Perfect competition
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Perfect competition provides both allocative efficiency and productive efficiency:
- Such markets are allocatively efficient, as output will always occur where price taking creates considerable difficulties for the demonstration of a general equilibrium except under other, very specific conditions such as that of monopolistic competition.
- In the short-run, perfectly competitive markets are not necessarily productively efficient, as output will not always occur where marginal cost is equal to average cost (MC = AC). However, in the long-run, productive efficiency occurs as new firms enter the industry. Competition reduces price and cost to the minimum of the long run average costs. At this point, price equals both the marginal cost and the average total cost for each good (P = MC = AC).
The theory of perfect competition has its roots in late-19th century economic thought. Léon Walras[2] gave the first rigorous definition of perfect competition and derived some of its main results. In the 1950s, the theory was further formalized by Kenneth Arrow and Gérard Debreu.[3]
Imperfect competition was a theory created to explain the more realistic kind of market interaction that lies in between perfect competition and a monopoly. Edward Chamberlin wrote "Monopolistic Competition" in 1933 as "a challenge to the traditional viewpoint that competition and monopolies are alternatives and that individual prices are to be explained in either terms of one or the other" (Dewey,88.) In this book, and for much of his career, he "analyzed firms that do not produce identical goods, but goods that are close substitutes for one another" (Sandmo,300.)
Another key player in understanding imperfect competition is Joan Robinson, who published her book "The Economics of Perfect Competition" the same year Chamberlain published his. While Chamberlain focused much of his work on product development, Robinson focused heavily on price formation and discrimination (Sandmo,303.) The act of price discrimination under imperfect competition implies that the seller would sell their goods at different prices depending on the characteristic of the buyer to increase revenue (Robinson,204.) Joan Robinson and Edward Chamberlain came to many of the same conclusions regarding imperfect competition while still adding a bit of their twist to the theory. Despite their similarities or disagreements about who discovered the idea, both were extremely helpful in allowing firms to understand better how to center their goods around the wants of the consumer to achieve the highest amount of revenue possible.
Real markets are never perfect. Those economists who believe in perfect competition as a useful approximation to real markets may classify those as ranging from close-to-perfect to very imperfect. The real estate market is an example of a very imperfect market. In such markets, the theory of the second best proves that if one optimality condition in an economic model cannot be satisfied, it is possible that the next-best solution involves changing other variables away from the values that would otherwise be optimal.[4]
Idealizing conditions of perfect competition
There is a set of market conditions which are assumed to prevail in the discussion of what perfect competition might be if it were theoretically possible to ever obtain such perfect market conditions. These conditions include:[5]
- A large number of buyers and sellers – A large number of consumers with the willingness and ability to buy the product at a certain price, and a large number of producers with the willingness and ability to supply the product at a certain price. As a result, individuals are unable to influence prices more than a little.[6]
- Anti-competitive regulation: It is assumed that a market of perfect competition shall provide the regulations and protections implicit in the control of and elimination of anti-competitive activity in the market place.
- Every participant is a price taker: No participant with market power to set prices.
- Homogeneous products: The products are perfect substitutes for each other (i.e., the qualities and characteristics of a market good or service do not vary between different suppliers). There are many instances in which there exist "similar" products that are close substitutes (such as butter and margarine), which are relatively easily interchangeable, so that a rise in the price of one good will cause a significant shift to the consumption of the close substitute. If the cost of changing a firm's manufacturing process to produce the substitute is also relatively "immaterial" in relationship to the firm's overall profit and cost, this is sufficient to ensure that an economic situation isn't significantly different from a perfectly competitive economic market.[7]
- economic utilityand make no trades that do not.
- No barriers to sunk costs.
- No government intervention.
- Non-increasing returns to scale and no network effects: The lack of economies of scale or network effects ensures that there will always be a sufficient number of firms in the industry.
- Perfect factor mobility: In the long run factors of production are perfectly mobile, allowing free long term adjustments to changing market conditions. This allows workers to freely move between firms.[8]
- Perfect information: All consumers and producers know all prices of products and utilities they would get from owning each product. This prevents firms from obtaining any information which would give them a competitive edge.[8]
- marginal costs meet marginal revenue.
- Well defined property rights: These determine what may be sold, as well as what rights are conferred on the buyer.
