Managerial Economics

Production Theory

MODULE VIII
Market Structure: Perfect Competition
 A market is any organisation whereby buyers and sellers of a good are kept in close touch with each
other. It is precisely in this context that a market has four basic components (i) consumers (ii) sellers (iii)
a commodity (iv) a price.
 Price determination is one of the most crucial aspects in microeconomics. Business managers are
expected to make perfect decision based on their knowledge and judgment. Since every economic activity
in the market is measured as per price, it is important to know the concepts and theories related to pricing
under various market forms.
 Perfect competition is a market structure characterised by a complete absence of rivalry among the
individual firms. Thus, perfect competition in economic theory has a meaning diametrically opposite to
the everyday use of this term. In practice, businessmen use the world competition as synonymous to
rivalry. In theory, perfect competition implies no rivalry among firms.

 Assumptions in a Perfect Competition

 In a perfectly competitive market structure there is a large number of buyers and sellers of the product
and each seller and buyer is too small in relation to the market to be able to affect the price of the product
by his or her own actions.
 This means that a change in the output of a single firm will not perceptibly affect the market price of the
product. Similarly, each buyer of the product is too small to be able to extract from the seller such things
as quantity discounts and special terms.
 The following are the assumptions:
1. Large numbers of sellers and buyers: The industry in perfect competition includes a large number
of firms (and buyers). Each individual firm, however large, supplies only a small part of the total
quantity offered in the market. The buyers are also numerous so that no monopolistic power can
affect the working of the market. Under these conditions each firm alone cannot affect the price in the
market by changing its output.
2. Product homogeneity: The technical characteristics of the product as well as the services associated
with its sale and delivery is identical. There is no way in which a buyer could differentiate among the
products of different firms. If the products were differentiated the firm would have some discretion in
setting its price. This is ruled out in perfect competition.

The assumption of large number of sellers and of product homogeneity implies that the individual
firm in pure competition is a price-taker: its demand curve is infinitely elastic, indicating that the firm
can sell any amount of output at the prevailing market price.

3. Free entry and exit of firms: There is no barrier to entry or exit from the industry. Entry or exit may
take time but firms have freedom of movement in and out of the industry. If barriers exist, the number

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of firms in the industry may be reduced so that each one of them may acquire power to affect the
price in the market.

4. Profit maximisation: The goal of all firms is profit maximisation. No other goals are pursued.

5. No government regulation: There is no government intervention in the market (tariffs, subsidies,

rationing of production or demand and so on are ruled out).

 The above assumptions are sufficient for the firm to be a price-taker and have an infinitely elastic demand
curve. The market structure in which the above assumptions are fulfilled is called pure competition. It is
different from perfect competition, which requires the fulfilment of the following additional assumptions.

6. Perfect mobility of factors of production: The factors of production are free to move from one firm
to another throughout the economy. It is also assumed that workers can move between different jobs.
Finally, raw materials and other factors are not monopolised and labour is not organised.

7. Perfect knowledge: It is assumed that all the sellers and buyers have complete knowledge of the
conditions of the market. This knowledge refers not only to the prevailing conditions in the current
period but in all future periods as well. Information is free and cost less.

 Market Condition
 The assumptions of perfect competition imply that a particular relationship exists between the firm and its
market.
 Figure 9.2(a) shows the market demand curve for a product. It shows the total amount of this product
demanded by consumers at different prices. It is a normal downward sloping demand curve showing that
for the industry as a whole quantity demanded increases as price falls.

 Figure 9.2(b) shows the seller perceived demand curve which is horizontal, i.e., it is perfectly elastic
demand with respect to price. It hits the vertical axis at the current market price, P. Two factors are
stopping the producer from charging a price such as P1 , which is higher than P-perfect knowledge and
homogeneous product.

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 If a higher price is charged, customers would know immediately that a lower price is available elsewhere,
and that the product for sale at the lower price is a perfect substitute for the more expensive product. The
producer is also not undercutting its rivals and charging a price, P2 which is lower than P.
 The firm's output is small compared to the industry as a whole and so its entire output can be sold at the
current market price of P. At a price lower than P the firm would not maximise its profit. Thus, over any
feasible range of output, the demand curve for the product of the individual firm is perceived to be
horizontal.

