5 OF PERFECT COMPETITION DEFINITION AND CHARACTER! ~ Definition of perfect competition mpetitive market is characterizeq by th ingac c presence ofalarge numberof small irmssellinga completely homoge product and enjoying an unrestricted Lec have a to entr 7 exit. Each firm is so small that its exit or ently Wie: Impact on th, e market, a firm will be a price lake market price. Hence, ina compelitiv! Broadly speaking, a perfectly cor ‘dentified from its characteristie, A perfectly competitive market can be i Major characteristics of it can be elaborated as follows: L. Large number of firms A basic characteristic of perfect competition is that there are numerous firms in the market and each of them constitutes a very small Proportion of the total supply. None of the firms can, therefore, influence the market price by way of enhancing supply or leaving the market altogether. py the same logic, if a new firm enters the market, it will have no impact on market supply or price level. 2. Homogeneous product One more basic characteristic of it is that all the firms supply an entirely homogeneous product. Itimplies that products of different firms are exactly similar in all respects. Technically speaking, they are perfect substitutes to each other and elasticity of substitution across them is infinity. A buyer will, therefore, have no preference for the product supplied by a particular firm. Hence, marketing strategies inclusive of sales promotion, advertisement, brand names and trademarks have no role to play in such a competitive market setting. 3. Free entry and exit Third basic characteristic of such a market setting is free entry and exit of the firms. It implies that a firm can enter or exit the market any time without making any impact on the market supply or price level. Because of it, firms will only make a normal profit in the long run. 4, Firms are price takers Since a firm holds an insignificant market share, it has to accept the pre vailing price, as determined by the market forces and operate accordingly: Inother words, a firm under perfect competition is a price taker and nota price maker. This can be further explained from Figure 12.1.Firm Price Industry Pp R= MR oO 7 xX Q Output oO Output Price determination A Price taker firm Figure 12.1 In panel A, price (P*) is determined through demand and supply forces by the industry. It is followed by the firm in panel B. At this price, firm will enjoy an unlimited demand and hence, it will find its equilibrium level of output with the help of its marginal cost curve. This will be discussed at length later in the chapter. 5. Independent decision making Since firms enjoy an unlimited demand at a given price, no individual seller will opt for any kind of collusion with others. Each of them will act independently without considering the competitor’s behaviour. In fact, there is no need to do so since the demand for all of them is unlimited at the prevailing price. Similarly, a buyer will also act independently given homogeneous nature of products. It nut shell, every operator will make independent decisions under a competitive market condition. 6. No government intervention In such a market scenario, government plays no role in price determina- tion. The prices are determined purely through price mechanism, In simple Words, government intervention in the form of taxes and subsidies, public % i) ulati . . distribution networks, licensing and regulation through w atchdog bodies ‘ave no place in it. 1. Perfect knowledge Each market operator, buyer or seller, hasa complete knowledge regard- ing the market, Thus, no buyer will pay and no se oo charge a price higher than the prevailing one. By the same ee a will offer a price discount as he can sell his entire output on the prevailing price. In short, eae 5 the ruling price and th ‘i ‘tire market supply will be transacted at Pp ere willbe no excess demand or supply in long run. This, as also the a next feature is not found under pure competition. : 8. Perfect mobility of production factors All factors of production are perfectly mobile, i.e. the one firm to another under perfect competition. Th factor mobility or no cost is associated with it. Th transportation cost. 