PERFECT COMPETITION

The highest degree of competition possible.

DEFINITION
Economists are able to use their model of a perfect market a s a means of assessing the degree of competition in real world markets. The set out they conditions necessary for a perfect market and then contrast these with situations found in the markets for goods and services. The degree competition in these real markets is based upon the extent to which they approximate to the model of perfect competition. It is necessary to point out that the competition referred to here is price competition. Firms are assumed to be engaged in a rivalry for sales which takes the form of underselling competitors. In a market operating under the conditions of perfect competition, there will be one, and only one, market price, and this price will be beyond the influence of any one buyer or a seller. The price is set through market demand and supply.

CHARACTERISTICS
A perfectly competitive market has a number of key characteristics. All units of the commodity are homogeneous, that is one unit is exactly like another. If this happens, then the buyers will have no preference for the good of any particular seller. There must be many buyers and many sellers so that the behavior of any one buyer or any one seller has no influence on the market price. Each individual buyer comprises such a small part of total supply that any change in their plans will have no influence on the market price. Buyers are assumed to have perfect knowledge of market conditions; they know what prices are being asked for the commodity in every part of the market. Equally sellers are fully aware of the activities of buyers and other sellers. There must be no barriers to the movement of buyers from one seller to another. Since all units of the commodity are identical, buyers will always approach the seller quoting the lowest price. Finally, it is assumed that there are no barriers to entry and exit of firms into the market.

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We can now see why, in a perfect market, there will be one and only one market price which is beyond the control of any one buyer or any one seller. Firms cannot charge different prices because they are selling identical products, each of them is responsible for a tiny part of the total supply, and buyers are fully aware of what is happening in the market.

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but the market demand curve for the output of the industry will be of the normal shape. because if it does not do so. Again we must guard against a common misunderstanding. then the firm cannot survive and will have to face negatice consequences. 2 . It can sell it s entire output at the ruling market price. Any changes in the amounts of these things which he brings to the market will have negligible effects on their prices. It sees the market price as given that is.THE INDIVIDUAL FIRM UNDER PERFECT COMPETITION Under the conditions of perfect competition the firm is powerless to exert any influence on price. This proves that when a firm is in perfect competition. must be a horizontal line at the ruling price. established by forces beyond this control. No matter how many units the firms sell it cannot change the price. therefore. the individual farmer has no influence on the prices at which he sells his wheat. If it tries to sell at higher prices its demand will drop zero. when the industry s demand and supply curve is in equilibrium. sloping downwards from left to right. The demand curve for the product of the firm will be perfectly elastic. in other words. or ilk. in most countries. a perfectly elastic demand curve. it has to keep its price same as of the industry s equilibrium price. The demand curve for the output of the single firm. or vegetables. For example. The firm under perfect competition is a price taker . the individual firm has its demand on the Market price of the industry. and there is obviously no incentive to sell at lower prices. or beef. Price Price D S D S D Quantity Quantity (a) Industry (b) Firm The graph above shows that.

this satisfies the condition of being a perfectly competitive market. There is a perfect mobility of factors. a number of models have been developed which retain some of the key features of perfect competition while allowing for the presence of economies of scale as well. Another example can be of vegetables and fruit vendors. This means that the unit cost of production remains constant as the scale of production increases. investment banks) may solely influence the market price. there are also numerous models and results that could be obtained. it is assumed that production takes place with constant returns to scale that means no economies. The flaw in considering the stock exchange as an example of Perfect Competition is the fact that large institutional investors (e. To avoid some of these problems. buyer can easily switch from one seller to another. of course. not as a complete description (for no markets may satisfy all requirements of the model) but as an approximation. To avoid some of these problems. In every street we can find kiosks in which the sellers are selling their product.PERFECT COMPETITION AND ECONOMIES OF SCALE A perfectly competitive firm having economies of scale is dependent on the size of the firm relative to the size of the market. which are also homogeneously available. there are also numerous models and results that could be obtained. Any new entrant can enter this market and there are no barriers or any stoppage for them to enter this market. Also. 3 . that is. KSE has numerous buyers and seller and none can create barriers of entry or exit in the stock exchange market. a number of models have been developed which retain some of the key features of perfect competition while allowing for the presence of economies of scale as well. By design. violates the condition that "no one seller can influence market price". quite a valid example of perfect competition where there are many stockholders and many buyers that mean many buyers and many sellers. they are large in number and provide homogeneous goods. it can open up the possibility of positive profits and strategic behavior among firms.g. A very noticeable perfect competitive market in Pakistan is of street foods. In most perfectly competitive models. Because there are numerous ways to conceive of strategic interactions between firms. a stock exchange resembles this. Because there are numerous ways to conceive of strategic interactions between firms. Karachi stock exchange. This. LOCAL MARKET HAVING PERFECT COMPETITION The closest thing to a perfectly competitive market would be a large auction of identical goods with all potential buyers and sellers present. When that assumption is changed.

the firm shown has high short run costs such that the ruling market price is below the average total cost curve. price MS price MC AC AR=MR PROFIT MD Industry output firm s output Not all firms make supernormal profits in the short run. they are at the break-even output). the profit-maximizing output is Q1.e. the AR curve also becomes the Marginal Revenue curve (MR). In the diagram above. Some firms may be experiencing sub-normal profits because their average total costs exceed the current market price. The area shaded is the economic (supernormal profit) made in the short run because the ruling market price P1 is greater than average total cost. A firm maximizes profits when marginal revenue = marginal cost. Other firms may be making normal profits where total revenue equals total cost (i. Their profits depend on the position of their short run cost curves. Because the market price is constant for each unit sold. At the profit maximizing level of output. In the diagram below. In the diagram shown above. The firm sells Q1 at price P1. the firm is making an economic loss (or sub-normal profits). MS MC AC LOSS AR=MR MD Industry output firm s output 4 . price P1 is the market-clearing price and this price is then taken by each of the firms.SHORT RUN PRICE AND OUTPUT FOR THE COMPETITIVE INDUSTRY AND FIRM In the short run the equilibrium market price is determined by the interaction between market demand and market supply.

There are hundreds and thousands of wheat producers all over the world and not one of them is large enough to influence the price of wheat. 5 .REALISM OF THE PERFECT COMPETITION MODEL Perfect competition is not to be found in the real world. and the standardized grading of commodities means that the products in any one grade is regarded as homogeneous. There are any producers and buyers. modern methods of communication make knowledge of market conditions almost perfect. although it is possible to point to some markets where there is some rough approximation to this idea.

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