Perfect Competition Examples Essay

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Perfect Competition Examples

Market structure is best defined as the organizational and other characteristics of a market. We focus on those characteristics which affect the nature of competition and pricing.Traditionally, the most important features of market structure are:

1. Number of Buyers and Sellers:

Number of buyers and sellers of a commodity in the market indicates the influence exercised by them on the price of the commodity. In case of large number of buyers and sellers, an individual buyer or seller is not in the position to influence the price of the commodity. However, if there is a single seller of a commodity, then such a seller exercises great control over the price.

2. Nature of the Commodity:

If the commodity is of homogeneous nature, i.e. identical in all respects, then it is sold at a uniform price. However, if the commodity is of differentiated nature (like different brands of toothpaste), then it may be sold at different prices. Again, if the commodity has no close substitutes (like Railways), then the seller can charge higher price from the buyers.

3. Freedom of Movement of Firms:

If there is freedom of entry and exit of firms, then price will be stable in the market. However, if there are restrictions on entry of new firms and exit of old firms, then a firm can influence the price as it has no fear of competition from other or new firms. 4. Knowledge of Market Conditions:

4. Knowledge of Market Conditions:

If buyers and sellers have perfect knowledge about the market conditions, then a uniform price prevails in the market. However, in case of imperfect knowledge, sellers are in a position to charge different prices. 5. Mobility of Goods and Factors of Production:

5. Mobility of Goods and Factors of Production:

When the factors of production can move freely from one place to another, then a uniform price prevails in the market. However, in case of immobility of goods and factors, different prices may prevail in the market.

Here are the four basic market structures:Perfect competition: Perfect competition happens when numerous small firms compete against each other. Firms in a competitive industry produce the socially optimal output level at the minimum possible cost per unit. Monopoly: A monopoly is a firm that has no competitors in its industry. It reduces output to drive up prices and increase profits. By doing so, it produces less than the socially optimal output level and produces at higher costs than competitive firms. Oligopoly: An oligopoly is an industry with only a few firms. If they collude, they reduce output and drive up profits the way a monopoly does.

Perfect competition: Perfect competition happens when numerous small firms compete against each other. Firms in a competitive industry produce the socially optimal output level at the minimum possible cost per unit. Monopoly: A monopoly is a firm that has no competitors in its industry. It reduces output to drive up prices and increase profits. By doing so, it produces less than the socially optimal output level and produces at higher costs than competitive firms. Oligopoly: An oligopoly is an industry with only a few firms. If they collude, they reduce output and drive up profits the way a monopoly does.

However, because of strong incentives to cheat on collusive agreements, oligopoly firms often end up competing against each other. Monopolistic competition: In monopolistic competition, an industry contains many competing firms, each of which has a similar but at least slightly different product. Restaurants, for example, all serve food but of different types and in different locations. Production costs are above what could be achieved if all the firms sold identical products, but consumers benefit from the variety. Other than the above mentioned four,

Duopoly(a special case of an oligopoly with two firms) Monopsony, (when there is only one buyer in a market) and Oligopsony (a market where many sellers can be present but meet only a few buyers are also among different market structures.

Key theories
As mentioned earlier, the identifying characteristics for each type of market structure include the Degree of Price Control
Nature of Demand Curve
Influence on Activities of other Firms
Overall Comparison

(I) Degree of Price Control:
Perfect Competition:
A firm under Perfect competition is a Price-taker, i.e. an individual firm has no control over the price and has to accept the price as determined by the market forces of demand and supply. Monopoly:

A monopolist is a Price-Maker, i.e., a firm has complete control over the price and fixes its own price. Monopolistic Competition:
A firm under monopolistic competition has partial control over the price, i.e. each firm is neither a price-taker nor a price-maker. An individual firm is able to influence the price by creating a differentiated image of its product through heavy selling costs. Oligopoly:

A firm under oligopoly follows the policy of price rigidity. Although, the firm can influence the prices, but it prefers to stick to its prices so as to avoid a price war. (II) Nature of Demand Curve:

i. Perfect Competition:
The demand curve for a perfectly competitive firm is perfectly elastic as it has to accept the price fixed by the market forces of demand and supply. ii. Monopoly:
The monopoly firm faces a downward sloping demand curve as more quantity can be sold only at a lower price. iii. Monopolistic Competition:
The firm under monopolistic competition also faces a downward sloping demand curve as more quantity can be sold only at a lower price. However, the demand curve is more elastic in comparison to demand curve under monopoly because of presence of close substitutes. iv. Oligopoly:

The demand curve for an oligopoly firm is indeterminate, i.e. it cannot be drawn accurately as exact behavior pattern of a producer cannot be ascertained with certainty. (III) Influence on Activities of other Firms:

i. Perfect Competition:
Each firm is so small that its behavior has no influence on the decisions of other firms operating in the market. ii. Monopoly:
There is only one firm in the industry. Therefore, the question of reaction from other firms does not arise, i.e. monopolist has full control over the industry. iii. Monopolistic Competition:
There are large numbers of firms and behaviour of each firm has less impact on activities of other firms. iv. Oligopoly:
There are few firms and behaviour of each firm has significant impact on activities of other firms. (IV) Overall Comparison:

What we analyze in all market structures and why the perfect competition is the most efficient? AR,MR
AC, MC
The point where MR=MC (Profit maximum)
Q* (equilibrium quantity)
P* (equilibrium price)

Perfect Competition – Economics of Competitive Markets
Pure or perfect competition is rare in the real world, but the model is important because it helps competition analyze industries with characteristics similar to pure competition. Examples of perfect competition are stock market and agricultural industries.

