A perfectly competitive market has three main characteristics; there are many buyers and sellers, goods are homogenous and there is free entry and exit into and out of the market. The reason to there being many buyers and sellers is because perfectly competitive firms operate at an efficient scale, which means a high consumers surplus, and because sellers can sell as much quantity as they like at the given market price. It's not desirable for sellers to decrease the price of their goods as this would reduce their profits, they also have no incentive to increase prices as this would lead them to have no demand, as consumers have perfect market knowledge and are able to purchase close substitute goods. Each firm operating in this market is known to be a price taker.
The aim of perfectly competitive firms is to maximize their profits. The point where they do so is shown on the following diagram:
The price of a good is equal to average revenue which is equal to marginal revenue, as this is the market price set for each quantity of the good. A firm will maximize their profits when price is equal marginal costs.
If a new firm see's that the market is profitable then this is attractive to them and they will enter the market. However, this will have the effect of increasing supply and Quantity which will lower the price and profits for all firms operating in that market. This could inevitably lead to some firms making zero profits. If this happens and the price of a good becomes less than their average total costs of production, then a firm may take the decision to shut down. They will still have to pay for their fixed and sunk costs, but they will be able to return to the market when economic conditions improve. In today's climate, many firms (especially firms selling goods with an elastic price elasticity of demand) would have gone into shut down due to the decreased demand as consumers have less disposable incomes - this would lead to their total revenue being less then variable costs. Some firms may also have left the market as their total revenue may not have covered their total costs. This would in theory have the effect of reducing supply in the market, which would reduce quantity and increase prices.
A perfectly competitive market can be seen as being socially efficient, a monopoly on the other hand can not. Instead of there being many buyers and sellers, in a monopolistic market, there is one dominant sole seller. (example - royal mail) A monopoly can be classified as any firm with more then 25% of the market share, or if a firms good or services has no close substitutes.
A characteristic of a monopoly is that it provides barriers to entry. This could occur because the government has given the firm exclusivity to their good or service by giving them a patent or copyright licence. This will allow them to be the sole seller of their product for many years, without any close substitutes, although the government will only offer this if it's in the interest of the public. A second reason to why a monopoly may exist is because they are the owner of a key resource, this will exclude other firms from producing the same good or service. A final reason may be that they have a lower total average cost of production which makes them more efficient then if two or more firms were producing the goods.
For a seller, owning a monopoly is attractive as they are able to be a price maker. Monopolists are able to maximize their profits by selling a quantity of their good where marginal costs is equal to marginal revenue, but set a price where this equilibrium meets the demand curve. However, a monopolist isn't desirable for consumers as they create a deadweight loss. (Shown below)
The third type of market structure is an oligopoly. This type of market can be seen as being imperfect (where as a monopoly and competitive markets can be seen as being perfect). There are only a few sellers who dominate this type of market, all of which sell similar goods- an example being supermarkets, which are dominated by Tesco, Sainsburys and ASDA. All of these firms could be seen as being price makers, therefore any action by one of the firms can affect the levels of profits for all the other firms operating in that market.
Firms operating in this market would be able to profit maximize if they tried to act like a monopoly market structure. Although, this may involve collusion which is seen as becoming efficient, but antitrust laws are set in place to prevent this from happening.( An example of collusion within supermarkets, was when they agreed to price fix milk in 2007.) However, because firms are not allowed to agree on prices and quantities of goods, firms in a oligopolistic market aim to increase their market share and become market leader, therefore they increase their output which has the effect of reducing prices. This means they are unable to profit maximize.
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Perfect competition is a market structure where many firms offer a homogeneous product. Because there is freedom of entry and exit and perfect information, firms will make normal profits and prices will be kept low by competitive pressures.
Features of perfect competition
- Many firms.
- Freedom of entry and exit; this will require low sunk costs.
- All firms produce an identical or homogeneous product.
- All firms are price takers, therefore the firm’s demand curve is perfectly elastic.
- There is perfect information and knowledge.
Diagram for perfect competition
- The industry price is determined by the interaction of Supply and Demand, leading to a price of Pe.
- The individual firm will maximise output where MR = MC at Q1
- In the long run firms will make normal profits.
What happens if supernormal profits are made?
If supernormal profits are made new firms will be attracted into the industry causing prices to fall. If firms are making a loss then firms will leave the industry causing price to rise
The features of perfect competition are very rare in the real world. However perfect competition is as important economic model to compare other models. It is often argued that competitive markets have many benefits which stem from this theoretical model.
Changes in long run equilibrium
1. The effect of an increase in demand for the industry.
If there is an increase in demand there will be an increase in price Therefore the demand curve and hence AR will shift upwards. This will cause firms to make supernormal profits.
This will attract new firms into the market causing price to fall back to the equilibrium of Pe
2. An increase in firms costs
The AC curve will increase therefore AR< AC
Firms will now start making a loss and therefore firms will go out of business. This will cause supply to fall causing prices to increase.
Efficiency of perfect competition
- Firms will be allocatively efficient P=MC
- Firms will be productively efficient. Lowest point on AC curve
- Firms have to remain efficient otherwise they will go out of business.
- Firms are unlikely to be dynamically efficient because they have no profits to invest in research and development.
- If there are high fixed costs, firms will not benefit from efficiencies of scale
- see more: efficiency of perfect competition
Examples of perfect competition
In the real world, it is hard to find examples of industries which fit all the criteria of ‘perfect knowledge’ and ‘perfect information’. However, some industries are close.
- Foreign exchange markets. Here currency is all homogeneous. Also, traders will have access to many different buyers and sellers. There will be good information about relative prices. When buying currency it is easy to compare prices
- Agricultural markets. In some cases, there are several farmers selling identical products to the market, and many buyers. At the market, it is easy to compare prices. Therefore, agricultural markets often get close to perfect competition.
- Internet related industries. The internet has made many markets closer to perfect competition because the internet has made it very easy to compare prices, quickly and efficiently (perfect information). Also, the internet has made barriers to entry lower. For example, selling a popular good on the internet through a service like e-bay is close to perfect competition. It is easy to compare the prices of books and buy from the cheapest. The internet has enabled the price of many books to fall in price so that firms selling books on the internet are only making normal profits.