CA Foundation Business Economics Study Material – Perfect Competition

CA Foundation Business Economics Study Material Chapter 4 Price Determination in Different Markets – Perfect Competition

PERFECT COMPETITION

Introduction:

Perfect competition is a market structure where there are large number of firms (seller) which produce and sell homogeneous product. Individual firm produces only a small portion of the total market supply.

Therefore, a single firm cannot affect the price.
– Price is fixed by industry.
– Firm is only a price taker.
– So the price of the commodity is uniform.

Features of perfect competition

Following are the main features of perfect competition:

1. Large number of buyers and sellers:
   • The number of buyers and sellers is so large that none of them can influence the price in the market individually.
   • Price of the commodity is determined by the forces of market demand and market supply.
2. Homogeneous Product:
   • The product produced by all the firms in the industry are homogeneous.
     – They are identical in every respect like colour, size, etc.
     – Products are perfect substitutes of each other.
3. Free entry and exit of the firms from the markets:
   • New firms are free to enter the industry any time.
   • Old firms or loss incurring firms can leave industry any time.
   • The condition of free entry and exit applies only to the long run equilibrium of the industry.
4. Perfect knowledge of the market:
   • Under perfect competition, all firms (sellers) and buyers have perfect knowledge about the market.
   • Both have perfect information about prices at which commodities can be sold and bought.
5. Perfect mobility:
   • The factors of production can move freely from one occupation to another and from one place to another.
6. No transport cost:
   • Transport cost is ignored as all the firms have equal access to the market.
7. No selling cost:
   • Under perfect competition commodities traded are homogeneous and have uniform price.
   • Therefore, firm need not make any expenditure on publicity and advertisement.

Equilibrium of the Industry:

• Industry is a group of firms producing identical commodities.
• Under perfect competition, price of a commodity is determined by the interaction between market demand and market supply of the whole industry.
• The equilibrium price is determined at a point where demand for and supply of the whole industry are equal to each other.
• No individual firm can influence the price.
• Firm has to accept the price determined by the industry.
• Therefore, the firm is said to be price taker and industry, the price maker.

Equilibrium of the industry is illustrated as follows:

The above table and fig. shows that at a price of ₹ 6 per unit, the quantity demanded equals quantity supplied.
The industry is at equilibrium at point ‘E’, where the equilibrium price is ₹ 6 and equilibrium | quantity is 60 units.

Equilibrium of a firm:

• We have already seen that under the perfect competition, the price of the commodity is determined by the forces of market demand and market supply le. price is determined by industry.
• Individual firm has to accept the price determined by the industry. Hence, firm is a PRICE TAKER.

• In the table – the equilibrium price for the industry has been fixed at ₹ 6 per unit through the inter-action of market demand and supply.
• Table – shows that the firm has no choice but to accept and sell their commodity at a price that has been determined by the industry ie. ₹ 6 per unit.
• The firm cannot charge higher price than the market price of ₹ 6 per unit because of fear of loosing customers to rival firms.
• There is no incentive for the firm to lower the price also.
• Firm will try to sell as much as it can at the price of ₹ 6 per unit.
• Table – shows that firm’s AR = MR = Price.

• Fig. shows that being a price taker firm, it has to sell at a given price i.e. ₹ 6 per unit.
• Therefore, firm’s demand curve is a horizontal straight line parallel to X-axis i.e. a perfectly elastic demand curve.
• We know that price of a commodity is also the AR for the firm.
• Therefore, demand curve also shows the AR for different quantities sold by the firm.
• As every additional unit is sold at a given price i.e. ₹ 6 per unit, the MR = AR and the two curves coincides.
• Thus, in a perfectly competitive market a firm’s AR = MR = Price = Demand Curve

Conditions for equilibrium of a firm:

• In perfect competition, the firms are price takers and output adjusters.
• This is because the price of the commodity is determined by the forces of market demand and market supply ie. by whole industry and individual firm has to accept it.
• Therefore firm has to simply choose that level of output which yields maximum profit at the prevailing prices.
• The firm is at equilibrium when it maximises its profit.
• The output which helps the firm to maximise its profit is called equilibrium output.
• There are two conditions for the equilibrium of a firm. They are —
  1. Marginal Revenue should be equal to the marginal cost i.e. MR = MC. (First order condition)
  2. Firm’s marginal cost curve should cut its marginal revenue curve from below i.e. marginal cost curve should have positive slope at the point of equilibrium. (Second order condition)
• If MR > MC, there is incentive to produce more and add to profits.
• If MR < MC, the firm will have to decrease the output as cost of production of additional units is high.
• When MR = MC, it is equilibrium output which maximises the profits.

