By Sumit Kumar Suman, CNLU
Pure competition is a market situation where there is a large number of independent sellers offering identical products. It means it is a term for an industry where competition is stagnant and relatively non-competitive. Companies within the pure competition category have little control of price or distribution of products. Pure competition is said to exist in a market where-
- There are a large number of buyer and sellers;
- Products are homogenous; and
- There is freedom of entry and exists of buyer and sellers.
In the sense of perfect competition is not only pure but also free from other perfection. It is a broader concept of pure competition. The essentials feature of pure competition is the absence of any monopoly element.
In the word of Chamberlin, pure competition means “competition unalloyed with monopoly elements,” whereas perfect competition involves “perfection in many other respects than the absence of monopoly”. It is possible to come across pure competition in real life but not perfect competition. Structure influences conduct which, in turn, affects performance.
Pure competition is a market situation where there is a large number of independent sellers offering identical products. It means it is a term for an industry where competition is stagnant and relatively non-competitive. Companies within the pure competition category have little control of price or distribution of products.
Pure competition involves-
- Very large number
- Standardized product
- Price Takers
- Free entry and exit
A very large number– a very large number of independently acting sellers, e.g., farm product, stock market, foreign exchange market.
Standardized product- Identical and homogeneous product. As long as the price is the same, the consumers will be indifferent about which seller they buy the product from
Price taker- Individual firm exert no significant control over the market price. Each firm’s quantity is too small to affect the market supply or price.
Competitive are price takers, they cannot affect the price, but adjust to it.
None of the sellers can ask for a higher price.
None will sell at a lower price.
Free entry and free exit- New firms can freely enter and existing firms can freely leave the market. No significant, technological, financial, or other obstacles prohibit new firms from selling their output in the market.
The purely competitive markets are used as the benchmark to evaluate market performance. It is generally believed that market structure influences the behavior and performance of agents with in the market. Structure influences conduct which, in turn, affects performance.
Pure competition and Monopoly are at each end of the spectrum of markets. In fact probably neither occur in market economies. Pure competition and monopoly are the boundaries and the “real world” (wherever that is) lies somewhere between the two extremes. Pure competition provides the benchmark that can be use to evaluate markets. The physician who attends you knows that 98.6o is a benchmark.
Your temperature may not be precisely 98.6o, but if it deviates significantly, that deviation suggests problems. It might be in your best interests to know what the “normal” temperature is and the cause of the deviation from “normal.”
There are three characteristics of pure competition:
Large number of buyers and sellers:
There are a large number of buyers and sellers and no one can influence the price of the commodity. A firm produces a small part of the total market output and as such a change in its output will not affect the market supply much. The price is determined by the industry as a whole. Therefore, a firm is a price taker rather than the price maker.
The products of all firms in the industries are homogenous. The buyers are unconcerned about the source of the product; no single seller’s product is preferred to that of any other seller. Similarly, sellers also do not care to whom they sell and no preferences among the buyers exist in the market.
Homogeneity of the product refers to the “physical characteristics” of the product, such as colour size, etc. and to the “environmental factors”, such as the location of the celler, credit facilities, etc. The products are therefore indistinguishable from one another or are perfect substitutes for one another. This implies that the firm can sell any amount of the product at the prevailing price only.
Free entry and exit from industry:
The new firms are free to enter the industry and the existing firms are free to leave the industry. There are no restrictions as such on the entry and exit on the firms. When the existing firms make excess profits in the short run, other firms are attracted by it and enter the industry. On the other hand, when the existing firms incur losses in the short run, some firms would leave the industry. This ensures that the firms earn only normal profits in the long run and as a result, there will not be any tendency for the firms to enter or leave the industry.
The firm in the pure competition:
A purely competitive market is characterized by a large number of relatively small firms. No single firm can influence the market price and are considered price takers. When the equilibrium price in the market falls, the equilibrium quantity will rise. Since the market price has fallen, the demand, AR and MR functions faced by the firm will fall to D*, AR* and MR*. Note that a decrease in market supply will shift the firm’s demand function up. An increase (decrease) in market demand would shift the firm’s demand up (down).
