UNIVERSITY OF PETROLEUM AND ENERGY STUDIES DEHRADUN

Economics Project ON Usefulness of Perfect Competition Submitted To

Dr. H. Roy

Submitted By
Ayushi Chowdhry Nilesh Kumar Madhup Gupta Manisha Mehta Kriti Kumar

Acknowledgment
This project would not have been accomplished without the assistance and guidance of University of Petroleum &Energy Studies of which we are the students. It is indeed, the cooperation of college that we have been successful in presenting this project to the reader. We are highly obliged to our teacher Dr. H.Roy for the time he has devoted for our project & help us a lot in every prospect. This work would not have been completed without the blessing of our Parents. I am also grateful to my senior who has assisted me in formulating the structure of this project. I would also like to thanks all my friends to the librarian of college of legal studies who have also helped me in my project. At last but not the least I will thank God without whose help & blessing I would not be able to complete this project.

Perfect Competition Introduction

A perfectly competitive industry is highly unlikely to exist in its entirety given the strong assumptions made about the operation of the market. All markets are competitive to one degree or another, but the vast majority of markets are characterized as imperfectly competitive. We do, though get closer to perfect competition in many markets for agricultural and other primary commodities. These are the only markets where there are enough sellers of products that are near perfect substitutes for each other. Perfect competition is a theoretical market structure. It is primarily used as a benchmark against which other market structures are compared. The industry that best reflects perfect competition in real life is the agricultural industry. In the case of Perfect competition, the firms earn a normal profit i.e. the average cost is equal to the average revenue. This happens because when the sellers are earning high amount of profit new firms are attracted into the market hence making the profit normal. In case the existing firms are facing losses, then many firms leave the market stabilizing the market with normal levels of profit. In the short term, perfectly-competitive markets are not productively efficient as output will not occur where marginal cost is equal to average cost, but allocatively efficient, as output will always occur where marginal cost is equal to marginal revenue, and therefore where marginal cost equals average revenue. In the long term, such markets are both allocatively and productively efficient. Under perfect competition, any profit-maximizing producer faces a market price equal to its marginal cost. This implies that a factor's price equals the factor's marginal revenue product. This allows for derivation of the supply curve on which the neoclassical approach is based. (This is also the reason why "a monopoly does not have a supply curve.") The abandonment of price taking creates considerable difficulties to the demonstration of existence of a general equilibrium except under other, very specific conditions such as that of monopolistic competition.

Main Assumptions of Perfect Competition.

Generally, a perfectly competitive market exists when every participant is a "price taker", and no participant influences the price of the product it buys or sells. Specific characteristics may include:

Each firm produces only a small percentage of total market output. It therefore exercises no control over the market price. For example it cannot restrict output in the hope of forcing up the existing market price. Market supply is the sum of the outputs of each of the firms in the industry

No individual buyer has any control over the market price - there is no monopoly power. The market demand curve is the sum of each individual consumers demand curve essentially buyers are in the background, exerting no influence at all on market price

Buyers and sellers must regard the market price as beyond their control

There is perfect freedom of entry and exit from the industry. Firms face no sunk costs that might impede movement in and out of the market. This important assumption ensures all firms make normal profits in the long run

Firms in the market produce homogeneous products that are perfect substitutes for each other. This leads to each firms being price takers and facing a perfectly elastic demand curve for their product.

Perfect knowledge consumers have perfect information about prices and products.

There are no externalities which lie outside the market

Perfect factor mobility - In the long run factors of production are perfectly mobile allowing free long term adjustments to changing market conditions.

Non-increasing returns to scale - Non-increasing returns to scale ensure that there are sufficient firms in the industry.

Perfect factor mobility - In the long run factors of production are perfectly mobile allowing free long term adjustments to changing market conditions. Zero transaction costs - Buyers and sellers incur no costs in making an exchange (perfect mobility).

PERFECT COMPETITION, CHARACTERISTICS

These four characteristics mean that a given perfectly competitive firm is unable to exert any control whatsoever over the market. The large number of small firms, all producing identical products, means that a large (very, very large) number of perfect substitutes exist for the output produced by any given firm. Large Number of Small Firms.

A perfectly competitive market or industry contains a large number of small firms, each of which is relatively small compared to the overall size of the market. This ensures that no single firm can exert market control over price or quantity. If one firm decides to double its output or stop producing entirely, the market is unaffected. The price does not change and there is no discernible change in the quantity exchanged. How many firms are needed in a perfectly competitive industry, such that each is so small it has absolute no market control? There is no actual number that answers this question. This is due partly to the fact that perfect competition is an idealized market structure that does not exist in the real world. It is also partly due to the notion that the number of firms is not as important as the result... that no firm has market control.