- Zero transaction costs: Buyers and sellers do not incur costs in making an exchange of goods.
Normal profit
In a perfect market the sellers operate at zero
Normal profit is a component of (implicit) costs and not a component of business profit at all. It represents all the
In circumstances of perfect competition, only normal profits arise when the long run economic equilibrium is reached; there is no incentive for firms to either enter or leave the industry.[11]
In competitive and contestable markets
Economic profit does not occur in perfect competition in
The same is likewise true of the
Profit can, however, occur in competitive and contestable markets in the short run, as firms jostle for market position. Once risk is accounted for, long-lasting economic profit in a competitive market is thus viewed as the result of constant cost-cutting and performance improvement ahead of industry competitors, allowing costs to be below the market-set price.
In non-competitive markets
Economic profit is, however, much more prevalent in uncompetitive markets such as in a perfect
The existence of economic profits depends on the prevalence of
However, some economists, for instance Steve Keen, a professor at the University of Western Sydney, argue that even an infinitesimal amount of market power can allow a firm to produce a profit and that the absence of economic profit in an industry, or even merely that some production occurs at a loss, in and of itself constitutes a barrier to entry.
In a single-goods case, a positive economic profit happens when the firm's average cost is less than the price of the product or service at the profit-maximizing output. The economic profit is equal to the quantity of output multiplied by the difference between the average cost and the price.
Government intervention
Often, governments will try to intervene in uncompetitive markets to make them more competitive.
If a government feels it is impractical to have a competitive market – such as in the case of a natural monopoly – it will sometimes try to regulate the existing uncompetitive market by controlling the price firms charge for their product.[13][14] For example, the old AT&T (regulated) monopoly, which existed before the courts ordered its breakup, had to get government approval to raise its prices. The government examined the monopoly's costs to determine whether the monopoly should be able raise its price, and could reject the monopoly's application for a higher price if the cost did not justify it. Although a regulated firm will not have an economic profit as large as it would in an unregulated situation, it can still make profits well above a competitive firm in a truly competitive market.[14]
Results
In a perfectly competitive market, the
As mentioned above, the perfect competition model, if interpreted as applying also to short-period or very-short-period behaviour, is approximated only by markets of homogeneous products produced and purchased by very many sellers and buyers, usually organized markets for agricultural products or raw materials. In real-world markets, assumptions such as perfect information cannot be verified and are only approximated in organized double-auction markets where most agents wait and observe the behaviour of prices before deciding to exchange (but in the long-period interpretation perfect information is not necessary, the analysis only aims at determining the average around which market prices gravitate, and for gravitation to operate one does not need perfect information).
In the absence of externalities and public goods, perfectly competitive equilibria are Pareto-efficient, i.e. no improvement in the utility of a consumer is possible without a worsening of the utility of some other consumer. This is called the First Theorem of Welfare Economics. The basic reason is that no productive factor with a non-zero marginal product is left unutilized, and the units of each factor are so allocated as to yield the same indirect marginal utility in all uses, a basic efficiency condition (if this indirect marginal utility were higher in one use than in other ones, a Pareto improvement could be achieved by transferring a small amount of the factor to the use where it yields a higher marginal utility).
A simple proof assuming differentiable utility functions and production functions is the following. Let be the 'price' (the rental) of a certain factor , let and be its marginal product in the production of goods and , and let and be these goods' prices. In equilibrium these prices must equal the respective marginal costs and ; remember that marginal cost equals factor 'price' divided by factor marginal productivity (because increasing the production of good by one very small unit through an increase of the employment of factor requires increasing the factor employment by and thus increasing the cost by , and through the condition of cost minimization that marginal products must be proportional to factor 'prices' it can be shown that the cost increase is the same if the output increase is obtained by optimally varying all factors). Optimal factor employment by a price-taking firm requires equality of factor rental and factor marginal revenue product, , so we obtain , .
Now choose any consumer purchasing both goods, and measure his utility in such units that in equilibrium his marginal utility of money (the increase in utility due to the last unit of money spent on each good), , is 1. Then , . The indirect marginal utility of the factor is the increase in the utility of our consumer achieved by an increase in the employment of the factor by one (very small) unit; this increase in utility through allocating the small increase in factor utilization to good is , and through allocating it to good it is again. With our choice of units the marginal utility of the amount of the factor consumed directly by the optimizing consumer is again w, so the amount supplied of the factor too satisfies the condition of optimal allocation.
