6/19/11

Perfect Competition as a market structure, a look at the rules and examples


A certain market (businesses producing the same product) can be considered to be a perfectly competitive market when it adheres to the following conditions:

1. When there is a large number of sellers or producers of the good.  The number is considered “large” when it is large enough that one firm has no control over the price of the product. 

2. All firms in the market or industry sell homogeneous products.  This means
that the goods they well are identical in every way!  They have the same packaging, name, color, taste, etc.  There has to be NO way you can tell who produced the good. 

3.  No barrier to entry or exit the market.  This means that firms can freely start a new business, or close down an existing one without much fuss or regulation.

It is also necessary that both firms and consumers have perfect information, and that firms are profit maximizers. Another important aspect of perfect competition is that no firm in a perfectly competitive market will make or lose economic profit in the long run.  This is directly a result of the lack of barriers to entry or exit.  If firms have negative economic profit, some will leave until economic profit is zero.  If firms have positive economic profit, other firms will enter until economic profit is zero again.
 


Probably the closest you will ever come to seeing a perfectly competitive market is when you go to the grocery store, or somewhere like whole foods and you see the bulk bins of flour, rice, and other goodies.  Now these still have names above them, but at least in the bins they have identical packaging and they have similar colors and tastes.

Chatham Marketplace


These rules are put into place to make sure that only one thing matters… PRICE.  If everything else is identical, then the only thing we can observe and frankly care about is the price of the good.  It is an economists dream to have everything else taken care of (or assumed away) and only have to worry about the price of a good.

Because each firm is too small to effect price, this means that ONE price will apply to ALL of the firms.  No exceptions here, all firms receive the same price for their good.  What this means is that when graphing their received price level (or marginal revenue), it is horizontal or completely flat!

Bade and Parkin


Now let’s consider cost for a perfectly competitive firm.  To keep it simple in this example we will only consider marginal cost and average cost.  Both of these costs have direct relationships to total cost.

Marginal Cost- How much it costs to produce the NEXT good. 

Marginal costs’ relationship to fixed cost is:

For those of you unfamiliar with calculus, we assume that the change in output is always one (because it is the NEXT unit produced), and we see how much total cost changes.  So if you are producing 50 units and your TC is 307, and you produce one more and your TC goes up to 311, then your marginal cost is??? That’s right 4.  Producing that next unit added 4 to your TC so your MC is 4.

Average Cost- Given your production to this point, what is your average cost.  This is easy, just remember the definition of average, take your total cost and divide it by Q (your quantity produced).  So using the example above, if our total cost is 307, and we were producing 50 units, then our AC (average cost) would be 307/50 or 6.14.  And if our TC is 311 and we are producing 51 units?  We get 311/51 or 6.09.  Which brings me to my last important point.

Important:  The AC curve ALWAYS chases the MC curve.  This  means that when the MC curve is below the AC curve, then the AC curve is going down.  And when the MC curve is above the AC curve, than the AC curve is going up.  The MC curve ALWAYS intersects the AC curve at its minimum (where it is flat).  For an example of this, look back one paragraph.  Our AC was 6.14, then we added a MC of 4 (which is lower than our current AC)  what would we expect to happen??? That’s right, we would expect our AC to go down, and that is exactly what it did moving to 6.09.


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