Here are two extreme examples that will help illuminate this notion. Example 1 is Phil's home grown zucchinis. Phil is one among gazillions (a really large number) of people who grow zucchinis in their backyard gardens. Phil has no control over the zucchini market because the total zucchini market contains gazillions of zucchini producers, each producing only a handful of zucchinis. Should Phil decide to produce more zucchinis, fewer zucchinis, or none at all, the zucchini market and especially the zucchini price are unaffected. Zucchini buyers continue buying zucchinis from the remaining gazillions of zucchini producers as if nothing changed. As far as the market is concerned, nothing has changed.

Example 2 is the innovative folks at Quadra DG Computer Works, which produces the Quadra 400 Data RAM Cartridges (a memory storage cartridge used in the Quadra 400 Data RAM Computer Storage System). In this hypothetical economic world, Quadra DG Computer Works is only one of three companies that produce computer storage products. Because it holds a market share of 33 percent, Quadra DG has a substantial degree of market control. Should Quadra DG decide to produce more or fewer Quadra 400 Data RAM Cartridges, or stop producing them altogether, then the computer storage market takes notice. The price and quantity exchanged are likely to change.

Identical Goods.

Each firm in a perfectly competitive market sells an identical product, which is also commonly termed "homogeneous goods." The essential feature of this characteristic is not so much that the goods themselves are exactly, perfectly the same, but that buyers are unable to discern any difference. In particular, buyers cannot tell which firm produces a given product. There are no brand names or distinguishing features that differentiate products by firm. This characteristic means that every perfectly competitive firm produces a good that is a perfect substitute for the output of every other firm in the market. As such, no firm can charge a different price than that received by other firms. If they should try to charge a higher price, then buyers would immediately switch to other goods that are perfect substitutes.

Once again, Phil the zucchini grower offers an example. Phil's zucchinis are no different than Becky's zucchinis, which are no different than Dan's zucchinis, which are no different than Alicia's zucchinis, which are no different than any of the other zucchinis produced by any of the other gazillions of zucchini growers. They look the same. They taste the same. And most important, they satisfy the same zucchini need.

Perfect Resource Mobility.

Perfectly competitive firms are free to enter and exit an industry. They are not restricted by government rules and regulations, start-up cost, or other barriers to entry. While some firms incur high start-up cost or need government permits to enter an industry, this is not the case for perfectly competitive firms. Likewise, a perfectly competitive firm is not prevented from leaving an industry as is the case for government-regulated public utilities. Perfectly competitive firms can acquire whatever labor, capital, and other resources that they need without delay and without restrictions. There is no racial, ethnic, or sexual discrimination.

For example, if Phil wants to leave the zucchini industry and entry the kumquat industry, he can do that without restriction. Likewise if Becky is a kumquat producer who wants to entry the zucchini industry, she can do so without restraint. Phil and Becky are not faced with upfront investment cost nor brand-name recognition that might prevent them from entering a perfectly competitive industry. When they enter an industry they can instantly compete on equal ground with existing firms.

Perfect Knowledge In perfect competition, buyers are completely aware of sellers' prices, such that one firm cannot sell its good at a higher price than other firms. Each seller also has complete information about the prices charged by other sellers so they do not inadvertently charge less than the going market price. Perfect knowledge also extends to technology. All perfectly competitive firms have access to the same production techniques. No firm can produce its output faster, better, or cheaper because of special knowledge of information. Phil, for example, has all of the information needed to grow zucchinis. This is the same information possessed by Becky, Dan, Alicia, and the other gazillions of zucchini producers.

Phil also knows that the going price of zucchinis is 50 cents. All of the Zucchini buyers know that the going price is fifty cents. In contrast, Quadra DG Computer Works has several patents on the production of Quadra 400 Data RAM Cartridges that are not available to its competition (Omni Ram and MegaMem).

Assumptions and Conditions

In neoclassical economics there have been two strands of looking at what perfect competition is. The first emphasis is on the inability of any one agent to affect prices. This is usually justified by the fact that any one firm or consumer is so small relative to the whole market that their presence or absence leaves the equilibrium price very nearly unaffected. This assumption of negligible impact of each agent on the equilibrium price has been formalized by Aumann (1964) by postulating a continuum of infinitesimal agents. The difference between Aumanns approach and that found in undergraduate textbooks is that in the first, agents have the power to choose their own prices but do not individually affect the market price, while in the second it is simply assumed that agents treat prices as parameters. Both approaches lead to the same result. The second view of perfect competition conceives of it in terms of agents taking advantage of and hence, eliminating profitable exchange opportunities. The faster this arbitrage takes place, the more competitive a market. The implication is that the more competitive a market is under this definition, the faster the average market price will adjust so as to equate supply and demand (and also equate price to marginal costs). In this view, "perfect" competition means that this adjustment takes place instantaneously. This is usually modeled via the use of the Walrasian auctioneer (see article for more information). The widespread recourse to the auctioneer tale appears to have favored an interpretation of perfect competition as meaning price taking always, i.e. also at nonequilibrium prices; but this is rejected e.g. by Arrow (1959) or Mas-Colell et al.

