There are various market structures in the economy, including perfect competition which is often considered the ideal structure but is theoretical. When comparing perfect competition to other structures like monopoly, monopolistic competition, and oligopoly, it becomes clear that perfect competition is ideal primarily because it possesses productive and allocative efficiency.
In perfect competition, numerous small firms produce identical products. Buyers have perfect information and no single trader can affect the market price. The market price is determined by market forces. Firms can freely enter or exit the market.
In the short run, firms in perfect competition are known as “price takers” and must accept the predetermined price set by the market. The demand curve they face for their product is perfectly elastic, as depicted in Figure 1. P1 represents the market price, which cannot be altered by the firm. Attempting to sell at a higher price would result in no sales since buyers perceive no difference in quality between the firm’s product and others produced by competitors. Additionally, there is no motivation for any firm to set a lower price than P1.
In order to maximize profits, the firm must determine its output level at the point where marginal revenue is equal to marginal cost. This is demonstrated in Figure 2, which combines the demand curves with the short-run cost curves. The firm experiences constant average revenue and marginal revenue since the demand curve is horizontal. The firm will choose an output level of q1, where MR=MC. When considering the entire industry, the demand curve typically slopes downward, as portrayed in Figure 3. On the supply side, the industry supply curve S1 is derived by aggregating the individual firms operating within the market, as depicted in Figure 2.
The price will adjust to P1 at the intersection of demand and supply, and the firms in the industry will supply Q1 output. Figure 2 demonstrates that the firm maximizes profits by accepting the market price, P1, and producing up to the point where MR=MC, at q1. At this price, the firm is making super-normal profits as its average revenue exceeds its average cost. Figure 2 illustrates the shaded area adP1b as the amount of total profits being made. In the short run, the firm may also earn sub-normal profits, which is depicted in Figure 4.
When the average cost curve is above the horizontal demand curve, the firm is producing at the point where MR=MC, and the firm is producing q2. At this point, the firm’s average revenue is less than its average cost. The firm is thus making sub-normal profits at the price P2 and the total amount of sub-normal profits made is represented by the shaded area abP2d. In the long run, all factors of the firm can be adjusted, allowing new firms to enter and existing firms to exit the industry.
When a substantial amount of new companies are lured into the sector due to excessive profits, it will result in a rightward shift of the industry’s supply curve depicted in Figure 5 from S1 to S*. The influx of new companies will persist until all extraordinary profits are eradicated, leaving only ordinary profits. In instances where firms generate below-average profits, numerous companies will exit the industry, leading to a leftward shift of the supply curve in Figure 5 from S2 to S*. Consequently, prices will rise, enabling firms to earn ordinary profits.
One of the key conditions for long-run profit maximization in an industry is when no firms enter or exit. In this equilibrium, normal profits are earned, meaning that price (P), average revenue (AR), marginal revenue (MR), marginal cost (MC), and average total cost (ATC) are all equal (as shown in Figure 6). When a firm is producing at the minimum point of average cost, productive efficiency is achieved. Allocative efficiency occurs when price is equal to marginal cost. Perfect competition leads to productive efficiency in the long run, although not in the short run when a firm is not required to operate at minimum average cost.
Both short-run and long-run productive efficiency can be accomplished when perfect competition exists. Conversely, at the opposite end of the market structure spectrum lies monopoly, in which a single seller possesses exclusive control over a good with no alternatives available. As a result, monopolies are shielded from competition. Additionally, there exist obstacles to entry into the market that assist the firm in preserving its market dominance for an extended duration. Unlike perfect competition, monopolies exhibit a downward-sloping demand curve representing average revenue, as depicted in Figure 7.
The monopolist has the power to determine both price and output, making them a “price maker” on the demand curve. The marginal revenue curve (MR) is related to the average revenue curve with a fixed relationship. MR intersects the vertical axis at the same point as AR and has a slope that is twice as steep. At the maximum point of the total revenue curve, MR is zero. Similar to a perfectly competitive firm, a monopolist seeking to maximize profits will produce where MR equals MC. This is represented as QM in Figure 7.
In Figure 7, the monopolist determines PM as the price that will clear the market for the level of output. This enables the monopolist to earn super-normal profits, represented by the shaded area VCWPM. The presence of barriers to entry ensures that these profits cannot be eliminated through competition, unlike in a perfectly competitive market. However, monopolies are unlikely to be productively efficient as they do not produce at the minimum point of long-run average cost. Furthermore, they do not achieve allocative efficiency since the price is always set above marginal cost.
Monopolistic competition is a type of market where numerous firms produce similar products that are not exactly identical, such as travel agents and hairdressers. These firms differentiate their products and encounter demand curves that slope downward. Each firm competes with others by making slight distinctions in their products, enabling them to establish customer loyalty to their brand. Consequently, the demand for their products will be relatively price-sensitive. New firms can enter this market if they notice that existing firms are generating above-normal profits.
The industry has a low concentration ratio due to the presence of numerous firms. Figure 8 displays the short-run equilibrium in a monopolistic competition scenario. To maximize profits, a firm will select an output level where MR=MC, which happens at output QS. Subsequently, the firm will determine the price level PS. These actions enable the firm to earn super-normal profits, depicted by the shaded area VWCPS. Over time, new firms will be enticed to join the industry as existing firms continue to generate super-normal profits.
The average cost curve will be affected by this, causing an increase in average cost at all levels of output. Figure 9 illustrates this situation. The firm is now focused on maximizing profits while maintaining a balance between average cost and average revenue, resulting in normal profits. As a result, there is no additional motivation for other firms to enter the market. Figure 9 clearly shows that neither productive nor allocative efficiency will be achieved. The firm does not reach the minimum point on the long-run average cost curve and charges a price above marginal cost.
Oligopoly is a market with a small number of sellers. In this type of market, each firm must consider the behavior and reactions of its rivals when making economic decisions. Strategic actions are necessary for both reacting to competitors’ decisions and anticipating their future actions. To effectively set prices, a firm must predict how consumers will respond to changes because it cannot accurately observe its demand curve. Figure 10 illustrates this concept by showing the current price (P) and corresponding quantity sold (Q). The demand curve can vary between two extreme possibilities.
The firm perceives that it faces a kinked demand curve D’ when other firms either ignore or copy its action. If other firms ignore its action, d’ will be the relevant demand curve, which is relatively elastic. On the other hand, if other firms copy the firm’s moves, D will be the relevant demand curve. Combined, the firm’s perception is that it faces a kinked demand curve D’. At the kink, the marginal revenue curve has a discontinuity. Therefore, Q represents the profit-maximizing level of output under a range of cost conditions from MC1 to MC2. In a contestable market, the existing firm can only make normal profit as it cannot raise prices without attracting entry from new competitors.
For a market to be contestable, it must lack barriers to entry or exit and sunk costs. Moreover, new firms should not have a competitive disadvantage compared to existing firms. Existing firms cannot set prices higher than average cost and are susceptible to hit-and-run entry, where a firm enters the market temporarily to profit and then exits. Despite making only normal profits, neither productive nor allocative efficiency is attained.
Perfect competition is widely regarded as the superior market structure in comparison to others due to its achievement of both productive and allocative efficiency, a characteristic lacking in other structures. Nonetheless, it should be noted that perfect competition is primarily a theoretical concept and rarely manifests in reality. Nonetheless, it functions as a benchmark for evaluating various market structures.
Additional insights on the impact of firms differentiating their products or market traders operating with incomplete information can be found in the following sources:
- Book: Economics for Business and Management by Alan Griffiths & Stuart Wall – (P. 200-245)
- Websites:
