Perfect competition: occurs when none of the individual market participants (ie buyers or sellers) can influence the price of the product.

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1 Perfect Competition In this section of work and the next one we derive the equilibrium positions of firms in order to determine whether or not it is profitable for a firm to produce and, if so, what quantities of the product the firm should supply at different prices of the product. To do this, we have to consider demand conditions as well. You have already been introduced to the four standard forms of market structure: perfect competition, monopoly, monopolistic competition and oligopoly. In this section we focus on the position of a firm which operates under conditions of perfect competition. Perfect competition: occurs when none of the individual market participants (ie buyers or sellers) can influence the price of the product. The price is determined by the interaction of demand and supply and all the participants have to accept that price. All the participants are therefore price takers they can only decide what quantities to supply or demand at that price. Conditions for Perfect Competition Perfect competition exists if the following conditions are met 1. Large number of buyers and sellers of the product: the number must be so large that no individual buyer or seller can affect the market price. 2. No collusion between sellers: each seller must act independently. 3. Homogenous goods: all the goods sold in the market must be identical. There should therefore be no reason for buyers to prefer the product of one seller to the product of another seller. 4. Freedom of entry and exit: buyers and sellers must be completely free to enter or leave the market. There must be no barriers to entry in the form of legal, financial, technological, physical or other restrictions which inhibit the free movement of buyers or sellers. 5. Perfect knowledge: all the buyers and sellers must have perfect knowledge of market conditions. For example, if one firm raises its price above the market price, it is assumed that all the buyers will know that the other firms are charging a lower price and will therefore not buy anything from the firm that is charging a higher price. 6. No government intervention: government must not influence buyers or sellers. 7. Perfectly mobile factors of production: that is, labour, capital and the other factors of production must be able to move freely from one market to another. No market meets all the requirements for perfect competition. Markets that come close to meeting these conditions are found in agriculture, for example in the markets for maize, wheat, fruit and vegetables. An individual farmer is usually regarded as the best example of a perfect competitor. However, farmers often form cooperatives to control the supply of agricultural Bishops Economics Department Page 1

2 products, and government also tends to intervene in markets for agricultural products. When this occurs, the conditions for perfect competition are no longer met. Financial markets, like the JSE Securities Exchange, also approximate perfect competition. There are many buyers and sellers, the goods (eg shares in a company) are homogeneous and anyone is free to participate. So, if perfect competition is more theoretical than practical, why bother learning about it? Perfect competition represents a standard or norm against which the functioning of all other markets can be compared. This is common practice in all branches of science Note that the word perfect in perfect competition does not mean that it is necessarily the most desirable form of competition it simply signifies the highest or most complete degree of competition. Demand for the product of a perfectly competitive firm Under perfect competition the price of a product is determined by supply and demand. The individual firm is a price taker and can sell any quantity at the market price. No firm will charge a price higher than the current market price because it will then lose all of its customers. Nor will a firm gain anything by charging a price that is lower than the existing market price, since it can sell as many units of its output as it wishes at the market price. Under perfect competition the individual firm is faced by a demand curve which is horizontal (or perfectly elastic) at the existing market price. The graph on the left shows that the price of the product (P1) is determined in the market by the forces of supply (SS) and demand (DD). The position of the individual firm is shown in the graph on the right. Bishops Economics Department Page 2

3 The firm can sell any quantity at the prevailing market price. At prices higher than P 1 the quantity demanded = zero as consumers will be able to purchase the product at a price of P 1 from any other supplier. Firms will not supply at prices lower price than P 1 because they can sell all of their output at a higher price (P 1 ). As can be seen form the table above, under perfect competition the firm receives the same price for any number of units of the product that it sells. Its marginal revenue (MR) and average revenue (AR) are thus both equal to the market price, that is, MR = AR = P. The firm s total revenue can be represented graphically by a straight line which starts at the origin and which has a slope equal to the price of the product shown below. Bishops Economics Department Page 3