Steve Keen notes, following George Stigler, that if firms do not react strategically to one another, the slope of the demand curve that a firm faces is the same as the slope of the market demand curve. Hence, if firms are to produce at a level that equates marginal cost and marginal revenue, the model of perfect competition must include at least an infinite number of firms, each producing an output quantity of zero. As noted above, an influential model of perfect competition in neoclassical economics assumes that the number of buyers and sellers are both of the power of the continuum, that is, infinity even larger than the number of natural numbers. K. Vela Velupillai quotes Maury Osborne as noting the inapplicability of such models to actual economies since money and the commodities sold each have a smallest positive unit. Thus nowadays the dominant intuitive idea of the conditions justifying price taking and thus rendering a market perfectly competitive is an amalgam of several different notions, not all present, nor given equal weight, in all treatments. Besides product homogeneity and absence of collusion, the notion more generally associated with perfect competition is the negligibility of the size of agents, which makes them believe that they can sell as much of the good as they wish at the equilibrium price but nothing at a higher price (in particular, firms are described as each one of them facing a horizontal demand curve). However, also widely accepted as part of the notion of perfectly competitive market are perfect information about price distribution and very quick adjustments (whose joint operation establish the law of one price), to the point sometimes of identifying perfect competition with an essentially instantaneous reaching of equilibrium between supply and demand. Finally, the idea of free entry with free access to technology is also often listed as a characteristic of perfectly competitive markets, probably owing to a difficulty with abandoning completely the older conception of free competition. In recent decades it has been rediscovered that free entry can be a foundation of absence of market power, alternative to negligibility of agents.

Free entry also makes it easier to justify the absence of collusion: any collusion by existing firms can be undermined by entry of new firms. The necessarily long-period nature of the analysis (entry requires time!) also allows a reconciliation of the horizontal demand curve facing each firm according to the theory, with the feeling of businessmen that "contrary to economic theory, sales are by no means unlimited at the current market price" (Arrow 1959 p. 49). Sraffian economists see the assumption of free entry and exit

as characteristic of the theory of free competition in Classical economics, an approach that is not expressed in terms of schedules of supply and demand.

Results

In the short-run, it is possible for an individual firm to make an economic profit. This situation is shown in this diagram, as the price or average revenue, denoted by P, is above the average cost denoted by C.

However, in the long period, economic profit cannot be sustained. The arrival of new firms or expansion of existing firms (if returns to scale are constant) in the market causes the (horizontal) demand curve of each individual firm to shift downward, bringing down at the same time the price, the average revenue and marginal revenue curve. The final outcome is that, in the long run, the firm will make only normal profit (zero economic profit). Its horizontal demand curve will touch its average total cost curve at its lowest point. (Seecost curve.) In a perfectly competitive market, a firm's demand curve is perfectly elastic.

As mentioned above, the perfect competition model, if interpreted as applying also to short-period or very-short-period behaviour, is approximated only by markets of homogeneous products produced and purchased by very many sellers and buyers, usually organized markets for agricultural products or raw materials. In real-world markets, assumptions such as perfect information cannot be verified and are only approximated in organized double-auction markets where most agents wait and observe the behaviour of prices before deciding to exchange (but in the long-period interpretation perfect information is not necessary, the analysis only aims at determining the average around which market prices gravitate, and for gravitation to operate one does not need perfect information). In the absence of externalities and public goods, perfectly competitive equilibria are Pareto-efficient, i.e. no improvement in the utility of a consumer is possible without a worsening of the utility of some other consumer. This is called the First Theorem of Welfare Economics. The basic reason is that no productive factor with a non-zero marginal product is left unutilized, and the units of each factor are so allocated as to yield the same indirect marginal utility in all uses, a basic efficiency condition (if this indirect marginal utility were higher in one use than in other ones, a Pareto improvement could be achieved by transferring a small amount of the factor to the use where it yields a higher marginal utility).

