What is Perfect Competition?
It is the structure of the market that is said to exist when with many buyers and sellers exchanging similar commodities and its price is fixed by the market forces, demand, and supply, and a single firm cannot cause an impact over the price or market value of the homogenous product. This structure of the market is called perfect competition.
Before going further into the understanding perfect competition the following formulas are important:
- Total cost (TC) = Total fixed cost (TFC) + Total variable cost (TVC)
- Marginal cost (MC) = Change in Total cost(ΔTC)/Change in Output(ΔQ)
- Average cost (AC) = Average fixed cost (AFC) + Average variable cost (AVC)
- Average cost (AC) = Total cost (TC)/Output (Q)
- Total revenue (TR) = Price(P) or Average revenue (AR) * Output(Q)
- Average revenue (AR) = Total revenue (TR)/Output (Q)
- Marginal revenue (MR) = Change in Total revenue (ΔTC)/Change in Output(ΔQ)
Features of Perfect Competition
The perfectly competitive market structure must follow the following conditions:
- Many buyers and many sellers: There are many buyers and many sellers that the individual demand of a buyer or seller has no effect on the market and an individual seller can sell the output produced at a given price.
- Homogeneous commodity: Firms in the perfectly competitive market sell homogeneous products, there is a similarity in the product sold by different sellers in the market and is perfect substitutes for each other.
- Entry and exit of firms are free: The firms have the freedom of moving in and out in this market. In other words, in this form of market joining of upcoming firms is there and existing firms in the market will not become an obstacle for the new firms. Moreover, the existing firms in the market enjoy something more than normal profit when new firms join the market. Some of the firms suffer from losses when they close or shut down their business. The firms can freely enter and exit in this market only under short-run conditions and not under long-run conditions.
- Perfect knowledge: The participants in the market have perfect knowledge of the availability of the commodity and its product price and the other regarding information of the market. The producers in this form of the market cannot take different prices from different buyers.
- Mobility of resources: The resources perfectly mobile i.e., the resources can be transferred at will.
- Transportation costs are not required: There is an absence of transportation cost i.e., all goods are domestically produced which also ensures that the producers will not be able to charge a higher price for a product.
Equilibrium Conditions Under Short-Run
In equilibrium conditions in the short run, the main motive of the firm under perfect competition is profit maximization and it will only happen when the firm reaches equilibrium. The firm in the competitive market decides how much to produce at the price prevailing in the market.
To attain equilibrium condition in the short run, these following two conditions are to be satisfied:
- The first-order condition (FOC) for equilibrium or the necessary condition i.e., marginal cost (MC) = marginal revenue (MR).
- The second-order condition (SOC) for equilibrium or the sufficient condition is that the marginal cost curve cuts the marginal revenue curve from below i.e., the marginal cost curve will be upward rising at the equilibrium point.
Graphical Explanation of Short-Run Equilibrium
Graphical explanation of the equilibrium under short-run of a perfectly competitive firm is explained below:
On the Y-axis or the vertical axis, price, revenue, and cost or the total cost and revenue are plotted and on the X-axis or the horizontal axis, the amount of production or the output is plotted. The SAC and SMC are the short-run average cost and marginal cost curves respectively and AC and MC are the average cost and marginal cost curves of a firm. In the short run, there is no entry or exit of new firms from the market under perfect competition.
In the first panel, the firm is earning supernormal gain or profit; in this case, at point E1 the equilibrium condition has been satisfied. At this equilibrium point, the output will be OA1 and the total revenue earns is OA1E1P1 and the total cost is OHGA1. The profit is HP1E1G.
In the second panel, it shows that the firm is earning a normal profit, in this case, the equilibrium price and equilibrium output will be OP2 and OA2 respectively. Since the cost of production, revenue and cost are the same, the firm enjoys normal profit instead of extra profit or loss. This is why point E2 is called the breakeven point of the firm.
The third panel shows that the firm attains equilibrium and suffers from losses. The equilibrium point can be attained by the firm even after suffering from losses. The amount of loss if P3 CDE3.
Hence, the firm in the short run may earn supernormal profit or normal profit or incur a loss.
Equilibrium Conditions Under Long-Run
In equilibrium conditions, in the long run, to get maximum profit by the firm under perfect competition can be changed by fluctuating the production scale. Moreover, in the long run, fixed inputs do not exist because there only exist variable inputs. Existing firms will earn an only normal profit because entry and exit are free in the perfectly competitive market and will also ensure abnormal profits or losses will be wiped out. To attain equilibrium conditions under long run, the firm under perfect competition must satisfy the following three conditions:
- Marginal revenue (MR) = Marginal cost (MC)
- There is an upward-sloping marginal cost curve.
- Price (P) = Average cost (AC)
If the third condition is satisfied, only then the firm will earn a normal profit. The price existing in the market of a perfectly competitive firm is always equivalent to marginal revenue. Thus, the aforesaid three conditions of equilibrium can be written as,
Price (P) = Marginal revenue (MR) = Marginal cost (MC) = Average cost (AC)
i.e., Price (P) = Average cost (AC) = Marginal cost (MC)
The equilibrium conditions of a perfectly competitive firm in the long run, is explained with the graphical explanation below:
Graphical Explanation of Long-Run Equilibrium
On the Y-axis or the vertical axis, price, revenue, and cost or the total cost and revenue are plotted and on the X-axis or the horizontal axis, the amount of production or the output is plotted. The LAC and LMC are the long-run average cost and marginal cost curves respectively. PL is the marginal and average revenue curve. In the long run, at point E equilibrium conditions are fulfilled. The equilibrium production and the equilibrium price are OB and OP respectively. In this case, when the average cost is equal to OP or EB, the firm will get a normal profit consequently. The firm will earn a normal profit i.e., the amount of excess profit will become zero. The firm cannot remain in equilibrium at a price that is more or less than the equilibrium price in the long run.
Let us assume that the price rises more than the price at the equilibrium point, an increment in the amount of the production of output which will consequently lead to entering of upcoming firms in this market and it will stop only as long as the price reduces to price at the equilibrium point and extra profit will start to decrease.
If the price falls less than the price at the equilibrium point, the amount of production will decrease which will consequently lead to the exit of new firms in the market because the firms will suffer from losses and it will stop when the price increases and reaches the equilibrium price and it will stop the firm from exiting the industry.
Context and Applications
This topic is significant in the professional exams for both undergraduate and graduate courses, especially for
- BA in economics
- MA in economics
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