Perfect Market Competition

Introduction

In the previous chapter we have examined the production and the cost of producing goods and services.n But a firm’s decision on production depends on the characteristics of the service industry in whichthe firm is operating.

In this chapter and next chapter, we will define different types of markets, their characteristics, their determination of equilibrium in the short run and long run and some of their unique charactristics.

We will explain the meaning of a firm and its objectives.

Theory of a Firm

• Definiton of a firm

– Is an institution that buys or hires factors of production and organizes them to produce and sell goods and services

– An independent unit which produces goods and services for sale.

– A unit engaged in production with the objective of maximizing profits.

Objective of a firm

– The main goal or abjective is profit maximization.

Accounting profit vs Economic Profit

Example : A firm’s total revenue is RM 50,000, the total explicit cost is RM 20,000 and total implicit cost is RM 10,000. Calculate the accounting profit and economic profit

Total Profit = Total Revenue – Total CostTP = TR - TC

PA = TR – TC(total explicit cost)= 50,000 - 20,000= RM 30,000

PE = TR – TC (Total explicit cost +Total implicit cost )

= 50,000 - (20,000 + 10,000)= RM 20,000

Equilibrium of a firm

- Definition

Implies the desirable level to attain under given condition

A firm is in equilibrium when it earns maximum profit or minimum loses.

has no tendency to increase or decrease output.

Equilibrium output is the output level which gives maximum profit.

4 graphTR/TC TR/TC

Profit / Loss Profit / Loss

Quantity

Quantity Quantity

Quantity

Marginal Approach

• Invovles marginal revenue and marginal cost

• A firm is said to be in equilibrium when marginal revenueis equal to marginal cost.

MARGINAL REVEUE = MARGINAL COST

Cost / Revenue Cost / Revenue

Quantity Quantity

• Both the perfect competition and imperfect competition markets give the same explanation on maximizing profit. The only difference in both market is the MR curve.

• The relationship between MR and MC is as follows :i. MR > MC – A firm can increase its profits by

increasing output

ii. MR < MC – A firm can reduce its loses by decreasing output

iii. MR = MC – Profit are at maximum

Market Structure

Definiton• Definition of a Market

– An arrangement that facilitates the buying and selling of a product, service, factor of production, or future commitment.

– Or in other words, a market is a place where the buyer and seller meet one another to transact business

• Definition of Market Structure– The number and distribution size of buyers and sellers in the

market for a particular goods and services.– An indication of the number buyers and sellers: their market

shares the degree of product standardization and the ease of the market entry and exit.

– Explain the power of a firm determine the market price.

Market

Structure

Perfect Competition

Monopolistic competitin

Monopoly

Oligopoly

Classification of Markets

Market FormCharacteristics

PerfectCompetition

MonopolisticCompetition

Oligopoly Monopoly

Number of firms

Large number Large Few One

Type of product

Homogenous Differentiated Homogenous or Differentiated

Unique : no close substitute

Control over price

None Some Some Considerable

Condition for entry

Very easy Relatively easy Significant obstacles

Blocked

Price elasticity of demand

Infinite Large Small Very Small

Example Wheat, corn Food, clothing Automobile, ciggarettes

Local fixed phone serviceelectricity

Perfect Competition

• Perfect competition is a market in which there are a large number of buyers and sellers, buying and selling identical products etc

• Example of products in a perfect competition market are agricultural goods such as vegetable, fruits and others.

• Characteristics

1. Large number of buyers and sellers• An important featur of perfect competition is the

existence of alarge number of buyers and sellers

• The quantity of a single seller sells in a market so small compared to the overall industry.

• Therefore no one can influence the market price of goods.

• Thus, in perfect competition, firms are price takers because the individual sales volume is realtively small compared to market volume.

2. Free entry and exit– There are no restriction on the entry of new firms to

the industry or the exit of firms.– A new firm can easily enter into perfect competition

market and exit it at any time it chooses.

3. Non-Price Competition– Sellers practice non-price competition such as

advertising, free gifts, discount, after sales service and promotions when these sellers cannot compete among themselves using pricing strategies

– The role of non-price competition is insignificant as many sellers sell the products at fixed price and furthermore the product is identical

4. Homogenous

– All the firms will sell identical or homogenous products

– Buyers cannot differentiate products in the term of quality, packaging, colour and design

– Hence, the firm cannot charge different prices for the same products in the market

– Product which are similar in nature but different in terms of quality and packaging are not homogenous products.

5. Perfect knowledge of the market

– All the sellers and buyers will have perfect knowledge of the market.

– Sellers cannot influence buyers and similarly buyers cannot influence sellers.

– Sellers must know the price charge by other sellers in the market and the buyers must know the price being charged by another sellers.

– If any seller charges a higher price, the buyer will buy from different sellers

6. Perfect mobility of factors of production

– Factors of production can freely move from one occupation to another from one place to another.

– There is no barrier of movement.

– The existence of perfect mobility will lead to existence of large sellers in the market.

7. Absence of transport cost

– There should not be any transport costs between sellers.

– It is assumed that various firms will work closely with each other so that transport costs are not incurred

– If two identical products are at two different places, their prices will be different because of transport costs

– Therfeore there will no transport cost.

• Price determination in Perfect Competition

• Graph

Short run Equilibrium

• The

• Two Types

– Total Approach

– Marginal Approach

Total Approach

Marginal Approach

The three

Shut-down Point

• Graph

Short-run Supply Curve

Long run- Equilibrium

Effect of Entry

Effect of Exit