Demand

The individual firm will view its demand as perfectly elastic. A perfectly elastic demand curve is a horizontal line at the price. The demand curve for the industry is not perfectly elastic, it only appears that way to the individual firms, since they must take the market price no matter what quantity they produce. Therefore, the firm’s demand curve is a horizontal line at the market price. Marginal revenue (MR) is the increase in total revenue resulting from a one-unit increase in output. Since the price is constant in the perfect competition. The increase in total revenue from producing 1 extra unit will equal to the price. Therefore, P= MR in perfect.

In the short run, the interaction between demand and supply determines the “market-clearing” price. A price P1 is established and output Q1 is produced. This price is taken by each firm. The average revenue curve is their individual demand curve. Since the market price is constant for each unit sold, the AR curve also becomes the marginal revenue curve (MR) for a firm in perfect competition. For the firm, the profit maximising output is at Q2 where MC=MR. This output generates a total revenue (P1 x Q2). Since total revenue exceeds total cost, the firm in our example is making abnormal (economic) profits. This is not necessarily the case for all firms in the industry since it depends on the position of their short run cost curves. Some firms may be experiencing sub-normal profits if average costs exceed the price – and total costs will be greater than total revenue.

The adjustment to the long-run equilibrium in perfect competition If most firms are making abnormal profits in the short run, this encourages the entry of new firms into the industry This will cause an outward shift in market supply forcing down the price The increase in supply will eventually reduce the price until price = long run average cost. At this point, each firm in the industry is making normal profit. Other things remaining the same, there is no further incentive for movement of firms in and out of the industry and a long-run equilibrium has been established. This is shown in the next diagram. Assuming in the diagram above that there has been no shift in market demand. The effect of increased supply is to force down the price and causes an expansion along the market demand curve. But for each supplier, the price they “take” is now lower and it is this that drives down the level of profit made towards normal profit equilibrium. Characteristics of competitive markets

The common characteristics of markets that are considered to be “competitive” are: Lower prices because of many competing firms. The cross-price elasticity of demand for one product will be high suggesting that consumers are prepared to switch their demand to the most competitively priced products in the marketplace. Low barriers to entry – the entry of new firms provides competition and ensures prices are kept low in the long run. Lower total profits and profit margins than in markets which dominated by a few firms. Greater entrepreneurial activity – the Austrian school of economics argues that competition is a process. For competition to be improved and sustained there needs to be a genuine desire on behalf of entrepreneurs to innovate and to invent to drive markets forward and create what Joseph Schumpeter called the “gales of creative destruction”. Economic efficiency – competition will ensure that firms move towards productive efficiency. The threat of competition should lead to a faster rate of technological diffusion, as firms have to be responsive to the changing needs of consumers. This is known as dynamic efficiency. The importance of non-price competition

In competitive markets, non-price competition can be crucial in winning sales and protecting or enhancing market share. Perfect competition and efficiency Perfect competition can be used as a yardstick to compare with other market structures because it displays high levels of economic efficiency.

1. Allocative efficiency: In both the short and long run we find that price is equal to marginal cost (P=MC) and thus allocative efficiency is achieved. At the ruling price, consumer and producer surplus are maximised. No one can be made better off without making some other agent at least as worse off – i.e. we achieve a Pareto optimum allocation of resources.

2. Productive efficiency: Productive efficiency occurs when the equilibrium output is supplied at minimum average cost. This is attained in the long run for a competitive market. Firms with high unit costs may not be able to justify remaining in the industry as the forces of competition drive down the market price.

3. Dynamic efficiency: Since perfectly competitive market produces homogeneous products – in other words, there is little scope for innovation designed purely to make products differentiated from each other and allow a supplier to develop and then exploit a competitive advantage in the market to establish some monopoly power. Some economists claim that perfect competition is not a good market structure for high levels of research and development spending and the resulting product and process innovations. Indeed it may be the case that monopolistic or oligopolistic markets are more effective long term in creating the environment for research and innovation to flourish. A cost-reducing innovation from one producer will, under the assumption of perfect information, be immediately and without cost transferred to all of the other suppliers.

That said a contestable market provides the discipline on firms to keep their costs under control, to seek to minimise wastage of scarce resources and to refrain from exploiting the consumer by setting high prices and enjoying high profit margins. In this sense, competition can stimulate improvements in both static and dynamic efficiency over time. The long run of perfect competition, therefore, exhibits optimal levels of economic efficiency. But for this to be achieved all of the conditions of perfect competition must hold – including in related markets. When the assumptions are dropped, we move into a world of imperfect competition with all of the potential that exists for various forms of market failure

Inefficiency in Monopolistic Competition

Monopoly is the other market structure, which is most different from perfect competition. Compared to a perfectly competitive market monopoly is less efficient . Monopolistic firms’ profit maximizing production levels occur when their marginal revenues equals their marginal costs. This quantity is less than what would be produced in a perfectly competitive market. It also means that producers will supply goods below their manufacturing capacity. Monopoly creates deadweight loss and inefficiency, as represented by the yellow triangle. The quantity is produced when marginal revenue equals marginal cost, or where the green and blue lines intersect. The price is determined based on where the quantity falls on the demand curve, or the red line.

Conclusion: The importance of market structure in an economy cannot be over emphasized as the effect of market structure on an economy, it’s development or degradation is recently been realized. Thus we as the part of the economy need to understand the value of this concept while dealing with others (buyers/sellers) in any market place to yield the optimum benefit and to create win-win situation for all of us.

References:
Grant SJ.(2000), Introductory Economics, (7th edn), Pearsons Eucation, UK. http://en.wikipedia.org/wiki/Market_structure http://www.slideshare.net/mithileshtrivedi581/market-structure-and-types-of-market-strucyure

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