Economics For Accountants
Perfect competition is a market structure defined by four characteristics. It is a market of perfect knowledge for all the buyers and sellers. For buyers, they know all the prices and all the availability of all goods in the market. For sellers, there is no production sequence. All new and old producers produce the same quality of goods. This makes them fully alert of prices, costs and market opportunities.
Second characteristic, there are a large number of buyers and sellers. However, none are big enough to influence the market. For all firms produce a small proportion of supply towards the total of the industry supply, and therefore has no control whatsoever to affect the price of the product. This make all firms price takers for there are so many firms in the industry.
Third characteristic, there are no barriers to entry. This means that it is easy for new firms to enter the industry. Current firms cannot do anything to stop them. However, it takes time for new firms to enter into the industry.
Fourth characteristic, the goods produced in a perfectly competitive market are homogenous. This means that the products are absolutely identical to each other. Firms attempt to minimize their costs and move towards productive efficiency, therefore there is no branding or advertising
(Stephen Dobson and Susan Palfreman, 1999)
Homogenous products lead to no brand loyalty making a perfectly elastic horizontal demand curve. This is along the point of price because consumers have plenty of choice over a wide range of substitute products. The price is established in the industry by the connection of demand and supply. If the point of price were to be set higher than the demand, the firm would lose all of its customers. Demand equals to the average revenue and marginal revenue curve. Firms would see a perfectly elastic demand every time they sell a unit, the same amount of revenue would come in. Firms would see the same amount of extra revenue come in every time they sell a unit on a perfectly elastic demand situation. Marginal revenue is horizontal on top of the average revenue curve, which is unusual but unique to this market structure. In other market structures, the average revenue slopes downwards and the marginal revenue slopes twice as steep but not in perfect competition. There is a marginal cost curve that is for standard use and an average cost curve. The average cost curve is drawn as if the firm is making abnormal profits. Abnormal profit is another way of saying supernormal profits. This is possible but only in the short-run. Marginal cost and average revenue point shows what has been produced in quantity. Between average cost and average revenue shows the abnormal profits of the quantity
(Tutor2u, n.d.Perfect competition – the economics of competitive markets)
The market may allow firms to make abnormal profit in the short run, but only temporarily. This is because, what happens in perfect competition if firms are making abnormal profits: new entrants would enter the market, there is no production technique, there are no secrets, and there is perfect knowledge with no barriers to entry to stop them coming in. This makes new firms interested into entering the industry because of the attraction of the abnormal profits. As they enter the industry, the supplier in the industry expands, which leads to the price being driven down, which then leads to abnormal profits for the individual firms being eroded. What is left is the long run equilibrium position which does not allow abnormal profits. Now there are no more abnormal profits because of the long run equilibrium but also what is seen is the level of output is at the lowest point of the average cost curve that shows there is product efficiency. What’s more is because of the last unit made, firms have allocated the same amount of extra cost as customers have allocated the same extra revenue and the price. There is also allocative efficiency in this market structure. This is the only market structure where you get both productive and allocative efficiency when the firm is profit maximising as perfect competition in the long run.
This is the case where the new firms entered into the industry expanding the supply driving the price down and eroding the abnormal profits but this position is also reached when firms are also making a loss. If firms were making a loss in perfect competition, some firms would have been driven out of the industry. This means the supply would have decreased making prices driven back up. Whether there are too many or too few firms, the long run equilibrium is here when there is just a right of number of firms and no abnormal profit can be made. There is no incentive for new firms to enter and no reason why firms should be pushed out the industry either.
When there has been profit made in the short run, as shown earlier, supply increases. This leads to an increase in the industry supply but decreased each individual firm quantity. This is quite unusual but the industry supply increased, price was driven down meaning each firm made less quantity itself even though the whole industry supply increased (Tutor2u, n.d.Long run price and output under perfect competition) .
The differences between the perfect competition and the monopoly market structure are the ease of entry and exit for firms, type of product sold, type of firm and profit in short run and long run. First of all, ease of entry and exit for firms. For the perfect competition market structure, new firms can easily enter the market structure, as there are no barriers of entry. This means that new firms know that there is a profit to be made in some area, location or industry can easily set up. For monopoly, there are high barriers of entry stopping new firms from entering the market structure. These barriers of entry are created by existing or dominant firms in a monopoly to prevent competition entering the market structure.
Second difference is the type of product sold. For a perfect competition market structure, the product sold is homogenous. Identical products in the perfect competition market structure are perfect substitutes. What is assumed is that the consumers have perfect knowledge of the product. This means that the consumers are aware of the price sold by other suppliers. For the monopoly, the product sold is not a perfect substitute. This makes the monopoly’s product unique.
Third difference is the type of firm. Since the perfect competition market structure faces the two characteristics recorded above. This means that the firms in this market structure are powerless to influence the price. This means they have no control to increase the price of the product. This is because if the firm increases the price on their product, the same firm will lose competition to other firms. This is why firms are considered to be price takers in the perfect competition market structure. Firms in monopoly market structure are Price Makers. This means that they can influence the price of their product sold to consumers. The monopoly is able to do that, as the monopolist is the single seller in a market.
Last difference is profit. For the perfect competition firms, there is a possibility to earn abnormal profit in the short run, but not possible in the long run. This is because, in a perfect competition market structure, when existing firms earn profit, new firms will enter the market structure, shrinking the profit. For the monopoly, there is a possibility to earn abnormal profit in short run and long run, as there is the existence of barriers of entry to prevent new firms to enter the marketJohn Sloman,2007)
Are there really industries that are perfectly competitive? Some agricultural goods can be argued to be perfectly competitive. For example, a person going to a market and buying potatoes from five different stalls. The person bought five potatoes from each stall, totalling twenty-five potatoes altogether. The person then put the twenty five potatoes into a bag and went back to the first supplier, the first potato seller and asking which five potatoes was bought from you. The potato seller could not pick the same five. This seems to indicate homogenous goods. When the supplier who supplied the goods earlier but could not pick out the same product that was sold. This example shows that maybe agricultural goods can be argued to be perfectly competitive.
Another example can be foreign exchange can be perfectly competitive because the goods are homogenous. One dealer sells dollars and another foreign exchange supply dollars then the dollars are homogenous. However, the barriers to entry can be argued.
It is not important that it really exist. The important part is that the market structure is seen as a theoretical extreme. This can be seen and judged how closely real world industries approximate to this even though they are not truly perfectly competitive.
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