Perfect Competition - Essay Example

?Running Head: PERFECT COMPETITION Topic: Perfect Competition Lecturer: Presentation: Perfect Competition There are various types of market systems in an economy such as monopoly, oligopoly and free markets depending on the number of buyers and sellers in the market as well as the type of products traded. Perfect competition is whereby there are many buyers and sellers dealing with homogeneous products and no participant has the power to determine the price or quality of a product. Monopolistic competition on the other hand, is whereby there are many firms selling similar but not identical products hence firms have market power while oligopolistic competition is a situation where there are few sellers selling identical products (Mankiw, 2011). The market with perfect competition according to Baumol & Blinder (2011) is characterized by many small buyers and sellers such that none can influence market conditions; all firms are price takers. The products sold are identical and have close substitutes and this makes it hard for such a condition to be met for in reality, a market has differentiated products due to technological innovations. An example of such products includes agricultural products such as a bushel of wheat. Firms are free to enter or exit the market without any problem and also the factors of production are mobile. The market is also based on the assumption that all the participants have perfect information regarding the prices and quality of products. The buyers thus are able to make choices of the products they want to buy and the producers are aware of what the buyers want hence it is easy to decide on the quantity to produce (Anderton, 2006). Since the participants have perfect information regarding the market and are free to enter and exit at any time, there are no transaction costs incurred in the exchange of goods. The profit maximization of the firms occurs where marginal revenue is equal to marginal cost and the market price is equal to marginal cost. Due to these conditions, it is very rare to have perfect competition although technological advancements are driving markets towards such a situation. For example, the trade in currency or money markets where participants are assumed to have perfect information and currency is same regardless of where it is being traded. Another characteristic of such a market is non-existence of externalities. According to Nicholson (2005), perfect competition ensures optimum allocation of resources in the economy. Since price is equal to the marginal cost, consumer and producer surplus can be maximized. If a producer finds that the output is not bring in revenue, he/she can top producing the product and put the resources into more profitable use especially because there are no barriers to entry or exit. In this situation, no one can be made better off without making someone else worse off. For example, if production of wheat is not profitable, the producer can shift to production of other grains and in the process may lay off some staff and recruit others with the required skills. Competition also pushes prices down and makes the producers to find ways of producing at minimum cost hence productive efficiency is achieved (Geoff, 2006). The supply curve of a perfect market is the marginal cost curve and the demand curve is the price line which is equal to average revenue and marginal revenue. Since the price remains the same regardless of quantity produced, the demand curve is horizontal. In the short run, firms make abnormal profits as total revenue is greater than total costs thus attracting entry of new firms into the market especially due to lack of entry barriers. As firms enter the market, the market supply curve shifts outwards pushing the prices down consequently lowering the profits by firms. Since each firm earns sufficient revenue to cover variable costs, some firms may shut down to avoid paying variable costs as revenue is low but they still continue paying fixed costs (Mankiw, 2011). The fixed costs become sunk costs as they must be paid hence are ignored when making supply decisions. If revenue is greater than variable costs, a firm may choose to continue operating but if revenue is less than variable costs, the firm can shut down or move to a more profitable business. Firms continue to enter and leave the market while adjusting to new market conditions. In the long-run, firms have fully adjusted to new market conditions. The price falls until price is equal to long run average cost hence each firm makes normal profits. In such a case, there are no incentives for firms to enter or leave the industry thus a long-run equilibrium is reached. Anderton (2006) argues that a firm’s supply curve is perfectly elastic in the long run hence making it impossible for firms to make economic profit. They only make profit enough to cover economic costs or a normal profit where marginal costs are equal to marginal revenue. However, a firm cannot continue incurring fixed costs if it is not making profit hence in the long-run after feasible long-term adjustments, if price or revenue is greater than average costs the firm can continue operating but if price is less than average costs, the firm can exit the industry. At long-run equilibrium