• Fig. shows that OP is the price determined the industry and firm has to accept it.
• At prevailing price OP the firm faces horizontal demand curve or average revenue curve.
• Since the firm sells every additional unit at the same price, marginal revenue curve coincides with average revenue curve.
• In the fig. at point ‘A’, MR = MC but second condition is not fulfilled.
• Therefore, OQ₁ is not equilibrium output. Firm should expand output beyond OQ₁ because
  – it will result in the fall of marginal cost, and
  – add to firm’s profits.
• In the fig. at point ‘B’ not only
  MR = MC
  but MC curve cuts the MR curve from below Le. it has positive slope.
• Therefore, OQ₂ is the equilibrium level of output and point ‘B’ represents equilibrium of firm.

Supply curve of the firm in a competitive market

In a perfectly competitive industry, the MC curve of the firm is also its supply curve. This can be explained with the help of following figure.

• The fig. shows that at the market price OP₁ the firm faces demand curve D,.
• At OP₁ price the firm supplies OQ₁ quantity because here MC=MR.
• If the price rises to OP₂ the firm faces demand curve D₂.
• At OP₂ price the firm supplies OQ₂ quantity.
• Similarly at OP₃ and OP₄ price corresponding supplies are OQ₃ and OQ₄ respectively.
• Thus, the firm’s marginal cost curve indicates the quantities of output which it will supply at different prices.
• It can be observed that the competitive firm’s short run supply curve is identical only with that portion of MC curve, which lies above the AVC.
• Hence, price ≥ AVC.

Short Run Equilibrium of a Competitive Firm. (Price – Output Equilibrium)

A competitive firm in the short run attains equilibrium at a level of output which satisfies the following two conditions:

1. MC = MR, and
2. MC curve cuts the MR curve from below.

When a competitive firm, is in short run equilibrium, it may find itself in any of the following situations —

1. it break evens i.e. earn NORMAL PROFITS where Average Revenue = Average Cost i.e. AR = AC.
2. it earns profit i.e. earn SUPER NORMAL PROFITS where Average Revenue > Average Cost i.e. AR > AC.
3. it suffer LOSSES where Average Revenue < Average Cost i.e. AR < AC.

Normal Profits (AR = AC):
A firm would earn normal profits if at the equilibrium output AR=AC.

Super Normal Profits (AR > AC):
A firm would earn super normal profits if at the equilibrium output AR > AC.

Losses (AR < AC):
A firm suffer losses, if at the equilibrium level of output, its AR < AC.

• When the firm incur losses, a question arises whether it should continue to produce or should it shut down ?
• The answer to this lies in the cost structure of the firm.
• Total cost of a firm = Total Fixed Costs + Total Variable Costs
• Fixed costs once incurred cannot be recovered even if the firm shuts down.
• Therefore, whether to shut down or not depends on variable costs alone.
• If AR (Price) > AVC or AR = AVC, the firm can continue to produce even though it suffer losses at the equilibrium level of output.
• If AR (Price) < AVC, the firm should shut down.

Long run Equilibrium of a Competitive Firm

• In a perfectly competitive market there is no restriction on the entry or exit of firms.
• Therefore, if existing firms are earning super normal profits in the short run, they will attract new firms to enter the industry.
• As a result of this, the supply of the commodity increases. This brings down the price per unit.
• On the other hand, the demand for factors of productions rises which pushes up their prices and so the cost of production rises.
• Thus, the price line or AR curve will go down and cost curves will go up.
• As a result of this, price line or AR curve becomes tangent to long run average cost curve. This wipes out super normal profit.
• Hence, in long run firms earn only normal profits.

• Fig. Shows that long run LMR = LMC = LAC = LAR = Price
• The firm is at equilibrium at point E₁
• E₁ is the minimum point of LAC curve. Thus firm produces equilibrium output OQ₁ at the minimum or optimum cost.
• In the long run under competitive market —
  – Firms earn just normal profits, and
  – competitive firms are of optimum size because they produce at optimum cost Le. at the lowest point of long run average cost curve.