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PERFECT COMPETITION

The highest degree of competition possible.

DEFINITION
Economists are able to use their model of a perfect market a s a means of assessing the degree of
competition in real world markets. The set out they conditions necessary for a perfect market and then
contrast these with situations found in the markets for goods and services. The degree competition in
these real markets is based upon the extent to which they approximate to the model of perfect
competition. It is necessary to point out that the competition referred to here is price competition. Firms
are assumed to be engaged in a rivalry for sales which takes the form of underselling competitors.

In a market operating under the conditions of perfect competition, there will be one, and only one,
market price, and this price will be beyond the influence of any one buyer or a seller. The price is set
through market demand and supply.

CHARACTERISTICS
A perfectly competitive market has a number of key characteristics.

- All units of the commodity are homogeneous, that is one unit is exactly like another. If this
happens, then the buyers will have no preference for the good of any particular seller.
- There must be many buyers and many sellers so that the behavior of any one buyer or any one
seller has no influence on the market price. Each individual buyer comprises such a small part of
total supply that any change in their plans will have no influence on the market price.
- Buyers are assumed to have perfect knowledge of market conditions; they know what prices are
being asked for the commodity in every part of the market. Equally sellers are fully aware of the
activities of buyers and other sellers.
- There must be no barriers to the movement of buyers from one seller to another. Since all units
of the commodity are identical, buyers will always approach the seller quoting the lowest price.
- Finally, it is assumed that there are no barriers to entry and exit of firms into the market.

We can now see why, in a perfect market, there will be one and only one market price which is beyond
the control of any one buyer or any one seller. Firms cannot charge different prices because they are
selling identical products, each of them is responsible for a tiny part of the total supply, and buyers are
fully aware of what is happening in the market.

1
THE INDIVIDUAL FIRM UNDER PERFECT COMPETITION
Under the conditions of perfect competition the firm is powerless to exert any influence on price. It sees
the market price as given that is, established by forces beyond this control. For example, in most
countries, the individual farmer has no influence on the prices at which he sells his wheat, or beef, or ilk,
or vegetables. Any changes in the amounts of these things which he brings to the market will have
negligible effects on their prices. The firm under perfect competition is a “price taker”.

The demand curve for the output of the single firm, therefore, must be a horizontal line at the ruling
price; in other words, a perfectly elastic demand curve. No matter how many units the firms sell it
cannot change the price. It can sell it’s entire output at the ruling market price. If it tries to sell at higher
prices its demand will drop zero, and there is obviously no incentive to sell at lower prices. Again we
must guard against a common misunderstanding. The demand curve for the product of the firm will be
perfectly elastic, but the market demand curve for the output of the industry will be of the normal
shape, sloping downwards from left to right.

Price Price

D S

S D

Quantity Quantity

(a) Industry (b) Firm

The graph above shows that, when the industry’s demand and supply curve is in equilibrium, the
individual firm has its demand on the Market price of the industry. This proves that when a firm is in
perfect competition, it has to keep its price same as of the industry’s equilibrium price, because if it does
not do so, then the firm cannot survive and will have to face negatice consequences.

2
PERFECT COMPETITION AND ECONOMIES OF SCALE
A perfectly competitive firm having economies of scale is dependent on the size of the firm relative to
the size of the market.

In most perfectly competitive models, it is assumed that production takes place with constant returns to
scale that means no economies. This means that the unit cost of production remains constant as the
scale of production increases. When that assumption is changed, it can open up the possibility of
positive profits and strategic behavior among firms. Because there are numerous ways to conceive of
strategic interactions between firms, there are also numerous models and results that could be
obtained. To avoid some of these problems, a number of models have been developed which retain
some of the key features of perfect competition while allowing for the presence of economies of scale
as well. Because there are numerous ways to conceive of strategic interactions between firms, there are
also numerous models and results that could be obtained. To avoid some of these problems, a number
of models have been developed which retain some of the key features of perfect competition while
allowing for the presence of economies of scale as well.

LOCAL MARKET HAVING PERFECT COMPETITION


The closest thing to a perfectly competitive market would be a large auction of identical goods with all
potential buyers and sellers present.

By design, a stock exchange resembles this, not as a complete description (for no markets may satisfy all
requirements of the model) but as an approximation. The flaw in considering the stock exchange as an
example of Perfect Competition is the fact that large institutional investors (e.g. investment banks) may
solely influence the market price. This, of course, violates the condition that "no one seller can influence
market price".

Karachi stock exchange, quite a valid example of perfect competition where there are many
stockholders and many buyers that mean many buyers and many sellers; this satisfies the condition of
being a perfectly competitive market. Also, KSE has numerous buyers and seller and none can create
barriers of entry or exit in the stock exchange market.

Another example can be of vegetables and fruit vendors, they are large in number and provide
homogeneous goods. There is a perfect mobility of factors, that is, buyer can easily switch from one
seller to another.

A very noticeable perfect competitive market in Pakistan is of street foods. In every street we can find
kiosks in which the sellers are selling their product, which are also homogeneously available. Any new
entrant can enter this market and there are no barriers or any stoppage for them to enter this market.

3
SHORT RUN PRICE AND OUTPUT FOR THE COMPETITIVE INDUSTRY
AND FIRM
In the short run the equilibrium market price is determined by the interaction between market demand
and market supply. In the diagram shown above, price P1 is the market-clearing price and this price is
then taken by each of the firms. Because the market price is constant for each unit sold, the AR curve
also becomes the Marginal Revenue curve (MR). A firm maximizes profits when marginal revenue =
marginal cost. In the diagram above, the profit-maximizing output is Q1. The firm sells Q1 at price P1.
The area shaded is the economic (supernormal profit) made in the short run because the ruling market
price P1 is greater than average total cost.

price price

MS MC

AC

AR=MR

PROFIT

MD

Industry output firm’s output

Not all firms make supernormal profits in the short run. Their profits depend on the position of their
short run cost curves. Some firms may be experiencing sub-normal profits because their average total
costs exceed the current market price. Other firms may be making normal profits where total revenue
equals total cost (i.e. they are at the break-even output). In the diagram below, the firm shown has high
short run costs such that the ruling market price is below the average total cost curve. At the profit
maximizing level of output, the firm is making an economic loss (or sub-normal profits).

MS MC

AC
LOSS
AR=MR

MD

Industry output firm’s output

4
REALISM OF THE PERFECT COMPETITION MODEL
Perfect competition is not to be found in the real world, although it is possible to point to some markets
where there is some rough approximation to this idea. There are hundreds and thousands of wheat
producers all over the world and not one of them is large enough to influence the price of wheat. There
are any producers and buyers; modern methods of communication make knowledge of market
conditions almost perfect, and the standardized grading of commodities means that the products in any
one grade is regarded as homogeneous.

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