Theory of Perfect Competition

Meaning

of Perfect Competition
It refers to a market situation where there are large no. of buyers and
sellers.
 The sellers sell homogeneous product at a uniform price.
 This price is not determined by the firm but by the industry.
 Characteristics of Perfect Competition:
1. Large no. of Buyers and seller: Though they are large but too
small in the industry to influence the price of the product bought or
sold by him. Thus firm under perfect competition the firm cannot
influence the market price by changing the quantity of its product.
Thus firm is the price taker rather than a price maker. The demand
curve of firm is perfectly elastic because the firm can sell any
amount of output at prevailing price.
2. Homogeneous Product: the products sold are homogenous,
identical and are highly substitutable. Since all are selling identical
products there is no scope for advertisement and publicity by an
individual firm. Implying that there are no selling costs.
3. Independent Decision Making: buyers and sellers are free from
any barriers or restrictions with regard to their buying and selling of
any product. There is no agreement between buyers and sellers in
respect of the production, quantity or price of a good. Nor have the
buyers any attraction to buy the good from a particular seller.
4. Freedom of entry and exit of the firm: any firm can enter
any industry and any old firm can withdraw from any industry.
There is no legal or social barriers on the entry of new firms into
any industry. It means that new firms can easily enter industry
if it appears profitable. Conversely, existing firms can leave the
industry if they expect or experience losses.
5. Perfect Knowledge: under it buyers and sellers have perfect
knowledge of the relevant price. The buyers must be aware of
all prices. They would not pay a price higher than the price
dictated by the market. Seller would not sell at a price than that
dictated by the market. Consequently price would remain
uniform.
6. Perfect Mobility: resources are perfectly mobile i.e. resources
must be able to enter or leave the market. They must be able
to switch from one use to another. Labour must be able to move
from one region to another and from one job to another.
7. Absence of transport costs: buyers and seller incur no costs
in making exchanges. Thus there is no transport cost, because
it is assumed that all firms have equal access to the market,
they have not to incur any transport cost.
 Pure and Perfect Competition
The difference between the two is merely that of
degree.
The concept of pure competition has mainly been
propounded by Prof. Chamberlin.
A market having the following characteristics is
called pure competitive market:
Large no. of buyers and sellers
Homogeneous product
Free entry and exit of firms
Independent decision making, and
Lack of transport cost.
Apart from above 5 characteristics, perfect
competition market has additional conditions viz.
prefect knowledge and perfect mobility.
Price determination under Perfect
Competition
Under perfect competition price of a
commodity is not determined by any
individual seller or a firm. It is determined
by the forces of market supply and market
demand for a commodity. i.e. it is
determined by the industry.
Equilibrium price of a commodity is
determined at a point where market
demand for a product is equal to its market
supply.
 In above figure price of good X is determined by the industry at that point
where demand is equal to supply. Price of the good, under perfect
competition is therefore determined by the industry and each firm has to
sell its product at this very price. Fig 2(A), market DD curve intersect
market SS curve at E. this give eqm price OP. Fig 2(B) gives firm’s demand
curve. The firm will have to sell all its output at this prevailing price OP. it
may sell more or less of unit but this OP price only. It can’t change the price
as it is determined by the industry by the forces of demand and supply.
 Thus firm’s demand curve will be parallel to OX- axis signifying that the
firm cam sell any number of units at OP price.
 Firm’s demand curve PP is also its AR and MR curve. Under perfect
competition, AR=MR as their curves coincide with each other.
Short run Equilibrium of the
Firm
In the short run, the competitive firm has a
fixed plant, it attempts to maximise the profits
or minimise its losses by adjusting its output
through changes in the amount of variable
factors.
There are two complementary approaches of
determining the level of output at which firm
will realise maximum profits or minimise its
losses of will be in equilibrium.
These approaches are Total Revenue (TR) and
Total Cost (TC) approach; and Marginal Revenue
(MR) and Marginal Cost (MC) approach.
TR and TC Approach
In the short run, the firm should produce
that output level that maximize profits or
minimize its losses. Both these situations
are explained as follows:
1. Maximum Profit: A firm will be
equilibrium when its is earning maximum
profit, profit is the difference between total
revenue and total cost. Π = TR- TC
A firm will be in equilibrium when profit is
maximum that is the difference between TR
and TC is maximum.
 In fig, OX –axis shows commodity
and cost, revenue and profits are
shown on OY-axis. TR is total
revenue, TC is total cost and TPC
is total profit curve.
1. When firm produces less than
OM1 ouput, it incurs losses as
TC is more than TR from O to
M1 i.e TC curve is above TR.
2. When firm produces at M1, then
it is neither profit neither loss.
Both TR=TC and it is called
breakeven point.
3. Between any level of output M1
and M1 firm makes profit as
TR>TC and TR curve is above
TC curve. Beyond M2 output
firm again would incur losses as
TC>TR. It is only between M1
and M2 level of output that a
firm may make profit and it is
RS i.e M level of output where
profit is maximum. Thus firm
will be in eqm at OM level of
output.
MR and MC Approach
1. If MR >MC and MC is rising the
firm will increase its output:
firm will produce till MR>MC. It is
because on each such unit, the
firm is getting more of revenue
than additional cost. Hence
addition in units will add to profit.
2. If MR<MC and MC is rising
firm will decrease its output:
because each additional sale will
increase more cost than revenue.
Thus addition of output will add to
losses.
3. If MR=MC and MC is rising the
firm has reached its eqm
output: the firm will maximize
profits or minimise losses by
producing at that point where
MR=MC.
4. Eqm Conditions:
a) MC=MR (necessary or First order
Condition)
b) MC curve intersects MR curve
from below (Sufficient or second
order condition)
 Three situation under short run
equilibrium of firm
 Super Normal Profit: a
firm is in eqm when MR=MC
and MC is more than MR
after this point of
intersection.
 Firms earn supernormal
profit when AR>AC. In fig, E
is eqm pt where MR=MC and
MC>MR after this. OM is
eqm output. At this output
AR=EM and AC=AM. Since
AR(EM)>AC(AM). The firm is
earning super normal profit.
 Total super normal profit of
firm is OM(BA)* EA= EABP is
the shaded region on
supernormal profit.
Normal Profits: it just
covers the reward for
entrepreneurial services
and are included in the
cost of production.
The firm in eqm earns
normal profits when its
AC=AR. In fig, E is eqm
pt and OM is eqm
output. At E, MR=MC
and MC is more than
MR after this. The firm
earns normal profits at
OM output because at
this output
MC=MR=AR=AC.
 Minimum Loss: minimum loss
is incurred when AC>AR by an
amount equal to Fixed cost (AC-
AR=FC) i.e. when price or
AR=AVC. Even if the firm
suspends production it will have
to bear the cost of fixed factors.
 As long as price or AR is more
than AVC the firm will continue
its production. In case price(AR)
is less than the AVC, the firm will
prefer to shut down.
 In fig, AR price is determined by
industry is OP, eqm is at E where
MR=MC and Mr cuts MR from
below. At ON eqm output firm AC
is AN and firms AR is EN which is
more. Which represent per unit
loss. AEPB represent loss region.