Implication of Perfect Competition

Implication of Perfect Comp.                                              

FEATURES OF PERFECT COMPETITION

Introduction

Perfect competition is a state of a market. Anything which facilitates contact between buyers

and sellers constitutes a market. It may be a face to face meeting at some place or simply verbal

negotiations through telephone, internet, etc.

Conventionally, in microeconmoics the markets are classified into these states: perfect

competiton, monopoly, monopolistic competition and oligopoly. There are many criteria of

classification, the number of sellers, similarity of products, availability of information, mobility of firms

and the inputs engaged in the firm, etc. Whatever the criteria the end result is reflected in one thing :

how much influence an individual seller, on his own, is able to exercise on the market. Lower the

influence more the competitive nature of the market it indicates. If the influence of an individual seller

is zero, or virtually zero, the market is said to be perfectly competitive.

Meaning

Perfect competition can be defined either in terms of its characteristic features, or in terms of

the unique end result of these characteristics. Unique in the sense that it is specific to a perfectly

competitive market. In terms of its features, a perfectly competitive is a market where there are

large number of buyers and sellers, the firms produce homogeneous products, the buyers and sellers

have perfect knowledge and the firm are free to entry or make an exit in and out of industry. In terms

of the end result of these features which is unique to this market, a perfectly competitive market is

one in which an individual firm cannot influence the prevailing market price of the product on its own.

Features and their implications

A perfectly competitive market has the following features:

1. Large number of sellers and buyers

Note that 'large number' is not a specifically defined number. However, it has a specific implication.

Let us talk about the large number of sellers first. The words 'large number' imply that the number

of sellers is large enough to render a single seller's share in total market supply of the product

insignificant. It has a further implication. Insignificant share means that if only one individual firm

reduces or raises its own supply, the prevailing market price remains unaffected. The prevailing

market price is the one which was set through the interaction of market demand and market

supply forces, for which all the sellers and all the buyers together are responsible. One single

seller has no option but to sell what it produces at this market determined price. This position of

an individual firm in the total market is referred to as price taker. This is a unique feature of a

perfectly competitive market.

Similarly, the 'large number' of buyers also has the same implication. A single buyer's share in

total market demand is so insignificant that the buyer cannot influence the market price on his

own by changing his demand. This makes a single buyer also a price taker.

To sum up, the feature 'large number' indicates ineffectiveness of a single seller or a single buyer

in influencing the prevailing market price on its own, rendering him simply a price taker.

2. The products of all the firms in the industry are homogenous

It means that the buyers treat the products of all the firms in the industry as homogenous. The

products produced by the firms are identical, or treated as identical, or perfectly standardized.

The buyers do not distinguish the output of one firm from that of the other.

The implication of this feature is that since the buyers treat the products as identical they are not

ready to pay a different price for the product of any one firm. They will pay the same price for the

products of all the firms in the industry. On the other hand, any attempt by a firm to sell its product

at a higher price will fail.

To sum up, the 'homogenous products' feature ensures a uniform price for the products of all the

firms in the industry.

3. Perfect knowledge about markets for outputs and inputs.

The firms have all the knowledge about the product market and the input markets. Buyers also

have perfect knowledge about the product market.

Let us take the product market first. The implication of perfect knowledge about the product

market is that any attempt by any firm to charge a price higher than the prevailing uniform price

will fail. The buyers will not pay because they have perfect knowledge. There is no ignorance

factor operating in the market. The sellers do not charge a lower price due to ignorance. The

buyers do not pay a higher price due to ignorance. A uniform price prevails in the market.

As regards the knowledge about the input markets, the implicit assumption is that each firm has

an equal access to the technology and the inputs used in the technology. No firm has any cost

advantage. Cost structure of each firm is the same. All the firms have a uniform cost structure.

Since there is uniform price and uniform cost in case of all firms, and since profits equals cost

less price, all the firms earn uniform profits.

4. Freedom to firms to enter or to leave the industry in the long run

Freedom of entry means that there are no artificial barriers and natural barriers in the way of a

new firm wishing to enter into industry. The artificial barriers may take the form of patent rights,

legal restrictions, etc. The natural barrier may take the form of huge capital expenditure required

to start a new firm, which the firm wishing to enter is not able to arrange.

Freedom of exit means no barriers in the way of a firm deciding to leave the industry. Government

rules, labour laws, loss of huge fixed capital etc. do not come in the way.

The freedom of entry and exit of firms has an important implication. This ensures that no firm can

earn above normal profits in the long run. Each firm earns just the normal profits, i.e. minimum

necessary to carry on business. In Microeconomics, normal profits is treated as an opportunity

cost, and therefore, counted in calculation of total cost. Since profit equals total revenue minus

total cost, normal profit means zero economic profit. Why? Let us explain.

Suppose the existing firms are earning above normal profits, i.e. positive economic profits.

Attracted by the positive profits, the new firms enter the industry. The industry's output, i.e. market

supply, goes up. The price comes down. New firms continue to enter and the price continues to

fall till economic profits are reduced to zero.

Now suppose the existing firms are incurring losses. The firms start leaving. The industry's output

starts falling, price starts going up, and all this continues till losses are wiped out. The remaining

firms in the industry then once again earn just the normal profits.

Only zero economic profit in the long run is the basic outcome of a perfectly competitive market.

Average Revenue and marginal revenue curves of a perfectly competitive firm

The forces of market supply (i.e. supply by industry) and market demand (demand by all the buyers)

determine the market price. The firm, being a price taker, adopts this price and is free to sell any

quantity it likes at this price. The price taker feature determines the shape of the firms AR and MR

curves.

 OLIGOPOLY

MEANING

Oligopoly is a market situation in which an industry has only a few firms (or few large firms producing

most of its output) mutually dependent for taking decisions about price and output. The two

features of this definition – few firms and interdependence between firms – are explained in a section

below.

TYPES

If in an oligopoly market, the firms produce homogeneous products, it is called perfect oligopoly.

If the firms produce differentiated products, it is called imperfect oligopoly.

If in an oligopoly market, the firms compete with each other, it is called a non-collusive, or noncooperative,

oligopoly. If the firms cooperate with each other in determining price or output or both,

it is called collusive oligopoly, or cooperative oligopoly.

When there are only two firms producing a product, it is called duopoly. It is a special case of

oligopoly.

FEATURES

(1) Few firms

Few firms mean either only a few firms in number or a few big firms producing most of the output

of the industry. The exact number of firms is not defined. The word ‘few’ signifies that the number

of firms is manageable enough to make a guess of the likely reactions of rival by a firm.

(2) Firms are interdependent in taking price and output decisions.

When there is only a limited number of firms, it is likely that rivals have some knowledge as to

how these firms operate. It one firm does something about the price and quantity of the product it

produces, the rivals are likely to take quick note of it and react by changing their own price and

output plans. Therefore the given firm, expecting reactions from its rivals, takes into account such

possible reactions before taking any decision about the price and output of the product it produces.

It makes each firm dependent on other firms in the industry.

(3) Barriers to the entry of firms.

The main reason why the number of firms is small is that there are barriers which prevent entry of

firms into industry. Patents, large capital, control over the crucial raw materials etc, prevent new

firms from entering into industry. Only those who are able to cross these barriers are able to

enter.

(4) Non-price competition

Firms try to avoid price competition for the fear of price war. They use other methods like advertising,

better services to customers, etc to compete with each other.