Equilibrium in perfect competition is that point where market demands will equal to market supply. Firm's price will be determined at this point. In short run, equilibrium will be affected from demand. In long run, both demand and supply of product will affect the equilibrium in perfect competition. Firm will receive only normal profit in long run at the equilibrium point

Perfect Competition - the economics of competitive markets Introduction The degree to which a market or industry can be described as competitive depends in part on how many suppliers are seeking the demand of consumers and the ease with which new businesses can enter and exit a particular market in the long run. The spectrum of competition ranges from highly competitive markets where there are many sellers, each of whom has little or no control over the market price - to a situation of pure monopoly where a market or an industry is dominated by one single supplier who enjoys considerable discretion in setting prices, unless subject to some form of direct regulation by the government. In many sectors of the economy markets are best described by the term oligopoly - where a few producers dominate the majority of the market and the industry is highly concentrated. In a duopoly two firms dominate the market although there may be many smaller players in the industry. Competitive markets operate on the basis of a number of assumptions. When these assumptions are dropped - we move into the world of imperfect competition. These assumptions are discussed below Assumptions behind a Perfectly Competitive Market 1. Many suppliers each with an insignificant share of the market this means that each firm is too small relative to the overall market to affect price via a change in its own supply each individual firm is assumed to be a price taker 2. An identical output produced by each firm in other words, the market supplies homogeneous or standardised products that are perfect substitutes for each other. Consumers perceive the products to be identical 3. Consumers have perfect information about the prices all sellers in the market charge so if some firms decide to charge a price higher than the ruling market price, there will be a large substitution effect away from this firm 4. All firms (industry participants and new entrants) are assumed to have equal access to resources (technology, other factor inputs) and improvements in production technologies achieved by one firm can spill-over to all the other suppliers in the market

5. There are assumed to be no barriers to entry & exit of firms in long run which means that the market is open to competition from new suppliers this affects the long run profits made by each firm in the industry. The long run equilibrium for a perfectly competitive market occurs when the marginal firm makes normal profit only in the long term 6. No externalities in production and consumption so that there is no divergence between private and social costs and benefits 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 maximises profits when marginal revenue = marginal cost. In the diagram above, the profitmaximising 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.

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 maximising level of output, the firm is making an economic loss (or sub-normal profits)

The Effects of a change in Market Demand In the diagram below there has been an increase in market demand (ceteris paribus). This causes an increase in market price and quantity traded. The firm's average revenue curve shifts up to AR2 (=MR2) and the profit maximizing output expands to Q2. Notice that the MC curve is the firm's supply curve. Higher prices cause an expansion along the supply curve. Following the increase in demand, total profits have increased. An inward shift in market demand would have the opposite effect. Think also about the effect of a change in market supply - perhaps arising from a cost-reducing technological innovation available to all firms in a competitive market.

We now consider the adjustment process of a perfectly competitive industry towards the long run equilibrium.

The Usefulness
Price There is a lot of competition faced by the firms in a perfect competition. Hence the consumer would prefer the seller who sells at the least price. Thus the consumers benefit in a perfectly competitive market.

Quality Under the system of perfect competition, the general efficiency of production is very high because inefficient producer who fail compete with others, leave the industry. Competition provides the most congenial atmosphere for scientific invention and technological progress. Inventions and innovations leads to economic development.

Wide choices Since every commodity is produced by a large number of producers in case of perfect competition consumers do not feel the scarcity of essential goods. The mobility of the factors of production enables them to get best rewards. Shut-down Point It is of utmost importance to decide whether one should continue business or not when the firm is not in a position to cover the cost. To explain this problem a distinction is made between variable cost and fixed cost. Variable cost is avoidable cost by not producing the goods and services. Fixed cost is unavoidable since it has to be borne in the short-run even if the plant remains closed. A firm has to cover what is avoidable otherwise there is no reason why the entrepreneur should suffer the loss. The principle derived here is that for a firm to operate in the short-run its total revenue (TR) must be equal to its variable cost (TVC) if not, the firm should close down. The shut down point is the one below which the firm would not operate and would start functioning at that point. In the long-run it must be noted that all costs are variable, therefore a firm must cover all the cost and earn normal profit.

Normal profits When there is high amount of profit in the market, new firms are attracted and hence reduce the profit of the existing firms to a normal level. Also, when there is more than normal loss in the market, the existing firms who have suffered losses leave the industry hence stabilizing the market with normal levels of profit. No Entry Barriers Perfect competition is a highly efficient form of market. To ensure efficiency through competition, anyone who wishes to carry on the business must be allowed to do so. Similarly one who feels that he cannot compete and therefore wants to quit must have the freedom to exit.

Bibliography

Microeconomics . ..By V.K Ohri Economics and Economic TheoriesBy Salim Siddiqui Modern Economics By H.L Ahuja