4 The equilibrium of the firm under any conditions Firms want to maximise profit. Economic profit is the difference between revenue and cost (which includes normal profit). To examine the behaviour of firms, we therefore have to examine and combine their revenue and cost structures. Once these are known, two decisions have to be taken The firm must first decide whether or not it is worth producing at all. If it is worth producing, the firm must determine the level of production (ie the quantity) at which profit is maximised (or losses minimised). Two rules for profit-maximisation which apply to all firms are the shut-down rule and the profit maximising rule. The shut-down rule The shut-down rule: a firm should produce only if total revenue is equal to, or greater than, total variable cost (which includes normal profit). The shut-down rule can also be stated in terms of unit (average) costs a firm should only produce if average revenue (ie price) is equal to, or greater than, average variable cost. In the long run all costs are variable. Production should therefore only take place in the long run if total revenue is sufficient to cover all costs of production. But what about the short run, when certain costs are fixed? Should production occur only if total revenue is sufficient to cover total costs (ie total fixed costs and total variable costs)? The answer is NO. Once a firm is established, it cannot escape its fixed costs; they occur even if the firm does not produce at all. Therefore If total revenue > total variable cost OR if average revenue > average variable cost, then the difference can help cover some of the unavoidable fixed costs of the firm and it s advisable to maintain production in the short run. If total revenue = total variable costs OR if average revenue = average variable costs its loss will be the same if they continue or shut-down (ie equal to its fixed costs). In such conditions firms tend to continue production in order to retain their employees and clients. If total revenue < total variable costs OR average revenue < average variable cost, production will result in a loss greater than its fixed costs. In other words, the firm s losses will be minimised by not producing at all hence they will choose to shut-down. Bishops Economics Department Page 4

5 The Profit-Maximising Rule The second rule is that firms should produce that quantity of the product such that profits are maximised, or losses minimised. Profit is the difference between revenue and cost and profits are maximised where the positive difference between total revenue and total cost is the greatest. However, it is usually more useful to express the profit-maximisation condition in terms of revenue and cost per unit of production. The rule is that profit is maximised where marginal revenue (MR) is equal to marginal cost (MC). To explain why profits are maximised where MR = MC, it is useful to consider what happens if MR is not equal to MC. If MR > MC the firm is still making a profit on the last (extra) unit produced. Total profit increases by expanding its production until no extra profit is made on the last unit produced, that is, until MR = MC. At that quantity the firm s profit is maximised. At production levels beyond that point, MC > MR. Ie, the firm will make a loss on the production of each additional unit of output and its profit will decrease. So, profits are maximised when marginal revenue MR is just equal to marginal cost MC. In summary When MR is greater than MC (ie MR > MC), output should be expanded. When MR is equal to MC (ie MR = MC), profits are maximised. When MR is lower than MC (ie MR < MC), output should be reduced. The profit-maximising (or equilibrium) position of the firm under perfect competition We now combine the cost curves derived in the previous section, the two profit-maximising rules which apply to all firms, and the demand curve for the product of the firm, to examine the equilibrium of the firm under perfect competition. Firms in a perfectly competitive market are price takers and can only choose the output (quantity) at which it will maximise its profits (or minimise its losses). That quantity, we have seen, is where the positive difference between total revenue TR and total cost TC is at a maximum, or where marginal revenue MR is equal to marginal cost MC, provided, of course, that average revenue AR (= P) is at least equal to short-run average variable cost AVC (the shut-down rule). Bishops Economics Department Page 5

6 Equilibrium in terms of total revenue and total cost The total cost curve is shaped like a reversed S. It the total cost curve does not start at the origin, since part of the firm s cost is fixed. Total revenue (TR) of the firm under perfect competition is a straight line with a positive slope which starts at the origin and has a slope equal to the price of the product. Economic profit is the difference between TR and TC. At levels of output below Q 1 TC > TR and the firm therefore incurs economic losses (indicated by the shaded area). At Q 1 the firm s total economic profit is zero (since TR = TC). Between Q 1 and Q 2 the firm makes an economic profit at each level of output (indicated by the shaded area), since TR > TC. At Q 2 total economic profit is zero once more and at higher levels of output the firm again incurs economic losses. The firm s profit will be maximised where the positive vertical difference between TR and TC is the greatest (ie somewhere between Q 1 and Q 2 ). You can draw a tangent to the TC curve, parallel to the TR curve, such as the broken line in Figure At the point of tangency the vertical difference (ie total profit) will be at a maximum. There is, however, a way of determining the level of output at which profit is maximised without using a graph or a ruler. This is by applying the MR = MC rule which we explained earlier. Equilibrium in terms of marginal revenue and marginal cost Any firm maximises its profit (or minimises its losses) where marginal revenue MR is equal to marginal cost MC. Previously we proved that the firm s marginal revenue MR is equal to the market price P of the The profit maximising rule in the case of a perfectly competitive firm can therefore also be stated as P = MC (since MR = P). Recall from the previous section that the marginal cost curve is U-shaped. Using a numerical example we can now explain why profit is maximised when MR (or P, in this case) is equal to MC. Bishops Economics Department Page 6