Monopoly violates this optimal allocation condition, because in a monopolized industry market price is above marginal cost, and this means that factors are underutilized in the monopolized industry, they have a higher indirect marginal utility than in their uses in competitive industries. Of course, this theorem is considered irrelevant by economists who do not believe that general equilibrium theory correctly predicts the functioning of market economies; but it is given great importance by neoclassical economists and it is the theoretical reason given by them for combating monopolies and for antitrust legislation.
Profit
In contrast to a
- Neoclassical theory defines profit as what is left of revenue after all costs have been subtracted; including normal interest on capital plus the normal excess over it required to cover risk, and normal salary for managerial activity. This means that profit is calculated after the actors are compensated for their opportunity costs.[18]
- Classical economists on the contrary define profit as what is left after subtracting costs except interest and risk coverage. Thus, the classical approach does not account for opportunity costs.[18]
Thus, if one leaves aside risk coverage for simplicity, the neoclassical zero-long-run-profit thesis would be re-expressed in classical parlance as profits coinciding with interest in the long period (i.e. the
It is important to note that perfect competition is a sufficient condition for allocative and productive efficiency, but it is not a necessary condition. Laboratory experiments in which participants have significant price setting power and little or no information about their counterparts consistently produce efficient results given the proper trading institutions.[21]
Shutdown point
In the short run, a firm operating at a loss [ (revenue less than total cost) or (price less than unit cost)] must decide whether to continue to operate or temporarily shut down.[22] The shutdown rule states "in the short run a firm should continue to operate if price exceeds average variable costs".[23] Restated, the rule is that for a firm to continue producing in the short run it must earn sufficient revenue to cover its variable costs.[24] The rationale for the rule is straightforward: By shutting down a firm avoids all variable costs.[25] However, the firm must still pay fixed costs.[26] Because fixed costs must be paid regardless of whether a firm operates they should not be considered in deciding whether to produce or shut down. Thus in determining whether to shut down a firm should compare total revenue to total variable costs () rather than total costs (). If the revenue the firm is receiving is greater than its total variable cost (), then the firm is covering all variable costs and there is additional revenue ("contribution"), which can be applied to fixed costs. (The size of the fixed costs is irrelevant as it is a sunk cost. The same consideration is used whether fixed costs are one dollar or one million dollars.) On the other hand, if then the firm is not covering its production costs and it should immediately shut down. The rule is conventionally stated in terms of price (average revenue) and average variable costs. The rules are equivalent (if one divides both sides of inequality by gives ). If the firm decides to operate, the firm will continue to produce where marginal revenue equals marginal costs because these conditions insure not only profit maximization (loss minimization) but also maximum contribution.
Another way to state the rule is that a firm should compare the profits from operating to those realized if it shut down and select the option that produces the greater profit.[27][28] A firm that is shut down is generating zero revenue and incurring no variable costs. However, the firm still has to pay fixed cost. So the firm's profit equals fixed costs or .[29] An operating firm is generating revenue, incurring variable costs and paying fixed costs. The operating firm's profit is . The firm should continue to operate if , which simplified is .[30][31] The difference between revenue, , and variable costs, , is the contribution to fixed costs and any contribution is better than none. Thus, if then firm should operate. If the firm should shut down.