Changes in the conditions in the market alter the price. These changes in price provide information to the firms who then react to those changes.
Profit maximizing in the short run:
If the firm’s objective is to maximize profits (Π), they must maximize the difference between total revenue (TR) and total cost (TC). Π = TR –TC. It is possible to identify the output level that will maximize profits for the firm if the MR and MC functions are known. Where MR = MC, profits will be maximized (or losses minimized).
Before we consider these problems there are several points to reconsider.
- A normal profit is included as a cost of production just as wages, interest, rent and materials costs are expenses.
- The objective of the firm is to maximize profits (not revenue).
- MC is the change in TC (or VC) caused by a change in output.
MC = ΔTC/ΔQ = ΔVC/ ΔQ
AC is the total cost per unit. It is calculated by dividing TC by Q. AC tends to fall and then rise as output increases. When MC is less than AC, AC is decreasing. When MC is greater than AC, AC will be increasing. When MC equals AC, AC will be a minimum. AC=TC/Q
AVC is the variable cost per unit. It is calculated by dividing VC by Q. AVC tends to fall and then rise as output increases. When MC is less than AVC, AVC is decreasing. When MC is greater than AVC, AVC will be increasing. When MC equals AVC, AVC will be a minimum.
AVC = VC/Q
- The vertical distance between AC and AVC is the AFC. (AFC = AC-AVC) AFC will tend to decrease as long as output (Q) increases.
- Demand faced by a purely competitive firm is perfectly elastic (horizontal, straight line) at the market price.
- The AR is the same as the demand function.
- MR falls at twice the rate of AR. Since AR has a slope of 0 in a purely competitive market, MR and AR are the same in a purely competitive market.
- MR = price in a purely competitive market.
- A firm will offer additional units for sale so long as the price they obtain is greater than the opportunity cost (MC) of producing the units.
The behavior of the firm in the short run can be shown using total values (TR and TC) or unit values (MR, MC and AC).
Short run profits using TR and TC
Maximum profits will occur at the output level where there is the greatest vertical distance between TR and TC, when TR>TC. Since TR is a linear function this implies that the price for all quantities are the same, the firm is in a purely competitive market (the demand is perfectly elastic at the market price.). MR is defined as the change in TR associated with a change in Q. MR is the slope of TR, so MR is the price.
The TC intercept is at W, which is the fixed cost and shows that this is a graph depicting a short run condition. The TC function increases at a decreasing rate that implies that MC is falling and MP of the variable input is rising. Beyond the inflection point in the TC, TC increases at an increasing rate. The model shows “break-even” points (A and C) at output level QA and QC. At these breakeven point, the firm is earning a normal profit. (Remember normal profits are included in the cost functions.) Between output levels QA and QC, the TR>TC. This means that economic profits (Π) exist.
Maximum Π occurs at output level QB., the greatest vertical distance between TR and TC. Note that at point A (producing QA) the firm obtains a normal profit. If they produce and additional unit the MC (slope of TC at point A) is less than the slope of the TR (MR), i.e. they can produce additional units for less than someone is willing to pay for them. At output level QB, the slope of the TC (MC) isequal to the slope of the TR (MR). If they attempt to increase output above QB, the cost of additional units (shown by the slope of the TC) increases faster the increase in TR (shown by the slope to TR). Where the slope of the TC (MC) is the same as the slope of the TR (MR), profits (the vertical distance between TR and TC) are maximized.
Short Run Profits using Unit Cost and Revenue
The process of determining the output level that maximizes profits in the short run can also be made by an analysis of the unit cost and revenue functions. MC and MR determine whether to produce a given output of not. If the cost of and additional unit (MC) is less than the revenue obtained from that same additional unit (MR), producing the additional units will add to profits (or reduce losses). If the cost of additional units of output (MC) cost more than they add to revenue (MR), the firm should not produce the additional units. The rules for profit maximization are simple:
- MR >MC, produce it!
- MR < MC, don’t produce it!
- When MR = MC, you are earning maximum profits!
