces and sells. Likewise, consumers cannot affect the market price, which makes them price-takers.

Competitive markets share other some characteristics because the numbers of participants do not assure pricetaking behavior. First of all, the market share of a single producer—the fraction of the total production in a particular industry accounted for by a single producer`s output— must be small enough that a single producer is unable to affect market price. Secondly, an industry can be defined as competitive if consumers don`t attribute a noteworthy value to the products of any one producer.

Therefore, the necessary conditions for a competitive industry are as follows:

• There are many firms; a single firm produces and sells a tiny fraction of the total market sold to many consumers; a single consumer`s purchase is also a tiny fraction of the total market purchase.
• Producers and consumers are well informed about the quality and price of the good in question.
• Firms produce and sell an identical product.
• There are no restrictions on entry into (or exit from) the market, and established firms don`t have any specific advantage over new firms.

Moreover, it is easy for a firm that is currently in the industry to leave because of a lack of a sunk cost, which is a cost that has already been incurred and thus cannot be recovered.

A representative firm is fairly small, relative to total demand in the market in a perfectly competitive market. The production of a representative firm is characterized by constant return to scale. The main aim of a perfectly competitive firm is to maximize economic profit. A perfectly competitive price-taker firm must decide which technology to adopt and what quantity to produce in the short run along with deciding whether to exit or stay in a market in the long run.

Revenues and Revenue Curves of Competitive Firms

The total amount of money received by a seller, which is equal to price times quantity sold is called total revenue. The total revenue curve is a positively sloped linear line which shows the relationship between output and total revenue. Since the price for each unit is given in a perfectly competitive market, TR increases linearly with the quantity supplied.

Marginal Revenue, on the other hand, is the additional revenue obtained by selling one more unit.

Profit Maximization

Profit maximization and a firm`s supply decision can be analyzed in different ways.

In order to look at a firm`s decision, firstly, we can find the profit-maximizing output level by comparing the price and average cost (AC) for each unit produced. When the price is greater than AC, the firm earns a positive average profit. Therefore, it is rational to increase production when the price increases faster than the average cost.

Secondly, by comparing the marginal revenue and marginal cost, we can find the profit maximizing output level.

Marginal profit, which is a concept developed to analyze the relationship between profit and output, is the additional profit that a firm earns when it increases its output by one more unit. The marginal profit is equal to the marginal revenue minus marginal cost.

As the profit is maximized when MR equals MC, firms want to maximize the difference between total revenue and total cost, not the difference between MR and MC.

In brief, a seller should increase production up to the point where MR = MC. As MR = P under perfect competition, we can also define the profit maximizing solution by setting P = MC.

Regardless of the type of firm, the profit maximizing output level is the output level where the marginal profit is zero. However, in perfect competition, the marginal revenue equals the market price.

As for the short-run supply curve, all points on the MC curve show how much the firm would be willing to produce and supply at each price. The marginal cost curve determines the firm`s willingness to supply various levels of output at each price level. In a perfectly competitive market, the marginal cost curve is also the supply curve of a representative firm, and the industry supply curve is the horizontal sum of the individual firm’s supply curves.

If the demand curve shifts leftward, a firm may suffer an economic loss. This may lead to a situation in which the price would not be enough to cover the average cost. Hence, the firm may either shut down the operation immediately and bear the total fixed cost, or reduce the output level to the lowest point on the average variable cost to minimize losses.

The short-run market supply curve in a perfectly competitive market is the horizontal sum of the marginal cost curves of all the firms operating in an industry.

Basically, there are two factors that shift the MC curve and cause the market supply curve to shift:

• A decrease in production costs shifts the market supply curve rightward. For example, a technological innovation which leads to a rise in labor productivity decreases the unit labor cost and causes the market supply curve to shift to the right.
• In the long run, an increase in the number of firms, i.e., new firms entering the industry, shifts the market supply curve rightward.

Firms respond to positive economic profit and economic loss by either entering or exiting a market in the long run. Firms exit a market in which they are incurring an economic loss. However, New firms enter a market (industry) in which existing firms are making positive economic profit.

The effect of entry or exit on the market price after a change in the market demand is ambiguous. The results depend on external economies and external diseconomies. External economies refer to the changing circumstances outside of a representative firm that reduce the firm`s average profits as market supply increases. With no external economies or diseconomies, a firm`s cost structure remains constant as the market output changes.

Why do Competitive Firms Make Zero Profit in the Long Run?

In the short run, firms can make a profit or suffer an economic loss. However, in the long run a perfectly competitive firm makes zero profit.

Perfectly competitive market equilibrium is the market equilibrium in a perfectly competitive market in which the economic profit of each individual seller is zero, and there is no incentive for entry or exit.

In short, because of free entry and exit, all firms in a particular industry make normal economic profit and in the long-run equilibrium, no producer has an incentive to enter or exit.

Efficiency of Competition

Economic efficiency is effective use of scarce resources to achieve the highest possible amount of output, or the production of what people demand using the least amount of input. It is divided into two categories as production efficiency and allocation efficiency.

Production efficiency refers to a production level when it is produced at the lowest point on the long run average cost curve where marginal cost equals AC. On the other hand, allocative efficiency refers to a situation in which production meets consumer preferences.

The most important implication of the perfect competition analysis is that each firm acts in an economically efficient manner. In the long run, inefficient firms will be forced to exit the market. In theory, if there isn`t any exogenous obstacle that prevents a perfectly competitive firm from producing at the lowest AVC, then the consumer surplus and producer surplus is maximized. However, in the real world, inefficiencies are common, even in markets that approach the conditions of perfect competition. These inefficiencies may arise because of externalities, path dependence, and existence of public goods. Therefore, all theoretical inferences depend on the following critical assumptions:

• There are no positive or negative externalities. Externalities are side effects or unintended consequences, either positive or negative, that affect persons or entities, such as the environment, that are not among the economic actors directly involved in the economic activity that caused the effect.
• All buyers and sellers have perfect information. However, in assessing their options, economic actors make use of their existing knowledge but often need to collect additional information.
• Consumer demand curves are based on willingness to pay. The consumer demand curve reflects the benefits consumers obtain from their purchases. However, consumers often fail to predict the benefits of goods and services and economic actors sometimes make emotional decisions instead of rational choices.