therefore, the process of entry and exit ends since price equals average total cost and are said to operate at their efficient scale (Tucker, 2008). The proliferation of global trade and competition has contributed much to the markets moving away from market-possessing power to more perfect competition. In a monopolistic competition, each firm has power to set price and quality of its products hence has market power. Firms compete with each other for same products hence try to differentiate products in order to gain competitive advantage over the others and control the market (Baumol & Blinder, 2011). There is also free entry and exit of firms in the market as in perfect competition. Each country has competitive advantage over the others due to advancement in technology and availability of resources. However, due to trade liberalization, most of the barriers to trade have been removed through trade agreements thereby lowering transaction costs among countries leading to more perfect competition. Global trade has also enhanced transfer of technology and labor among countries thereby allowing countries to produce goods which they would not have produced efficiently. Through information technology, there is perfection of information which is a precondition for perfect competition (Chauffour & Maur, 2011). This has led to breakdown of trade barriers and lowering of transaction costs thereby a movement towards perfect competition. For example, a person in any part of the world can trade effectively in the currency or stock exchange market since information is available regarding the market conditions; participants have perfect information regarding prices and why the prices are high or low in the market. There is also greater factor mobility especially workers thus driving economic profit to zero as factors become variable. A country can invest where the labor is cheap hence foreign investments which compete with local producers to drive prices down to a uniform international price (Akbar, 2003). Akbar (2003) argues that most countries especially developed countries have introduced competition policy in their countries to eliminate monopoly. The market power of some firms has thus been reduced and firms can compete effectively in the market without any barriers thus more perfect competition. Furthermore, firms can reallocate resources to products which they can produce effectively to earn profit and exit production of products which cannot be produced efficiently leading to low revenue or losses hence optimum allocation of prices. Perfect competitive markets assume there are no externalities since the market is efficient. Each firm concentrates on making sure to cover its variable costs so as to maximize profit and marginal revenue is equal to marginal cost (Mankiw, 2011). Lipsey & Chrystal (2007) argue that all costs should be incurred by producers and all benefits to go to consumers. However, in the process of production, there are benefits and costs which are borne or received by the society and which the market participants do not account for. Negative externalities occur when private costs exceed social costs whereby social costs are incurred by society as a result of firm’s production processes. For example, a firm can cause pollution while operating leading to health costs and clean-up costs to the society. On the other hand, the firm may produce benefits to the whole society besides the consumers of products. For example, by providing people with drugs, the whole society gains by having a healthy population which is productive or reduced costs of caring for the sick and spread of diseases. The society’s resources are optimally allocated when social marginal costs are equal to social marginal benefits since in a perfect competition; private marginal cost equals private marginal benefits (Lipsey & Chrystal, 2007 p. 284). Social costs include private costs and costs to society while social benefits include private benefits plus benefits to whole society. When marginal social cost is greater than social marginal benefit, reducing the level of output would be of social gain to the society since the firm does not account for the costs. If social marginal benefits are higher than social marginal costs, there is social gain by increasing level of output. As a result, positive externalities are supposed to be encouraged for social gain and negative externalities discouraged by reducing production of such goods. References Akbar, Y (2003) Global Antitrust: Trade and Competition Linkages. England: Ashgate Anderton, A. (2006) Economics. USA: Pearson Baumol, W., Blinder, A (2011) Economics: Principles and Policy. 12ed. Mason, OH: Cengage. Chauffour, J., Maur, J (eds) (2011). Preferential Trade Agreements Policies for Development: A Handbook. Washington, DC: World Bank Geoff, R (2006) “Markets and Market Systems: Perfect Competition”. Tutor2u. Retrieved March 6, 2012, from http://tutor2u.net/economics/revision-notes/a2-microeconomics-perfect-competition.html. Lipsey, R., Chrystal, K (2007) Economics. Oxford: Oxford University Press. Mankiw, N (2011) Principles of Economics. 6ed. Mason, OH: Cengage. Nicholson, W (2005) Microeconomic Theory. 10edn. Mason, OH: Cengage Tucker, I (2008) Microeconomics for Today. Mason, OH: Cengage. Read More