The firm will produce units so long as the market price (P, which is equal to MR when Demand is perfectly elastic.) is greater than the cost of producing the additional unit (MC). If MC is greater than the price (or MR) the firm will not produce. All possible profits are captured where MR = MC. This is shown as point H at output level QH in Figure VII.5. At output level QH, where MR = MC, profits are a maximum and can be shown as the area CMMHP (the area in yellow). Total revenue (TR) is area 0QHHP.
TR is calculated by price multiplied by quantity, in this model, P*QH is the area 0QHHP. Total cost (TC) is area 0QHMCM (the product of the AC and quantity, which is CM*QH.
Loss Minimization and Shutdown in the Short run
In the short run, the maximum the firm must loose is its fixed cost. If the firm can recover all its variable cost it may as well operate unless it sees no hope of improvement in the future. In Figure VII.5 the firm is earning above normal profits by producing at QH output. If the price were to fall to CB (which is consistent with the minimum of the AC function) the firm would earn normal profits. (Remember that normal profits are included in the cost functions as an opportunity cost for the entrepreneur.)
If the price falls below CB, the firm will lose money, i.e. will earn less than normal profits. So long as the price is above CC, the firm is recovering all the variable cost and a little more to offset the fixed cost that it would have lost if the firm would have shutdown. At a price of CC, the firm is recovering all its variable cost and losing its fixed cost (which it would have done anyway if it had closed down.). Therefore, so long as the firm can recover all its variable costs at a price of CC, it may as well operate in the short run. Point C, at a price of CC and output of QC is called the shutdown point. It will always be at the point where the MC intersects the AVC (the minimum of the AVC).
In the long run, all costs are variable, therefore the shut down point inthe long run is the minimum of the LRAC where MC= LRAC. There may be other reasons for operating a production facility. In some cases, individuals may operate at less than normal profits because the get non-monetary benefits from being in a particular line of work or being “their own boss.” A government may encourage firms that produce particular products to operate for reasons of national defense or national pride. In these cases, public policy may be used to subsidize the firms that would find it necessary to shut down in a free market economy.
Profits in the Long Run Pure Competition
In the long run, producers are able to alter their scale of plant. The LRAC or envelope curve was constructed from a series of short run periods with different plant sizes. In the long run, the firm is essentially able to select the scale of the plant (or a specific set short run production and cost functions associated with a specific fixed (in the short run) input). This is essentially the meaning of “relative ease of exit and entry from the market. Another crucial aspect of long run pure competition is that the demand faced by the firm is perfectly elastic at the market price.
The AR and MR functions coincide with the firm’s demand function. Because the firm’s demand function is perfectly elastic, they cannot raise their price above the market price. If they do, their sales will fall to 0. There is no reason to lower their price below the market price because they can sell all they want to a market price. The firms in pure competition have no “market power.” Market power, in micro economics, refers to the ability of an agent to raise the price and not have their sales fall to 0. A quick review of price elasticity suggests that market power is influenced by a firm’s demand function. Purely competitive firms are price takers. These firms have no incentive to advertise. The largest producer in a purely competitive market can sell all they can produce or none at all and the market price will be unaltered. The process of long run equilibrium in pure competition can be shown in Figure VII.6. You may remember part of Figure VII.6 as Figure VII.3. Both the market and an individual firm’s demand and cost (supply) functions are shown.
In Figure VII.6, it is apparent that a market price below P* would result in the firm’s AC exceeding the AR at all levels. If this were the case firms would earn less than normal profits and would have an incentive to leave the market. As firms leave the market, the market supply decreases (shifts to the left) and the market price would rise. There are two important features in pure competition.
First, each firm is a price taker and has no market power. The demand function faced by the firm is perfectly elastic at the equilibrium price established in the market. This is because the output of the purely competitive firms is homogeneous and there are a large number of sellers, none of whom can influence the market price. Secondly, entry and exit from the market is relatively free. Above normal profits attract new producer/seller that increases the market supply driving the market price down.
