Assumptions of Perfect Competition - Economics Essay Example
Assumptions of Perfect Competition
The model of perfect competition is built on four assumptions:
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• Firms are price takers. There are so many firms in the industry that each one produces an insignificantly small portion of total industry supply, and therefore has no power whatsoever to affect the price of the product. It faces a horizontal demand ‘curve’ at the market price: the price determined by the interaction of demand and supply in the whole market.
• There is complete freedom of entry into the industry for new firms. Existing firms are unable to stop new firms setting up in business. Setting up a business takes time, however. Freedom of entry, therefore, applies in the long run.
• All firms produce an identical product. (The product is ‘homogeneous’.) There is therefore no branding or advertising.
• Producers and consumers have perfect knowledge of the market. That is, producers are fully aware of prices, costs and market opportunities. Consumers are fully aware of the price, quality and availability of the product.
These assumptions are very strict. Few, if any, industries in the real world meet these conditions. Certain agricultural markets are perhaps closest to perfect competition. The market for fresh vegetables is an example. Nevertheless, despite the lack of real-world cases, the model of perfect competition plays a very important role in economic analysis and policy. Its major relevance is as an ‘ideal type’.
Many on the political right argue that perfect competition would bring a number of important advantages. The model can thus be used as a standard against which to judge the shortcomings of real-world industries. It can help governments to formulate policies towards industry.
Before we can examine what price, output and profits will be, we must first distinguish between the short run and the long run as they apply to perfect competition. In the short run, the number of firms is fixed. Depending on its costs and revenue, a firm might be making large profits, small profits, no profits or a loss; and in the short run, it may continue to do so. In the long run, however, the level of profits affects entry and exit from the industry. If supernormal profits are made, new firms will be attracted into the industry, whereas if losses are being made, firms will leave.
Note that although we shall be talking about the level of profit (since that makes our analysis of pricing and output decisions simpler to understand); in practice it is usually the rate of profit that determines whether a firm stays in the industry or leaves.
The rate of profit (r) is the level of profit (TΠ) as a proportion of the level of capital (K) employed: r = TΠ/K. As you would expect, larger firms will require making a larger total profit to persuade them to stay in an industry. Total normal profit is thus larger for them than for a small firm. The rate of normal profit, however, will probably be similar.