Perfectly Competitive Markets - Essay Example

?Perfectly competitive markets. By: Economics. Presented [Institute] 07-03 This paper is written to highlight the features of a perfect market. In the first half it focuses on the changes in the consumer demand and how the market responds to it. Drawings are also incorporated in the paper to increase clarity. The paper also shows how the market forces adjust themselves to attain the short run and long run equilibrium that was disturbed by the initial change in demand. In the other half of the paper the key differences in the real world markets and the perfect market are defined and explained. The difference in the products and the way in which firms compete is also discussed. The assumptions that hold for the perfect market are also explained and highlighted. A perfectly competitive market is the one in which the market forces work without any hindrance. This means that the demand and supply interact to determine the price which is accepted by all the other firms. This market is only a theoretical one based on assumptions and it tells us that how a markets should respond to the changes in demand and supply. The perfect market is nonexistent in our real world like all the other perfect things but it is important to understand it. This is because the perfect market structure can be used to compare the other markets and their responses to changes in different situations. (Goshit & Mai-Lafia, 2009) Firstly, let us consider the case of equilibrium in a perfect market. The supply and demand will become equal at some point and that point will be considered as the equilibrium point of the market. The following drawing shows a perfect market at equilibrium. The forces of supply and demand fix the price at $5. (Goshit & Mai-Lafia, 2009) Now, like all the other markets, the perfect markets also faces demand and supply shocks to which it reacts accordingly. Mostly the market responds to changes in demand as the consumer is considered sovereign. Let us now consider the case where the consumer demand increases. This may be due to any reason but let us suppose that it is due to an increase in the price of a substitute. The market will shift accordingly. The following drawing shows how. (Archambault, 2008) The increase in demand will result in extra demand at the same price. This will create a shortage of the product. The supply will react accordingly and there will be a movement along the supply curve. This will lead to a new equilibrium at a higher price and a higher quantity. This is because the consumers were willing to pay more for the good and thus the market forces reacted and short run equilibrium was attained. This increase in demand will also add to the consumer and producer surplus which is the area between the two graphs. These two refer to the difference between the amount that the consumer or the producer expects and the price. (Krugman and Wells, 2008, p.71-72) The long run response of the market will be different. The long run equilibrium of a market is when the marginal cost becomes equal to the lowest of average total cost (ATC). This equilibrium will be disturbed by the increase in demand. The firms will now charge a higher price than their marginal costs and thus their average revenue will exceed their average total costs. The firms will be earning an abnormal profit. (Peck, 2006) The following graphs show the disturbance. As a result of the abnormal profit, new firms will enter the industry to make profit for themselves. This will cause the supply to increase. This increased supply will push the prices downwards back to normal with a higher amount of goods traded than before. The long run equilibrium will be attained and the market will return back to normal. (Burnette, 2012) The following graph shows the effect of new firms entering the market. Perfect markets differ from the markets we see daily. There are assumptions that need to be considered. The first one is that there are many sellers in the market, which means that the competition is intense. Secondly, there is a homogenous product i.e. all the firms produce the same kind of product and the consumers cannot identify which product belongs to which firm. Thirdly, all the firms are price takers. They can sell all at the industry price and nothing at a price higher than the industry. In addition to that, the information is available to the consumers and the producers and it is perfect. Furthermore, the firms can enter and exit the market without facing any barriers. This intensifies the competition as the profit making market will attract more and more firms and the equilibrium will be gained. Lastly, the consumers are rational and the firms maximize their profits. (Lipsey and Harbury, 1992, p.154) The real life markets however are far away from the perfect market and are imperfect the most of the times. These markets have few producers rather than many producers. This reduces the competition and increases the consumer exploitation. This makes them an oligopoly instead of a perfect market. A key difference between oligopoly and perfect market is the ease of entry and exit. There are barriers to entry in an oligopoly whereas there is freedom of entry and exit in a perfect