'y can freely move fron ere is no Testriction ere is also no scope for PERFECT AND PURE COMPETITION Perfect competition and pure competition are broadly the same and some. times used as synonyms, though there are a few basic distinctions between! the two. To be precise, perfect competition indicates a higher degree of market competition vis-a-vispure competition. The basic feature of thepure competition is the absence of monopoly element while perfect competition has to satisfy a couple of more conditions. In short, perfect competition is more comprehensive but restrictive as compared to pure competition, Table12.1 highlights the difference between the two, ‘ TABLE 12.1 a DIFFERENCE BETWEEN PERFECT ANI 'D PURE COMPETITION 4 Sr. No. Perfect Competition Large number of firms Homogeneous product Pure Competition Large number of firms 3 Homogeneous product Free entry and exit al Free entry and exit Firms are price taker Firms are price taker Independent decision making No government intervention Perfect knowledge wjarfafala}o |r |m Perfect mobility of production factors Normal and super normal profits Under perfect competition, each firm has profit maximization as its goal. AY firm’s profit (I) function can be defined as a surplus of total revenue (IR) over the total cost (TC). Symbolically, 4 M1=TR-TC where TR > TC There are two basic concepts relating to the profit of a firm: @ Normal profit and @ Super normal or abnormal profit.Norn, fit which a firm has to al ny oe mt of pro! Fi ents er Ofit i nimum amount Of F icular “ssentially oft is that mir -un so as to remain in the market of a part : Produc; arn in the long ru din the cost function as one o! « 5 . -ofit is incorporates * its elenyg,,. US, normal profit is inco it will exit the market for some other son's: If the firm is unable to do so, it rofi Ctivity Where it can generate the normal profit. In short, normal Profit wilt induce a firm to remain in an industry. : On the other hand, a super normal or abnormal profitis the profit which a am earns over and above the normal profit. Such a profit is possible only in short run. In the long run, it will lead market supply to increase as more firms enter theindustry and price of product will fall resulting super normal Profit to vanish, Thus, in long run all firms will earn a normal profit only. REVENUE CURVES UNDER PERFECT COMPETITION Exploring a profit m aximizing equilibrium of a firm will require knowledge of both revenue and cost concepts. A discussion on different cost concepts has been carried out earlier in the Chapters 10 and 11 of this volume. Let us now briefly discuss various revenue concepts and curves associated with them. As such following three types of revenue curves can be constructed: @ Total revenue (TR) curve @ Average revenue (AR) curve and @ Marginal revenue (MR) curve. Total revenue curve The TR curve shows the total receipts or sale proceeds of a firm by selling different quantities in the market. It is nothing but quantity sold multiplied by the price. A firm, being price taker in perfect competition, can sell its entire output at a given price. Table 12.2 shows the TR of a firm (row 3) when it sells more and more units of its output (row 1) at a given price (row 2), It is calculated by mul- tiplying value in row 1 by value in row 2. It can be observed that the TR has increased at a constant rate. As such, the TR curve, as shown in Figure 12.2, is a positively sloped straight line starting from the point of origin. TABLE 12,2 TTR, AR & MR IN A PERFECTLY COMPETITIVE MARKET 1 | Units of output (Q) ——> Vpe 2) 3 5 6 7 2 | Price (Rs) 5} 5 5] 5 5 5 5 3 | Total Revenue (Rs.) S| 10} 15} 20) 25] 30] 35 4 | Average Revenue (Rs.) 5| 5 5 5 5 5 | Marginal Revenue (RS.) 2 ee 5AR=MR Revenue/Price ~ oO Output Figure 12.2 : Revenue curves Average revenue curve The AR curve shows the per unit average receipt of the firm from sellinga certain quantity in the market, i.e. TR/Q. It (row 4) is calculated as the total receipt (row 3) divided by the number of units sold (row 1). One can see that AR at each level is equal to price. It is because firm can sell its entire | output at the given price. Thus, a firm’s AR curve in a perfectly competitive market is shown as a straight line parallel to X-axis or the quantity axis | (Figure 12.2). | Marginal revenue curve The MR is the sale proceeds of one additional unit by the firm. That is, marginal revenue of N® unit of a product (MR,) is total revenue from N units (TR,) minus total revenue from N-1 units (TR, ,). Or, MR, =TR,-TR,, It can also be estimated as change in total revenue divided by a change in product units. Or, MR, = ATR/AN As the firm sells each unit at asame price under perfect competition, them at each level will be the same as market price of the product (row 5). T hus, the MR curve will also be a straight line parallel to X-axis or the quantity axis. Since both MR and AR are equals to price, the MR curve will overlap 1, Geometrically, the AR at a point on TR curve will be the slope of a line from the "8 ° that point. Such a line will, however, overlap the TR curve in a perfectly competitiv? i | Therefore, AR will be slope of TR curve at each of its point, The TR curve bein © ne line, its slope will be same at each of its point and hence, AR curve will be a stash" parallel to quantity axis.Super normal profit A firm will earn super normal profit in short run if its SAC is less than the AR at the point of equilibrium. Such a firm has been depicted in Figure 125, SAC y SMC R oP AR=MR 5 8 oT Es s 0 Q, zs Output Figure 12.5 : Super-normal profit of a firm It shows firm’s equilibrium at point R where its output is OQ,. At point, both the equilibrium conditions are satisfied, ic. MR = MC and the MC curve is positively sloped at the point of intersection. The average cost of the firm, as represented by the SAC curve, is OT (= SQ,) at this output level. Based on it, profit can be estimated as 4 Total revenue — Total cost Given that total revenue is OPRQ, and total cost is OTSQ,, Profit = PISR = OPRQ, - OTSQ, This is the profit which the firm earns over and above the normal p! and hence, termed as super normal profit. It has been shown by the sha area in the figure. ] Normal profit Figure 12.6 depicts case of a firm which has been earning only a norm profit.s R MR=AR 3 P § 5 4 x oO Q, Output Figure 12.6 : Normal profit of a firm The figure shows equilibrium at point R where the output is OQ,. At this level of output, AC is RQ,, as shown by its SAC curve. It is equal to the per unit revenue which is also RQ,. It means that firm is making only normal profit which is a part of average cost. In this case, Total revenue = Total cost =OPRQ, Firm incurring losses As noted above, a firm can incur loss in short run. Such a firm is repre- sented in Figure 12.7. Y smc SAC sAVC e s BT cs QP R MR=AR By 2 U x oO 0, Output Figure 12.7 : Loss incurred by a firm i put ; . i vhere the ou! tothe given situation, firm’s equilibrium is at point Rw and ‘ sd by SAC curve a Weis 0Q,. The average cost of the firm is represented by S:the average variable cost by SAVC curve. The gap between SAC and gy, represents the average fixed cost (SAFC). SAvo The figure shows that at output level OQ,, average cost (SQ,) is more than 0 its average revenue (RQ,). Thus, the firm has incurred a per unit loss of SR (= SQ, - RQ,). Total I loss = Total cost — Total revenue Given that total cost = OTSQ, and total revenue = OPRQ, in the figure, Total loss = TSRP = OTSQ, - OPRQ, In this situation, one may ask what a firm should do to minimize its losses, Should it continue pro: tion and wait for high Answer to such questi uction and bear the losses or should it stop produe. er price level to come for a re-entry in the market? ions will depend upon the fact that is the firm able to recover at least the variable cost from its revenue or not. If the firm is able to recover the variable cost, or a little more, it should continue production and bear the loss which will be equal to or less than its fixed cost. In such a scenario, the firm will minimi losses by way of continuing production. The firm will continue do so in short run even if AR = SAVC. It is because of the fact that its loss will be equal to the fixed cost whether it stops production or continue to pro production and luce. Thus, the firm may be advised to continue the remain in the market. q However, if the AR < SAVC, firm should stop production and mink: mize the loss which will be equal to its fixed cost. If the firm continues production, in this situation, per unit loss will be, Thus, it will minimize losses (=AFC) by stopping the production altogethe Based on above, we c: mize losses (i) by conti AFC + (SAVC-AR) > AFC 4 ‘an discuss two situations in which a firm will mint inuing production and (ii) by stopping it altogether