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Perfect Competition as the Ideal Market Structure

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    There are different kinds of market structures in this economy. Perfect competition, as one of them, is often described as the ideal market structure, and only treated as a theoretical ideal. If we compare the perfect competition market with other types of market structure, such as monopoly, monopolistic competition, and oligopoly, it will be obvious that the perfect competition is ideal mainly due to the presence of productive and allocative efficiency.

    In perfect competition, there are a large number of small firms producing homogenous products, in other words, products produced by one firm is identical to the products produced by other firms in the market. There are also a large number of buyers within the market where they have perfect information about the products. Therefore, no individual trader is able to influence the market price. The market price is thus determined by the operation of the market. Firms in the perfect competition are able to enter the market if they think it’s a profitable step, and they can exit from the market without any obstacle.

    In short-run, the firm in the perfect competition act as a “price taker”, and has to accept whatever price is set in the market. The firm faces a perfectly elastic demand curve for its product, as shown in Figure 1. In this figure P1 is the price set in the market, and the firm cannot sell at any other price. If the firm tried to set above P1 it will sell nothing, as buyers know that there is no quality difference between the product as produced by other firms in the markets. Also, there is no incentive for any firm to set a price below P1.

    As the firm choose to produce at the profit maximum point, the firm needs to set output at a level where marginal revenue is equal to marginal cost. Figure 2 illustrates this by adding the short-run cost curves to the demand curves. The firm faces constant average revenue and marginal revenue, as the demand curve is horizontal and will choose output at q1, where MR=MC. Consider the industry as a whole; the demand curve is conventionally downward sloping, as shown in Figure 3. On the supply side, the supply curve is the sum of each firm operating in the market, the result is the industry supply curve S1, as shown in Figure 2.

    The price will then adjust to P1 at the intersection of demand and supply. The firms in the industry will supply Q1 output. In Figure 2, the firm maximises profits by accepting the price P1 as set in the market and producing up to the point where MR=MC, which is at q1. However, now the firm’s average revenue is greater than its average cost. The firm is thus making super-normal profits at this price and the amount of total profits being made is shown as the shaded area adP1b on Figure 2. In short-run, the firm may also earn sub-normal profits, which is shown in Figure 4.

    When the average cost curve is located above the horizontal demand curve, the firm is producing at the profit maximising 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 amount of total sub-normal profits being made is shown as the shaded area abP2d. In long run, all factors of the firm can be varied, therefore new firms can enter and existing firms can leave the industry.

    When a large number of new firms are attracted into the industry by super-normal profits, then this will shift the industry supply curve to the right in Figure 5 from S1 to S*. New firms will then continue to enter until any super-normal profit is competed away, that is only normal profit is earned. When firms earned sub-normal profits, a large number of firms would therefore leave the industry, shifting the supply curve to the left in Figure 5 from S2 to S*. Hence, the price will be risen, and earning normal profit.

    In summary, the long-run profit maximising equilibrium will only occur when there are no firms entering or leaving the industry. This will occur when normal profits are earned, i. e. when P=AR=MR=MC=ATC as shown in Figure 6. Productive efficiency is achieved when the firm is producing at the minimum point of average cost. Allocative efficiency is achieved when P=MC. As a result, under perfect competition, productive efficiency is achieved in the long run, but not in the short-run, when a firm need not be operating at minimum average cost.

    Productive efficiency is achieved in both the short run and the long run under perfect competition. At the opposite end of the spectrum of the market structures is monopoly, which is a market with a single seller of a good. There are no substitutes for the good; the monopoly is thereby insulated from competition. There are barriers to entry into the market; any barriers to entry into the market will ensure that the firm can sustain its market position into the future. Unlike the perfect competition, the demand curve for monopoly slopes downward, and the demand curve is regarded as showing average revenue as shown in Figure 7.

    As monopolist has some influence over price, it can make decisions regarding price as well as output. Therefore, the firm is a “price maker” and can choose a location along the demand curve. The marginal revenue curve (MR) has a fixed relationship with the average revenue curve. MR shares the intercept point on the vertical axis and has exactly twice the slope of AR. MR is zero at the maximum point of the total revenue curve. As with the firm under perfect competition, a monopolist aiming to maximise profits will choose to produce at the level of output at which MR=MC. This is at QM in Figure 7.