If profits are below normal, firms exit the market. This reduces the market supply and drives the price up. Long run equilibrium in a purely competitive market is established when the D (AR and MR) is just tangent to the long run average cost function (LRAC). This will be at the minimum of the LRAC where its slope is 0 (the demand function faced by the firm has a slope of 0). Firm earn normal profits at this point and there is no incentive to enter or leave the market. There is no incentive to alter plant size or change the output level. At the point of the long run equilibrium in Figure VII.6 at point C, the following conditions will exist:
- AR = AC; Firms earn a normal profit. There is no incentive for firms to enter or leave the market.
- LRMC = LRAC; the firm is operating with the plant size that results in the lowest cost per unit, i.e. the fewest resources per unit of output are used.
- MR =LRMC; the firm has no incentive to alter output or plant size.
- P = MR =MC; the price reflects the marginal value of the good to the buyers and the marginal cost to the producer/seller. Long run equilibrium in pure competition results in an optimal allocation of resources. The price reflects the marginal benefits of the buyers and the marginal cost of production. The user of the last unit of the good places a value (the price they are willing and able to pay) on the good equal to the cost of producing that unit of the good. Units of the good between 0 and the equilibrium quantity have a greater value than the cost of production. The purely competitive model provides a benchmark or criteria to evaluate the performance of a market; MB = P = MC. The marginal benefit (MB) to the buyer is suggested by the price they are willing and able to pay. The MB to the seller is the marginal revenue (MR) they earn. The marginal cost (MC) reflects the opportunity cost to society.
Perfect competition is a form of market in which there are a large number of buyers and sellers competing with each other in the purchase and sale of goods, respectively and no individual buyer or seller has any influence over the price. Thus perfect competition is an ideal form of market structure in which there is the greatest degree of competition. A perfectly competitive market is one in which economic forces operate unimpeded.
Perfect competition is a theoretical extreme some markets may approach it but none really obtain it. Economists use the perfectly competitive market model to evaluate the efficiency of actual markets with perfect competition as the standard, applied economists measure how actual markets and economies with missing markets allocate resources to develop policies and programs to improve resource allocation efficiency.
A perfectly competitive market is one in which economic forces operate unimpeded. Perfect competition with reference to economics allows for the best allocation of resources to maximize efficiency. In perfect competition, all the producers are price takers. No single producer can set prices; instead, each of them has to accept the lowest prevailing market price and adjust their operations to reduce costs as much as possible to be able to make profits.
1. There are a large number of independent, relatively small sellers and buyers as compared to the market as a whole. That is why none of them is capable of influencing the market price. Further, buyers/sellers should not have any kind of association or union to arrive at an understanding with regard to market Demand/price or sales.
2. The products sold by different sellers are homogenous and identical. There should not be any differentiation of products by sellers by way of quality, variety, colour, design, packaging or other selling conditions of the product. That is, from the point of view of buyers, the products of competing sellers are completely substitutable.
3. There is absolutely no restriction on entry of new firms into the industry and the existing firms are free to leave the industry. This ensures that even in the long run the number of firms would continue to remain large and the relative share of each firm would continue to remain insignificant.
4. Both buyers and sellers in the market have perfect knowledge about the conditions in which they are operating. Buyers know the prices being charged by different competing sellers and sellers know the prices that different buyers are offering.
5. The distance between the location of competing sellers is not significant and therefore the price of the product is not affected by the cost of transportation of goods. Buyers do not have to incur noticeable transport costs if they want to switch over from one seller to another.
6. There is a perfect mobility of resources. It means perfect mobility of resources ensures that the factors of production, i.e., the resources, can enter or exit a firm or the industry at will. No one is in a position to control the supply of any of the resources and resources are employed where they have the highest returns on them.
So, we can say that there must be fulfilled these following conditions for a perfect competition market:
- Both buyers and sellers are price takers;
- The number of firm is large;
- There are no barriers to entry;
- The firm’s products are identically;
- There is a complete information;
- Firms are profit maximizers.
Both buyers and sellers are price takers: A price taker is a firm or individual who takes the market price as given. In most markets, households are price takers – they accept the price offered in stores.
-The retailer is not perfectly competitive.
-A retail store is not a price taker but a price maker
- The number of the firms is large: Large means that what one firm does has no bearing on what other firms do. Any one firm’s output is minuscule when compared with the total market.
- There are no barriers to entry: Barriers to entry are social, political, or economic impediments that prevent other firms from entering the market.
-Barriers sometimes take the form of patents granted to produce a certain good.
-Social forces such as bankers only lending to certain people may create barriers.
- The firm’s product are identical: This requirement means that each firm’s output is indistinguishable from any competitor’s product.
- There is a complete information: Firms and consumers know all there is to know about the market – prices, products, and available technology. Any technological breakthrough would be instantly known to all in the market.
- Firms are profit maximizers: The goal of all firms in a perfectly competitive market is profit and only profit. The only compensation firm owners receive is profit, not salaries
Profit maximizing output in the short run:
Under perfect competition, since an individual firm cannot influence the market price by raising or lowering its output, the firm faces a horizontal demand curve, that is, the demand curve of any single firm is perfectly elastic – its elasticity is equal to infinity at all levels of output. If a firm charges a price slightly higher than the prevailing market price, demand for that firm will fall to zero because there are many other sellers selling exactly the same product. On the other hand, if a firm reduces its price slightly, its demand will increase to infinity and thus other firms will match the low price. A firm under perfect competition is a price-taker and not a price-maker. Because an individual firm’s demand or Average Revenue (AR) curve is horizontal under perfect competition, the Marginal Revenue (MR) curve of the firm is also horizontal and coincides with the AR curve. In other words, AR and MR are constant and equal at all levels of output. You should satisfy yourself that if the price (i.e. average revenue) is constant, marginal revenue will be equal to price.2 The
price-output determination and equilibrium of the firm under perfect competition may be explained through a numerical example. Suppose the demand and supply conditions of a product are represented by the following equations:
Aggregate Demand: Q = 25 – 0.5 P
Aggregate Supply: Q = 10 + 1.0 P
The equilibrium price would be at a point where aggregate demand equals aggregate supply:
25 – 0.5 P = 10 + 1.0 P or P = 10
Industry output at P = 10 is obtained by substituting this price into either the demand or supply function:
Q = 10 + 1.0 (10) = 20
Therefore equilibrium price, P = 10 and equilibrium output, Q = 20.
Figure 12.1 shows that when the market price is at P1, demand and marginal revenue facing the firm are D1 and MR1. The optimal output for the firm to 5 produce is at point A, where Marginal Cost (MC) = P1, and the firm will produce Q1 units of output. At Q1 level of output, the Average Total Cost (ATC) is less than the price and the firm makes an economic profit. Suppose the market price falls to P2, price equals MC at point C. Because at this level of output (Q2) average total cost is greater than price, total cost is greater than total revenue, and the firm suffers losses. The amount of loss is the loss per unit (CR) times the number of units produced (Q2).
At price level P2, demand is D2 = MR2, there is no way that the firm can earn a profit. This is because at every output level average total cost exceeds price (ATC > P). The firm will continue to produce only if it loses less by producing than by closing its operations entirely. When the firm produced zero output, total revenue would also be zero and the total cost would be the total fixed cost. The loss would thus be equal to total fixed cost. If the firm produces at MC = MR2 (point C), total revenue is greater than total variable cost, because P2 > AVC at Q2 units of output. The firm will be in a position to cover all its variable costs and still has CD times the number of units produced (Q2) left over to pay part of its fixed cost. This way the firm suffers a smaller loss when it continues production than it shut down its operations.
At market price P3, demand is given by D3 = MR3. The equilibrium output Q3 would be at T where MC = P3. At this output level, since the average variable cost of production exceeds price, the firm not only loses all its fixed costs but would also lose Rs. ST per unit on its variable costs as well. The firm could improve its earnings situation by producing zero output and losing only fixed costs. In other words, when price is below average variable cost at every level of output, the short-run loss-minimizing output is zero. To reiterate, the profit maximising output for a perfectly competitive firm in the short run is to set P = MC. Since P = MR, this is equivalent to setting MR = MC. In the short run, as the above discussion shows, it is possible for the firm to make above normal or economic profit. On the other hand, it is also possible for the firm to make losses, as long as those losses are less than its total fixed costs. In other words, the firm will continue to produce as long as P>AVC in the short run, because this is a better strategy than shutting down. The firm will shut down only if P< AVC.