 Short Run Analysis of a Perfectly Competitive Firm

 The aim of a firm is to maximise profits. In the short run some inputs are fixed and these give rise to fixed
costs which have to be incurred whether the firm produces or not. Thus, it pays for the firm to stay in
business in the short run even if it incurs losses. Thus, the best level of output of the firm in the short run
is the one at which the firm maximises profits or minimises losses.
 This is possible when the marginal revenue (MR) of the firm equals its short run marginal cost (MC). As
long as MR exceeds MC, it pays for the firm to expand output because by doing so the firm would add
more to its total revenue than to its total costs. On the other hand, as long as MC exceeds MR, it pays for
the firm to reduce output because by doing so the firm will reduce its total cost more than its total
revenue. Thus, the best level of output of any firm is the one at which MR=MC.
 Since, a perfectly competitive firm faces a horizontal or infinitely, elastic demand curve, P=MR, so that
the condition for the best level of output can be restated as one of which P=MR =MC.
 The fact that a firm is in short run equilibrium does not necessarily mean that it makes excess Notes
profits – whether the firm makes excess profits or losses depends on the level of the ATC at the short run
equilibrium. If the ATC is below the price at equilibrium, the firm earns excess.
 If, however, the ATC is above the price, the firm makes a loss. In the latter case the firm will continue to
produce only if it covers its variable costs. Otherwise it will close down, since by discontinuing its
operations the firm is better off: it minimises its losses. The point at which the firm covers its variable
costs is called "the closing down point".
 All firms in the industry have the same minimum long run average cost. This, however, does not meant
have all firms have the same efficiency.

 Long Run Analysis of a Perfectly Competitive Firm

 In the long run, all inputs and costs of production are variable and the firm can construct the optimum or
most appropriate scale of plant to produce the best level of output. The best level of output is one at which
price P=LMC equals the long run marginal cost (LMC) of the firm.
 The optimum scale of the plant is the one in which short run average total cost (SATC) curve is tangent to
the long run average cost of the firm at the best level of output. If existing firms earn profits, however,
more firms enter the market in the long run. This increases the market supply of the product and results in
a lower product price until all profits are squeezed out.
 On the other hand, if firms in the market incur losses, some firms will leave the market in the long run.
This reduces the market supply of the product until all firms remaining in the market just breakeven.

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Thus, when a competitive market is in long run equilibrium, all firms produce at the lowest point on their
long run average cost (LAC) curve and break-even.

 Shutdown Decision
 The supply curve of a competitive firm is its marginal curve. It is that part of the marginal cost curve
which is above the average variable cost curve.
 At a price P, the firm is incurring a loss, but it does not shut down because of fixed costs. In the short run,
a firm knows it must pay these fixed costs regardless of whether or not it produces. The firm only
considers the costs it can save by stopping production and those costs are its variable costs. As long as a
firm is covering its variable costs, it pays to keep on producing. It makes a smaller loss by producing. If it
stopped producing, its loss would be the entire fixed costs.
 However, once the price falls below AVC it will pay to shut down (point A). In that case the firm's loss
from producing temporarily and save the variable cost. Thus, the point at which MC = AVC is the shut-
down point (that point at which the firm will gain more by temporarily shutting down than it will by
staying in business.
 When price falls below the shut-down point, the average variable costs the firm can save by shutting
down exceed the price it would get for selling the good.
 When price is above AVC, in the short run, a firm should keep on producing even though it is making a
loss.
 As long as a firm's total revenue is covering its total variable cost, temporarily producing at a loss is the
firm's best strategy because it is making less of a loss than it would make if it were to shut down.

 Efficiency of a Firm
 Since the price in the market is unique, this implies that all firms in the industry have the same minimum
long run average cost. This, however, does not mean that all firms are of the same size or have the same
efficiency, despite the fact that their LAC is the same in equilibrium.
 The more efficient firms employ more productive factors of production and/or able managers. These more
efficient factors must be remunerated of their higher productivity, otherwise they will be bid off by the
raw entrants in the industry. Or, as the price rises in the market the more efficient firms earn a rent which
they must pay to their superior resources. Thus rents of more efficient factors become costs for the
individual firm, and hence the LAC of the more efficient firm shifts upwards as the market price rises,
even if the factor prices for the industry as a whole remain constant as the industry expands. In this
situation, the LAC of the old, more efficient firms must be redrawn so as to be tangent at the higher
market price. The LMC of the old firms is not affected by the rents occurring to its more productive
factors. It will be shifted only if the prices of factors for the industry in general increase. Thus, the more
efficient firms will be in equilibrium, producing that output at which the redrawn LAC is at its minimum
(at which point the LAC is cut by the initial LMC given that factor prices remain constant). Under these
conditions, with the superior, more productive resources properly costs at their opportunity cost, all firms
have the same unit cost in their long run equilibrium.