A decision to shut down means that the firm is temporarily suspending production. It does not mean that the firm is going out of business (exiting the industry).[32] If market conditions improve, and prices increase, the firm can resume production. Shutting down is a short-run decision. A firm that has shut down is not producing. The firm still retains its capital assets; however, the firm cannot leave the industry or avoid its fixed costs in the short run. Exit is a long-term decision. A firm that has exited an industry has avoided all commitments and freed all capital for use in more profitable enterprises.[33]
However, a firm cannot continue to incur losses indefinitely. In the long run, the firm will have to earn sufficient revenue to cover all its expenses and must decide whether to continue in business or to leave the industry and pursue profits elsewhere. The long-run decision is based on the relationship of the price and long-run average costs. If then the firm will not exit the industry. If , then the firm will exit the industry. These comparisons will be made after the firm has made the necessary and feasible long-term adjustments. In the long run a firm operates where marginal revenue equals long-run marginal costs.[34]
Short-run supply curve
The short-run () supply curve for a perfectly competitive firm is the marginal cost () curve at and above the shutdown point. Portions of the marginal cost curve below the shutdown point are not part of the supply curve because the firm is not producing any positive quantity in that range. Technically the supply curve is a discontinuous function composed of the segment of the curve at and above minimum of the average variable cost curve and a segment that runs on the vertical axis from the origin to but not including a point at the height of the minimum average variable cost.[35]
Criticisms
The use of the assumption of perfect competition as the foundation of
Some economists have a different kind of criticism concerning perfect competition model. They are not criticizing the
Another frequent criticism is that it is often not true that in the short run differences between supply and demand cause changes in price; especially in manufacturing, the more common behaviour is alteration of production without nearly any alteration of price.[37]
The critics of the assumption of perfect competition in product markets seldom question the basic
In particular, the rejection of perfect competition does not generally entail the rejection of free competition as characterizing most product markets; indeed it has been argued
The issue is different with respect to factor markets. Here the acceptance or denial of perfect competition in labour markets does make a big difference to the view of the working of market economies. One must distinguish neoclassical from non-neoclassical economists. For the former, absence of perfect competition in
Particularly radical is the view of the Sraffian school on this issue: the labour demand curve cannot be determined hence a level of wages ensuring the equality between supply and demand for labour does not exist, and economics should resume the viewpoint of the classical economists, according to whom competition in labour markets does not and cannot mean indefinite price flexibility as long as supply and demand are unequal, it only means a tendency to equality of wages for similar work, but the level of wages is necessarily determined by complex sociopolitical elements; custom, feelings of justice, informal allegiances to classes, as well as overt coalitions such as trade unions, far from being impediments to a smooth working of labour markets that would be able to determine wages even without these elements, are on the contrary indispensable because without them there would be no way to determine wages.[41]
Equilibrium in perfect competition
Equilibrium in perfect competition is the point where market demands will be equal to market supply. A firm's price will be determined at this point. In the short run, equilibrium will be affected by demand. In the long run, both demand and supply of a product will affect the equilibrium in perfect competition. A firm will receive only normal profit in the long run at the equilibrium point.[42]
As it is well known, requirements for firm's cost-curve under perfect competition is for the slope to move upwards after a certain amount is produced. This amount is small enough to leave a sufficiently large number of firms in the field (for any given total outputs in the industry) for the conditions of perfect competition to be preserved. For the short-run, the supply of some factors are assumed to be fixed and as the price of the other factors are given, costs per unit must necessarily rise after a certain point. From a theoretical point of view, given the assumptions that there will be a tendency for continuous growth in size for firms, long-period static equilibrium alongside perfect competition may be incompatible.[43]
See also
References
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Tirole, Jean, "The Theory of Industrial Organization", Cambridge, Massachusetts: The MIT Press, 1988. - ^ a b Robinson, J. (1934). What is perfect competition?. The Quarterly Journal of Economics, 49(1), 104-120.
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- ^ Binger & Hoffman, Microeconomics with Calculus, 2nd ed. (Addison-Wesley 1998) at 312–14. A firm's production function may display diminishing marginal returns at all production levels. In that case both the curve and the curve would originate at the origin and there would be no minimum (or min ). Consequently, the entire curve would be the supply curve.
- ^ This was the kind of criticism made by the "autisme economie" movement Example of this kind of criticisms: http://www.paecon.net/PAEtexts/Guerrien1.htm
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- Roberts, J. (1987). "Perfectly and imperfectly competitive markets", The New Palgrave: A Dictionary of Economics, v. 3, pp. 837–41.
- Robinson, Joan. “Chapter 16.” The Theory of Imperfect Competition, 2nd ed.
- Sandmo, Agnar. “Chapter 13: New Prospectives on Markets and Competition.” Economics Evolving: A History of Economic Thought, Princeton University Press, Princeton, NJ, 2011.
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- Stigler J. G. (1987). "Competition", The New Palgrave: A Dictionary of Economics, Ist edition, vol. 3, pp. 531–46.
External links
- The Perfect Market Economy Archived 2016-03-20 at the Wayback Machine