7 Suppose a firm produces a product which it sells in a perfectly competitive market where the price is R10 per unit. The firm s fixed cost amounts to R5. The firm s daily output, revenue and cost are summarised in Table 12-1 and the MR and MC of the firm are also shown graphically in Figure Bishops Economics Department Page 7

8 Referring to Figure 12-5 Point a - the marginal cost MC of the first unit produced is R4. This is lower than the marginal revenue of R10 (ie the price of the product). The production of the first unit thus adds R6 (ie R10 R4) to the profit of the firm. Point b: the MC of the second unit (R6) < MR of the second unit (R10). The production of the second unit thus adds R4 (ie R10 R6) to the profit of the firm. Point c: production of the third unit costs R8. It can be sold for R10. The firm will therefore add to its profit by producing the third unit. The extra profit will be R2 (ie R10 R8). Point d: for the fourth unit MC = MR (= P) = R10 and the firm therefore makes no further profit. This serves as a signal that the point of maximum profit has been reached. Point e: if the firm produces 5 units of the product, MC (R12) > MR. The firm s profit will thus decline by R2 (ie R10 R12) if a fifth unit of the product is produced. To summarise A firm should expand its production as long as MR > MC up to the point where MR = MC (at which point profit will be maximised) At production beyond that point, MR < MC and the firm s profit will fall. The firm s profit position can be illustrated clearly by adding average cost (AC) to the diagram showing average revenue AR, marginal revenue MR and marginal cost MC. Average cost (AC) = average fixed cost (AFC) + average variable cost (AVC) Profit per unit of output (or average profit) = average cost (AC) - average revenue (AR) When AR > AC the firm is earning an economic profit. When AR = AC the firm only earns a normal profit. The following 3 diagrams show the AR, MR, AC and MC of a firm under perfect competition. In all 3 diagrams, AR and MR = P. The same set of unit cost curves is used throughout, but we show three different market prices, and therefore three different AR and MR curves. Bishops Economics Department Page 8

9 In diagram (a) the market price is P 1, which is equal to the firm s AR and MR. Profit is maximised where MR = MC. This occurs at a quantity of Q 1. At Q 1, AR > AC (which is indicated as C 1 on the vertical axis). The firm thus makes an economic profit (or supernormal profit) per unit of production of P 1 C 1. The firm s total profit is given by the shaded area C 1 P 1 E 1 M, which is equal to the profit per unit of output (P 1 C 1 ) X quantity produced (Q 1 ). Alternatively, the area representing total profit can be obtained by subtracting the firm s total cost (C 1 X Q 1 = 0C 1 MQ 1 ) from its total revenue (P 1 X Q 1 = 0P 1 E 1 Q 1 ). The difference between these two areas is the shaded area C 1 P 1 E 1 M, which represents the firm s total economic profit. In diagram (b) the market price (and therefore also the firm s AR and MR) is P2. It is equal to MC at the point where MC intersects AC (ie at the minimum point of AC). The corresponding level of output is Q2. At that level of output AR is equal to AC (and TR = TC) The firm therefore does not earn an economic profit. It does, however, earn a normal profit, since all its costs, which include normal profit, are fully covered. Bishops Economics Department Page 9

10 In diagram (c) the market price (and therefore also the firm s AR and MR) is equal to P3. MR or price is equal to MC at a quantity of Q3. At Q3 AR < AC. It therefore makes an economic loss per unit of output, (C3 - P3). Total economic loss = P 3 C 3 ME 3. Whether or not the firm should continue production will depend on the level of AR (ie P3) relative to the firm s average variable cost AVC, which is not shown in the figure. (shut-down rule) Bishops Economics Department Page 10

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