market. (Arnold, 2008, p.512-513) Another major difference between the perfect markets and the oligopolies is the kinds of products traded. The products traded in an oligopoly are different from each other rather than being homogenous. This is because the competition in an oligopoly is not based on price. If a firm reduces its price, all the firms will follow and if a firm increases its price then no one will follow and the demand for that firm’s product will decline rapidly. This is the only way the firms in an oligopoly can compete. For instance two companies are making goods which are substitutes. Now if one of them reduces the price of their product, the other will also do in order to maintain the current level of sales. On the other hand, if any of them increases the price the other will not follow resulting in a loss to the first one. So oligopoly only has non-price competition. The firms in an oligopoly differentiate their product to get more customers. (Sloman, 2004) We discussed the nature of products in an oligopoly. Now we discuss their prices. In a perfect market the firms are price takers. However this may not be the case in oligopolies. Although there is not much change in the prices of the products, but still firms in an oligopoly can set their own prices. The price is set where it is above the marginal cost. This means that every additional unit brings in more revenue than the cost of producing it. This creates abnormal profits for the firms in that oligopoly and thus the other firms are attracted towards it but the barriers to entry become functional here and stop the other firms from entering and getting the profit. The nature of the oligopoly affects the change of prices a lot. If the oligopoly becomes collusive and the firms start to join for their interest then they might be able to increase the price and all will follow as a team but in a pure oligopoly, the price doesn’t change very often. (Wessels, 2000, p.388-390) The information is asymmetric in oligopolies. So the consumers have less knowledge about the firms and their costs. The firms on the other hand may have better information about the spending patterns of the consumers which helps them to differentiate their product accordingly. (Janssen, M. et al., 2010) The perfect market theory assumes that the consumer is always rational. There are people who weigh every step before taking it but the odds of finding these people are minimal. Nowadays, in the market people may not react rationally every time. There are occasions when people have to leave rationality behind. For instance if there is a wedding, people tend to spend regardless of the price. So in any market structure, consumers may not always be rational. (Basu, 2006) The firms in an oligopoly may or may not be profit maximizing. It depends on the situation of the market. If other firms are entering the market, then the firms may leave the profit maximization motive and stick to the predatory or eliminatory pricing policies. So the assumption may not hold true all the times. Although profit maximization is a goal for every firm but they may not pursue it all the time. (Sloman, 2008, p.182-183) To sum it up, the perfect market responds to the changes in consumer demand but the response is not identical to the real world markets. The long run and short run impacts of a demand change are different and result in the attainment of respective equilibriums. The perfect market is different from the markets we see in many aspects and the assumptions of a perfect market may not hold true all the time in the real world. Reference list Goshit, G. and Mai-Lafia, D. (2009) Theory of Perfect Competition. [online] Available at: http://www.nou.edu.ng/noun/NOUN_OCL/pdf/pdf2/BHM%20200%20Main%20Content%20(Mailafia%20&%20Goshit).pdf [Accessed: 7 Mar 2013]. Archambault, S. (2008) The Basics of Supply and Demand. [online] Available at: http://www.unm.edu/~sarchamb/pindyck_micro06_text_02.pdf [Accessed: 7 Mar 2013]. Krugman, P. and Wells, R. (2008) Microeconomics. 2nd ed. New York: Worth Publishers, p.71-72 Peck, J. (2006) Equilibrium in Perfectly Competitive Markets. [online] Available at: http://www.econ.ohio-state.edu/jpeck/H200/EconH200L11.pdf [Accessed: 10 Mar 2013]. Burnette, D. (2012) Perfect Competition. [online] Available at: http://people.rit.edu/jdbgse/Documents%20211/CN_intromicro_8.pdf [Accessed: 10 Mar 2013]. Lipsey, R. and Harbury, C. (1992) First Principles of Economics. 2nd ed. London: Oxford University Press, p.154. Sloman, J. (2004) Economics for Business. 3rd ed. Delhi: Pearson Education, p.262-275. Wessels, W. (2000) Economics. 3rd ed. New York: Barron's Educational Series, p.388-390. Arnold, R. (2008) Economics. 9th ed. Mason: Cengage Learning, p.512-513. Janssen, M. et al. (2010) Oligopolistic Markets with Sequential Search and Asymmetric Information. [online] Available at: http://www.bi.edu/InstitutterFiles/Samfunns%C3%B8konomi/Papers/JPW.pdf [Accessed: 11 Mar 2013]. Basu, K. (2006) Consumer Cognition and Pricing in the Nines in Oligopolistic Markets. [online] Available at: http://ecommons.library.cornell.edu/bitstream/1813/3485/2/consumercog_06.pdf [Accessed: 11 Mar 2013]. Sloman, J. (2008) Economics. 6th ed. New Delhi: Pearson Education, p.182-183. Read More