Chapter 9

Limited Decision-Making in Perfect Competition

Objectives:

 To describe and to understand perfect competition

 To learn how to maximize profit in perfect competition

Market structure, in economics, depicts how firms are differentiated and

categorized based on the types of goods they sell and how their operations are
affected by external factors and elements. Economic market structures can be
grouped into four categories: perfect competition, monopolistic competition,
oligopoly, and monopoly.

Perfect competition is the least competitive business environment there is. In

perfect competition, you can’t set your product’s price and you have no incentive
to advertise or innovate. You don’t compete with other firms.

 What perfect competition really refers to is a special outcome.

 As the owner of a firm in perfect competition, you choose to produce the
quantity of output that maximizes profit; however, you can't determine
price.
 Price is determined by market forces that are outside your control.
 Ultimately, perfectly competitive markets reach a long-run equilibrium
where the product's price equals minimum cost per unit.
 For consumers, however, this represents the lowest price that continues to
result in the product being available.
  Perfect competition is an ideal type of market structure where all
producers and consumers have full and symmetric information and no
transaction costs.
 There are a large number of producers and consumers competing with one
another in this kind of environment.
 Perfect competition is theoretically the opposite of a monopoly, in which
only a single firm supplies a good or service and that firm can charge
whatever price it wants since consumers have no alternatives and it is
difficult for would-be competitors to enter the marketplace.

Identifying the Characteristics of Perfect Competition

Perfect competition has four primary characteristics:

 A large number of firms: Your firm is one of a large number of firms, so it

produces a negligible amount of the total quantity of the commodity
provided in the market.
 Standardized commodity: All firms produce a standardized or
homogeneous commodity, which means the commodity produced by your
firm is no different from the commodity produced by any other firm. They
sell products with minimal differences in capabilities, features, and pricing.
This ensures that buyers cannot distinguish between products based on
physical attributes, such as size or color, or intangible values, such as
branding. Homogenous products are considered to be homogenous when
they are perfect substitutes and buyers perceive no actual or real
differences between the products offered by different firms.
 Easy entry and exit: There are no barriers to entry in perfect competition.
As a result, it is simple for new businesses to enter the market, and
similarly, it is simple for established businesses to leave the market.
Normally, completely competitive enterprises have relatively low fixed
costs, which makes entry and exit simple.
  Perfect information: The good’s price and quality are known to all buyers
and sellers.

In economic theory, perfect competition occurs when all companies sell

identical products, market share does not influence price, companies are able
to enter or exit without barriers, buyers have perfect or full information, and
companies cannot determine prices. In other words, it is a market that is
entirely influenced by market forces.

Example:

Consider a farmers market where each vendor sells the same type of milk.
There is little differentiation between each of their products, as they use the
same recipe, and they each sell them at an equal price. Customers also can’t
determine the difference like if this milk came from that big cow or the other
one. An individual or business that must accept market prices because it lacks
the market share to do so on its own is known as a price-taker. In a market
with perfect competition, all players in the economy are viewed as price
takers.

Price taker

The firm can’t set price; rather, the firm “takes” the price established by the
market’s supply and demand.

A price-taker is an individual or company that must accept prevailing prices in a

market, lacking the market share to influence market price on its own. All
economic participants are considered to be price-takers in a market of perfect
competition

Making an Offer the Firm Can’t Refuse: Market Price

As a result of perfect competition’s characteristics, each firm is a price taker.
When a firm is a price taker, price is established through supply and demand in
the market.

If businesses’ refuse to follow the market price that are set, customers will
purchase the product from one of the many rival companies that sell it for less
than the market price if a single firm tries to charge a price that is higher than the
market price. However, the business won't want to charge less than what the
market would bear.

The price at which a good or service can currently be purchased or sold is known
as the market price. The dynamics of supply and demand influence the market
price of a good or service.

Competing with Advertising

Advertising’s purpose is to enable the firm to sell more products at a higher price.
In a perfectly competitive market, advertising is a waste of money. Advertising
doesn't allow the perfectly competitive firm to charge a higher price because it is
a price taker, and since it can already sell any amount of its products, there is no
need for advertising to increase sales. Since everyone is aware that businesses in
every industry produce the same goods, advertising has no place in such a
structure. Additionally, consumers are already fully informed about the market
choices that are available to them.

Sprinting to Maximum Short-Run Profit

The firm simply determines the quantity of output to produce in order to

maximize profits. The firm can’t determine the product’s price; hence, the idea of
limited decision-making. In addition, the firm can’t change its fixed cost in the
short run.

Determining price is out of your control

Markets always move toward equilibrium, so the market-determined price
ultimately is the price that makes quantity demanded equal to quantity supplied.

The market demand curve for the good you produce is

where Qd is the market quantity demanded and P is the market price in dollars.

Maximizing profit with total revenue and total cost

Total revenue equals price multiplied by the quantity sold, or

P represents the commodity’s price as determined by supply and demand in the
market.

In Figure 9-1, total revenue is illustrated as an upward-sloping straight line. The

slope of the total revenue function is a constant and corresponds to the market-
determined price.

Total cost has two components — total fixed cost and total variable cost. Total
fixed cost is a constant, so even if your firm shuts down and produces zero units
of output, it still incurs total fixed cost. In Figure 9-1, total fixed cost corresponds
to the point where the total cost curve intersects the vertical axis at TFC.

Total profit equals total revenue minus total cost, or

Economists use the terms profit and economic profit interchangeably. Economic
profit is defined as the difference between total revenue and the explicit plus
implicit costs of production.
As an equation:

The explicit costs plus implicit costs include every cost associated with production,
including the opportunity cost of your time and financial investment. Therefore, if
economic profit equals zero, you stay in business.

Remember: Zero economic profit is okay. Positive

economic profit is even better. Negative economic
profit is always bad.