You are on page 1of 5

rizwan4education@yahoo.

com
Ch-3-1
Sir Rizwan
Perfect Competition
The assumptions
Every time we look at a market structure, we will start with a section on
assumptions. Although some of the market structures are more realistic
than others, all of them are essentially models that only work if one
adheres to a set of assumptions.
Perfect competition is probably the most unrealistic of the lot! As you
will see from the assumptions below, the world we are creating is not very
real at all! I hear you saying, ‘So whats the point of it! "ood #uestion.
Economists have created these models as benchmarks from which the
real world can be compared. $he model of pure monopoly is fairly
unrealistic as well, but one can learn about how firms in industries, which
are similar to the model, act in real life. In the same way, no industry is
perfectly competitive, but there are some that are fairly close, so
studying this model helps us understand how these industries operate.
So, here are the assumptions that we have to make for the model of the
perfectly competitive industry.
1. Numbers: In a perfectly competitive market, there are many buyers and
many sellers. In fact, the number of buyers and sellers is effectively infinite.
All firms in the industry act independently of each other.
2. Ease of entry: $his one is about barriers to entry. %e assume that there is
total freedom of entry into and e&it from the market. $here are no barriers to
entry or e&it.
3. Knowledge: In a perfectly competitive market, it is assumed that both
buyers and sellers have perfect knowledge, about prices in particular. 'uyers
and sellers know the e&act price of the product charged by all firms at all
times. $his means that there are no search costs for consumers (searching
for the best price).
. Product: $he product sold by the numerous firms in the market is
homogenous, or identical.
!. "a#imising assumption: All firms aim to ma&imise their profits. $hat is
their sole ob*ective. 'uyers aim to ma&imise their welfare through their
purchases.
$. "obility of factors: It is assumed that all of the factors of production are
perfectly mobile. If they are not being used as efficiently as they could, they
will instantly move to where they will be best used without any restrictions.
%. Price takers: +irms in perfectly competitive markets are price takers. $his
means that they have absolutely no control over the price they charge. $here
are so many firms that the actions of one firm will have no effect on the
1
rizwan4education@yahoo.com
whole market. $he price is derived from market supply and market demand,
over which each firm has no power. 'uyers also have no control over the
market price. If one consumer increased his demand significantly, it would
still be dwarfed by the cumulative demand from the other, infinite,
consumers.
Real world examples
It is almost impossible to think of a perfect e&ample of an industry, or
market, that displays these characteristics. $here are some that get close.
Some say that the Stock ,arket is one. $here are lots of buyers and
sellers, few barriers to entry (especially with Internet stock broking) and
the product is homogenous (for any one type of share, anyway). 'ut
although knowledge is meant to be perfect, Im not sure that it is.
Is agriculture, there are lots of buyers and sellers, the product is
homogenous (a potato is a potato, whichever farm you visit!) and prices
appear to be determined by the market. 'ut are they! In the European
-nion, prices are controlled via subsidies through the &ommon
'gricultural Policy.
'efore we can look at what actually happens in these markets, we need to
look at the revenue and cost curves, from which we will derive the demand
and supply curves for the market and each firm.
The revenue curves
(ere are the demand and re)enue cur)es for the market and each
firm:
2
rizwan4education@yahoo.com
Assuming that the good in #uestion is normal, the market demand curve will
be a normal looking downward sloping demand curve. E#ually, there is no
reason to believe that the market supply curve will be anything other than a
normal looking upward sloping supply curve.
%e said earlier that no one firm is big enough to affect the market price.
Imagine that one firm doubled its supply. $he industry supply curve would
shift to the right, but the move would be so infinitesimally small (given that
the firm is *ust one in a market of millions) that one would not be able to see
it. Effectively the price is unchanged.
.ence, every firm is a price taker setting their price at the market price of /0.
Each firms demand curve is perfectly elastic. $his means that they can sell
as much as they want at the given market price. If one of the firms were to
raise its price above /0, their sales would plummet to 1ero because the buyers
would go to one of the other numerous firms selling the identical good at /0. I
suppose a firm could lower its price below /0 to try and steal some market
share from their competitors, but whats the point! Each firm can sell as
much as they want at price /0.
+inally, notice that the firms demand curve has also been labelled A2 3 ,2. If
you cant remember why the demand curve is the a)erage re)enue curve, or
why average revenue 3 marginal revenue when A2 is constant, then look back
at the topic on ‘4osts and revenues.

The cost curves
%e have already stated that the market supply curve is a normal looking
upward sloping supply curve. 'ut what about the firms supply curve! $he
following diagrams will attempt to e&plain that each firms supply curve is their
marginal cost curve.
3
rizwan4education@yahoo.com
Assume that initially, 50 is the market demand curve, S the market supply
curve, and so the given market price is /0. $his means that each firm in the
market has an individual demand curve of d0. $his also represents their
average revenue curve (A2) and their marginal revenue curve (,2).
6ne of the key assumptions we made earlier was that each firm tries to
ma&imise profits. $his occurs at the level of output where marginal cost 3
marginal revenue (,4 3 ,2). If you do not remember why this is the case,
look back at the ‘4osts and revenues topic under the 7uick8earn called ‘/rofit.
8ooking at the diagram for the firm on the right, when the price is /0, the
condition ,4 3 ,2 occurs at point A, giving an output of #0. If there is a shift
to the right of the demand curve in the market (due to increased real incomes,
for e&ample), the given price will rise to /9, and each firm will have an
individual demand curve of d9. $his time, ,4 3 ,2 occurs at point ', giving
output #9. +or a shift to the left in market demand, the given price is /:, ,4 3
,2 occurs at 4 and output for each firm is #:.
+rom the analysis above, you can see that, effectively, if a firm wants to find
out how much he should supply at any given price, he simply reads this
amount off the marginal cost curve. $he marginal cost curve is doing the *ob
of a supply curve; it tells the firm its supply for any given price. .ence, the
marginal cost curve is the firms supply curve.
*he shut+down point
So, a perfectly competitive firms marginal cost curve is its supply curve. 'ut
as you will see, its supply curve is not the whole of the marginal cost curve.
4
rizwan4education@yahoo.com
$he two diagrams above are very similar to the two previous diagrams e&cept
Ive added the firms average cost and average variable cost curves (both are
short run curves).
8ets assume that the given market price is /0. 5oes each firm make profit or
loss! %ell, given the information we have, it is probably best to compare
average revenue and average cost (we dont have $2 and $4). At /0, A2 < A4,
so the firm is making super normal profit.
At /9, A2 3 A4, so each firm is making normal profit, or, in other words,
breaking even.
At /:, A2 = A4, so each firm is making a loss. 'ut, A2 < A>4. $his means that
the revenue each firm receives, on average, is still higher than their )ariable
costs. $hey can ‘cover their variable costs. $hey can still pay wages, pay for
raw materials and pay for the power to run the machines. $hey can e&ist! $he
costs they cant cover are some of the fi&ed costs. Imagine this as being
behind on the rent! A problem, but not the end of the world. $he point is that
the firm can keep operating.
'elow point S, the shutdown point, the firm has to shut down even in the
short run. +or instance, at the given price /?, A2 = A>4. $he firm cannot even
cover its variable costs of production. If a firm cannot even afford the raw
materials or the labour to make enough of the product to minimise their
losses, then they are in real trouble! $hey must shut down.
$he implication of all this is that, although the firms supply curve is the
marginal cost curve, in the short run it is only that part of the ,4 curve that is
above point S. $he supply curve for a perfectly competitive firm in the short
run is the part of the marginal cost curve abo)e the average variable cost
curve.
5