Perfect competition is an economic model that describes a hypothetical market
form in which no producer or consumer has the market power to influence
prices. According to the standard economical definition of efficiency (Pareto efficiency), perfect competition would lead to a completely efficient outcome. The analysis of
perfectly competitive markets provides the foundation of the theory of supply and
demand.
Requirements
Perfect competition requires that the following six parameters be fulfilled. In such a market, prices would normally move
instantaneously to economic equilibrium.
- Atomicity
- An atomistic market is one in which there are a large number of small producers and
consumers on a given market, each so small that its actions have no significant impact on others. Firms are price takers, meaning that the market sets the price that they must choose.
- Homogeneity
- Goods and services are perfect substitutes; that is, there is no product differentiation. (All firms sell an identical
product)
- Perfect and complete information
- All firms and consumers know the prices set by all firms (see perfect
information and complete information).
- Equal access
- All firms have access to production technologies, and resources are perfectly mobile.
- Free entry
- Any firm may enter or exit the market as it wishes (see barriers to entry).
- Individual buyers and sellers act independently
- The market is such that there is no scope for groups of buyers and/or sellers to come together with a view to changing the
market price (collusion and cartels are not possible under this market structure)
Behavioral assumptions of perfect competition are that:
- Consumers aim to maximize utility
- Producers aim to maximize profits.
To be exhaustive, note than some economists[1] do not
agree with this presentation of the model of perfect competition. Many reasons are advanced, but one of the main is that it
focuses on unnecessary conditions (atomicity, perfect information...)while it does not allow to answer to the question : "If
agents are price-takers, who sets the prices ?" Indeed, in this model, as firms and consumers can not set the
prices, it can't be - as it is often said (e.g. below) - that it is the firms who fix it. So, actually, there is a need for a
benevol agent who proposes prices to firms and consumers and fixes the ones at which exchange will occur. They also think that
the argument that a global entity called "the market" could fix the prices, when its consituants (producers and concumers) can
not is greatly disturbing[2]. Above other criticism, there
is also the lack of emphasis on the fact that no uncertainty about future prices or incomes, no transport cost, no indivisibility
can be integrated in this model."
Results
In the short-run, it is possible for an individual firm to make abnormal profit. This situation is shown in this diagram, as the
price or average revenue, denoted by
P is above the average cost denoted by
C .
However, in the long run, abnormal profit cannot be sustained. The arrival of new firms in the market causes the (horizontal)
demand curve of each individual firm to shift downward, bringing down at the same time the price, the average revenue and
marginal revenue curve. The final outcome is that, in the long run, the firm will make only normal profit (zero economic profit).
Its horizontal demand curve will touch its average total cost curve at its lowest point. (See
cost
curve.)
The model is a description of one type of market structure, most closely approximating
only a few markets, such as agriculture. In real-world markets, any of its assumptions may be violated. For example, firms will
never have perfect information about each other. Its usefulness as a scientific construct may be judged by the range of market
behavior explained by it and as a standard for comparison with other market structures.
In a perfectly competitive market, there will be allocative efficiency and
productive efficiency.
- Allocative efficiency occurs when price (P) is equal to marginal cost (MC), at which
point the good is available to the consumer at the lowest possible price.
- Productive efficiency occurs when the firm produces at the lowest point on the average cost curve (AC), implying it cannot
produce the goods any more cheaply. This would be achieved in perfect competition, since if a firm was not doing it another firm
would be able to undercut it by selling products at a lower price.
In contrast to a monopoly or oligopoly, it is impossible
for a firm in perfect competition to earn abnormal profit in the long run, which is to
say that a firm cannot make any more money than is necessary to cover its economic costs. If a firm is earning abnormal profit in
the short term, this will act as a trigger for other firms to enter the market. They will compete with the first firm, driving
the market price down until all firms are earning normal profit, it could be said that abnormal profit is 'competed away'. On the
other hand, if firms are making a loss, then some firms will leave the industry, reduce the supply and increase the price.
Therefore, all firms can only make normal profit in the long run.
It is important to note that perfect competition is a sufficient condition for allocative and productive efficiency, but it is
not a necessary condition. Laboratory experiments in which participants have significant price setting power and little or no
information about their counterparts consistently produce efficient results given the proper trading institutions (Smith, 1987,
p. 245).
The shutdown point
Shut down point is a point where firm stop producing
When a firm is making loss, it will have to decide whether to continue production or not. This decision will, in fact, depend on
the different total costs levels and whether the firm is operating in the short run or in the long run.
If the firm is in the short run, and is making a loss whereby:
- Total costs (TC) is greater than total revenue (TR)
- and whereby total revenue is equal to total variable cost (TVC)
it is advisable for the firm to continue production. If it fails to achieve these conditions, it is advised to close down so
that the only costs the firm will have to pay will be the fixed costs.
Even if the firm stop producing, it will have to continue to meet the level of fixed costs. Since whether the firm produces or
not, it will have to pay fixed costs, it is better for it to continue production in an attempt to decrease total costs and
increase total revenue, thus making profits. This can be done by:
- Increasing productivity. The most obvious methods involve automation and
computerization which minimize the tasks that must be performed by employees. All else constant, it benefits a business to
improve productivity, which over time lowers cost and (hopefully) improves ability to compete and make profit.
- Adopting new methods of production like Just In Time or lean manufacturing in an attempt to reduce costs and wastages.
In the long run, the condition to continue producing requires the price P to be higher than the ATC, i.e. the line
representing market price should be above the minimum point of the ATC curve.
If P is equal to ATC, the firm is indifferent between shutting down and continuing to produce. This case is different from the
short run shut down case because in long run there's no longer a fixed cost (everything is variable).
Examples
Some agricultural markets, with numerous suppliers and almost perfectly substitutable
products have been suggested as approximations for the perfect-competition model. The extent of its applicability may be
dependent on the market in question. Agricultural policies in many countries undermine the requirements for complete Pareto
efficiency to apply.
Perhaps the closest thing to a perfectly competitive market would be a large auction of identical goods with all potential
buyers and sellers present. By design, a stock exchange resembles this, not as a complete
description (for no markets may satisfy all requirements of the model) but as an approximation. The flaw in considering the stock
exchange as an example of Perfect Competition is the fact that large institutional investors (e.g. investment banks) may solely
influence the market price. This, of course, violates the condition that "no one seller can influence market price".
eBay auctions can be often be seen as perfectly competitive. There are very low barriers
to entry (anyone can sell a product, provided they have some knowledge of computers and
the Internet), many sellers of common products and many potential buyers.
In the eBay market competitive advertising does not occur, because the products are homogeneous and this would be redundant.
However, generic advertising (advertising which benefits the industry as a whole and does not mention any brand names) may
occur.
References
- ^ One of the most famous is Bernard
Guerrien, economics and mathematices teacher in Paris Panthéon-Sorbonne, also people regrouped in the mouvement
post-autistic economics
- ^ "The Arrow-Debreu model has nothing to do with competition and markets: it
is a model of a “highly centralized” economy, with a benevolent auctioneer doing a lot of things, and with stupid price-taker
agents", Guerrien, see [1]
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