    The monopolist then identifies the price that will clear the market for the level of output- in Figure 7 this is PM. This allows the monopolist to make super-normal profits, which is shown as the shaded area VCWPM in Figure 7. The existence of barriers to entry will prevent those profits from being competed away, as would happen in a perfectly competitive market. It is extremely unlikely to say a monopoly to productively efficient, as it is not producing at the minimum point of long-run average cost. Allocative efficiency is also not achieved, as price will always be set above marginal cost.

    Monopolistic competition is a market in which there are may firms producing similar, but not identical, products, e. g. travel agents, hairdressers. Firms produce differentiated products, and face downward-sloping demand curves. Each firm competes with the others by making its product slightly different, and allows the firms to build up brand loyalty among their customers. Therefore, demand will be relatively price-elastic. Firms are able to join the market if they observe that existing firms are making super-normal profits.

    The concentration ratio in the industry tends to be relatively low as there are many firms operating in the market. Figure 8 represents short-run equilibrium under monopolistic competition. If the firm is aiming to maximise profits, it will choose the level of output such that MR=MC. This occurs at output QS, and the firm will then chooses the price level PS. This allows the firm to earn super-normal profits shown in the shaded area VWCPS. In long run, new entrants will be attracted to enter into the industry as the existing firms are making super-normal profits.

    This will affect the position of the average cost curve, by pushing up average cost at all levels of output. Figure 9 shows the situation. The firm is now operating in such a way that it maximises profits; at the same time, AC=AR, therefore the firm is just making normal profits. There is thus no further incentive for more firms to join the market. It is clear from Figure 9 that neither of productive nor allocative efficiency will be met. The firm does not reach the minimum point on the long-run average cost curve; and price is charged above marginal cost.

    Oligopoly is a market with just a few sellers, and that when making economic decisions each firm must take account of its rivals’ behaviour and reactions. Each firm has to act strategically, both in reacting to rival firm’s decisions and in trying to anticipate their future actions. However, a firm must form expectations about how consumers will react to a price change because it cannot observe its demand curve with certainty. Figure 10 shows how it works. Suppose the price is currently set at P, the firm will then sell at Q. There are two extreme possibilities for the demand curve.

    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. Putting these together, the firm perceives that it faces a kinked demand curve D’. Also, the marginal revenue curve has a discontinuity at the link. Thus, Q is the profit maximising level of output under a wide range of cost conditions from MC1 to MC2. Contestable markets is a market in which the existing firm makes only normal profit, as it cannot set a higher price without attracting entry.

    For a market to be contestable, it must have no barriers to entry or exit and no sunk costs. Furthermore, new firms in the market must have no competitive disadvantage compared with the existing firms. The existing firm cannot set a price that is higher than average cost. The firm will also be vulnerable to hit-and-run entry, i. e. a firm could come into the market, take some of the supernormal profits, then exits again. Although the firm only makes normal profits, neither productive nor allocative efficiency is achieved.

    As we have compared perfect competition and other market structures, we can see that perfect competition is often described as the ideal market structure mainly due to the achievement of both the productive and allocative efficiency; where they are not found in other market structures. Perfect competition is merely a theoretical ideal, based on assumptions that rarely hold in the real world. However, allowing a glimpse of what the ideal market would look like, the model provides a measure against which alternative market structures can be compared.

    For example, it is possible for economists to examine how the market is affected if firms can differentiate their products, or of traders in the market are acting with incomplete information. Bibliography Book: 1. Economics for Business and Management by Alan Griffiths & Stuart Wall – (P. 200-245) Websites: 1. Moodle. rhul. co. uk 2. www. tutor2u. net/ – http://www. tutor2u. net/economics/revision-notes/a2-micro-perfect-competition. html – http://www. tutor2u. net/economics/revision-notes/a2-micro-monopoly. html – http://www. tutor2u. net/economics/revision-notes/a2-micro-monopoly-economic-ef

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