Profit maximizing output in the long run:
Now let us analyze the profit maximising output decision by perfectly competitive firms in the long run when all inputs and therefore costs are variable. In the long run, a manager can choose to employ any plant size required to produce the efficient level of output that will maximise profit. The plant size or scale of operation is fixed in the short run but in the long run it can be altered to suit the economic conditions. In the long run, the firm attempts to maximise profits in the same manner as in the hot run, except that there are no fixed costs. All costs are variable in the long run.
Here again the firm takes the market price as given and this market price is the firm’s marginal revenue. The firm would increase output as long as the marginal revenue from each additional unit is greater than the marginal cost of that unit. It would decrease output when marginal cost exceeds marginal revenue. This way the firm maximizes profit by equating marginal cost and marginal revenue.
PURE AND PERFECT COMPETITION: COMPARISON
Perfect Competition vs. Pure Competition
Recently, economists have started distinguishing between perfect competition and pure competition. For pure competition all the above-mentioned conditions of perfect competition need not be satisfied; it is enough if the first two conditions are fulfilled, i.e., there is a large number of buyers and sellers in the market and all producers produce an identical or homogeneous product.
The significance or implication of these two conditions taken together is, as explained earlier, that since each individual producer produces only an insignificant proportion of the total market supply of the commodity in question and since the product produced by all producers is identical, no individual producer is in a position to influence the market price of that commodity by his own individual action.
In other words, the AR (average revenue) curve of a producer under pure competition is horizontal straight line parallel to the axis of X. As against this, the essence of monopoly consists in the ability of the monopolist to influence the price of his own commodity (talking in terms of curves, the AR curve of a monopolist always slopes downwards to the right). Thus, we find that the chief characteristic or feature of the pure competition is the absence of monopoly element.
Perfect competition, on the other hand, is a wider concept and requires the fulfillment of several additional conditions (as explained above). The mere absence of monopoly element is not enough for perfect competition, whereas that is sufficient for pure competition. Thus, perfect competition is more restrictive than pure competition, so that while we do come across some cases of pure competition in real life, perfect competition is utterly unrealistic.
Examples of pure competition are to be found in the case of farm products like wheat, cotton, rice, etc. In their case, there is a large number of producers, each producing an insignificant proportion of the total market supply, and besides there is nothing much to choose between the wheat produced by farmer A and the wheat produced by* farmer B. In all these cases, the first two conditions of perfect competition which suffice for pure competition are satisfied, but we cannot indeed think of a commodity which has no cost of transport or the factors of production engaged in whose production may be, perfectly mobile or in the case of which there may be perfect knowledge among its buyers and sellers.
The main difference between pure competition and perfect competition is that in pure competition there is no element of monopoly enabling a producer to charge more. If the two conditions of pure competition are fulfilled, there can be no question of monopolistic control. In perfect competition, apart from the absence of monopoly, some other conditions are also essential, e.g., free entry and exit, the absence of transport cost, perfect knowledge.
Economics is best described as the study of humans behaving in response to having only limited resources to fulfill unlimited wants and needs.
Pure or perfect competition is rare in the real world, but the model is important because it helps analyze industries with characteristics similar to pure competition. This model provides a context in which to apply revenue and cost concepts developed in the previous lecture. Examples of this model are the stock market and agricultural industries. Perfect competition in the long run and short run.
Market economies are assumed to have many buyers and sellers, high competition and many substitutes. Monopolies characterize industries in which the supplier determines prices and high barriers prevent any competitors from entering the market. Oligopolies are industries with a few interdependent companies. Perfect competition represents an economy with many businesses competing with one another for consumer interest and profits.
Last formatted on February 20th, 2019.