Perfect Competition

Perfect competition suggests that perfect or best use of resources are being made by firms in markets where they face many competing firms. Competition between firms encourages them to make good use of the scarce resources, because in order to make profits, these firms must produce products that give the best value for money for consumers. Among all the types of market structures, the greatest competition between firms in a market is found in situations of perfect competition.

Characteristics of perfect competition

1. Homogenous products
All firms produce the same product which can also be called as a homogenous product.

2. Price takers
There are a very large number of buyers and sellers in the market, none of whom can buy or sell enough to be able to influence the price. Therefore each buyer or seller must accept the prevailing market price, they are known as price takers.

3. Perfect information
In perfect competition, buyers have perfect information about the prices and the products on sale, while all the sellers have perfect knowledge about the latest production techniques. Therefore, if a seller charges any price which is higher than the market price, people will stop buying from that seller.

4. Freedom of entry and exit
Firms can freely enter and exit the industry if they wish. That means there are no barriers to entry and exit.

There are only a few industries in the world which approximate to this model. However the foreign exchange market is a close approximation. There are a large number of foreign exchange dealers supplying the market, none of whom is large enough to influence the exchange rate. It is relatively easy to establish a bureau-de-change and thus enter the industry, and equally easy to leave. A foreign exchange dealer will know the market determined exchange rate. Currencies are homogenous — US dollars are indistinguishable from other US dollars sold by another bureau-de-change.

Demand and revenue

The model of perfect competition assumes that there are a large number of suppliers in the market. A firm in perfect competition can expand output or reduce output without influencing price. In other words a bureau-de-change cannot put up the exchange rate for US dollars and expect to sell anything. It may decide to lower the exchange rate, but there is no gain by doing this, as the foreign exchange dealer may sell all his output at the original higher price.

The demand curve for the foreign exchange dealer is horizontal, in other words perfectly elastic.

The perfectly competitive firm’s demand curve

The perfectly competitive firm’s demand curve

The horizontal demand curve as depicted in the above figure, is also the firm’s average and marginal revenue curves. If a firm sells all its output at the market price, then this price must be the average price or revenue. In addition if a firm sells an extra ie marginal unit, it will receive the same price for each additional unit as it did for each preceding unit sold, and therefore marginal revenue will be the same as average revenue.
Total Revenue = Price x Quantity therefore

Average Revenue = Total Revenue / Quantity     or    Price x Quantity / Quantity

Quantity cancels each other     Price x Quantity / Quantity

Therefore AR = Price

Cost and supply curves

In the perfectly competitive market, the supply curve of the firm is the marginal cost curve above the average variable cost in the short run and the average total cost in the long run.

The marginal cost of production ie the change in total cost resulting from the sale of one more unit, represents the lowest price a firm would be prepared to supply an extra unit of output for.

If the price of a good was £8, and the marginal cost £5, then the firm would produce the good and gain £3 super normal profit. If the price was £5 and marginal cost £5, then the firm would still produce the product, as the revenue gained will contain an element of normal profit. If the price fell to £4, and marginal cost remained at £5, then the firm would make a loss of £1 per unit. The firm would not supply the good in this case.

In the short run a firm will not necessarily shut down if it is making a loss. It will remain open as long as it covers the average variable cost. The firm will only stop supplying if average revenue or price is less than average variable cost.

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