Question

Suppose we have n firms in a perfectly competitive industry. The shapes of the marginal and average cost curves are as usual, i.e., they are U-shaped. The industry demand curve is downward sloping. Please answer the following questions associated with this simple model. a. Write down the basic assumptions of a perfectly competitive industry. We have frequently stated that these assumptions were very crucial in obtaining certain results from this model. Explain each assumption in that sense in a few sentences. b. Describe the industry equilibrium and corresponding long-run equilibrium of any firm in this market. For this analysis, you are supposed to draw two graphs. c. If there is an increase in the demand for the product in this industry, how is the market going to be affected? What will be the effect of this change on a representative firm in the short-run? Explain possible profit opportunities in the market. As you did in part (b), draw two graphs showing all these changes. For simplicity purposes, please use the same long-run AC curve for your analysis. d. How will the industry adjust to the change in the demand in the long-run? More briefly: (i) What will happen to the number of firms in the industry? (ii) What are the properties of the new long-run equilibrium in terms of profits? (iii) Which particular assumption(s) did you use in reaching these conclusions? Assume a change in total industry supply will not change the input prices.

Answer 1

Perfect competition refers to a market situation in which there are large number of buyers and sellers of homogeneous products.

The price of the product is determined by industry with the forces of demand and supply.

Under conditions of perfect competition, every seller should be selling the same quality of pens at the uniform prevailing price in the market. You may buy a pen from any shop at price Rs. 10. If another shopkeeper charges Rs. 12 for same quality of pen, nobody will buy from him. But if a shopkeeper charges Rs. 9 all will buy pens from that particular shop. But, both these situations are unrealistic.

There must be one price prevailing throughout the market. Thus, perfect competition in a market structure is characterized by the complete absence of rivalry among individual firms.

1. Large Number of Buyers and Sellers:

Large Number of Buyers and Sellers: It means no single buyer or seller can affect the price. If a firm enters into the market or exit the market, there will be no effect on the supply. Similarly if a buyer enters into the market or exit from the market, demand will not be affected. Thus no individual buyer or seller can affect the price.

2. Homogeneous Products:

The second assumption of perfect competition is that all sellers sell homogeneous product. In such a situation, the buyers have no reason to prefer the product of one seller to another. This condition is present only when the commodity is a substance of definite chemical and physical composition i.e., salt, tin, specified grade of wheat etc.

3. No Discrimination:

Under perfectly competitive market, buyers and sellers must buy and sell freely among themselves. It implies that buyers and sellers must be willing to deal openly with one another to buy and sell at the market price. This may be true of one and all that may wish to do so without offering any special deals, discounts, or favours to selected individuals.

4. Perfect Knowledge:

A competitive market is (me in which the buyers and sellers are in close contact with each other. It means that, there is perfect knowledge of the market on the part of buyers and sellers. It implies that a large number of buyers and sellers in the market exactly know how much is the price of the commodity in different parts of the market.

In other words, there must be knowledge on the part of each buyer and seller of the prices at which transactions are being carried on, and of the prices at which other buyers and sellers are willing to buy or sell.

5. Free Entry or Exit of Firms:

In the long run, under perfect competition, firm can enter into or exit from the industry. There is no let or hindrance on firms as far as their entry into or exit from the market. In other words, there are no legal or social restrictions on the firm. Large number of sellers can be possible only if there is free entry of firms.

6. Perfect Mobility:

There must be perfect mobility of factors of production within the country which ensures uniform cost of production in the whole economy. It implies that different factors of production are free to seek employment in any industry that they may like.

7. Profit Maximization:

Under perfect competition, all firms have a common goal of profit maximization. Thus, there is absence of social welfare of the general masses.

8. No Selling Cost:

Under perfect competition, there are no selling costs.

9. No Transport Costs:

There shall not be any cost of transport between sellers. If transport costs exist buyers are prevented from moving from one seller to another to take advantage of price difference. This means that transport cost has no influence on the pricing of a product. In other words, these are always uniform price in the market.

The industry is in long-run equilibrium when a price is reached at which all firms are in equilibrium (producing at the minimum point of their LAC curve and making just normal profits).At the market price, P, the firms produce at their minimum cost, earning just normal profits.

As the quantity supplied in the market increases (by the increased production of expanding old firms and by the newly established ones) the supply curve in the market will shift to the right and price will fall until it reaches the level of P1 at which the firms and the industry are in long-run equilibrium.

The LAC in figure 5.14 is the final-cost curve including any increase in the prices of factors that may have taken place as the industry expanded.

The condition for the long-run equilibrium of the firm is that the marginal cost be equal to the price and to the long-run average cost

LMC = LAC = P

The firm adjusts its plant size so as to produce that level of output at which the LAC is the minimum possible, given the technology and the prices of factors of production. At equilibrium the short-run marginal cost is equal to the long-run marginal cost and the short-run average cost is equal to the long-run average cost. Thus, given the above equilibrium condition, we have

SMC = LMC = LAC = LMC = P = MR

This implies that at the minimum point of the LAC the corresponding (short-run) plant is worked at its optimal capacity, so that the minima of the LAC and SAC coincide. On the other hand, the LMC cuts the LAC at its minimum point and the SMC cuts the SAC at its minimum point. Thus at the minimum point of the LAC the above equality between short-run and long-run costs is satisfied.

If the above conditions are fulfilled, perfect competition leads to the optimal resource allocation defined by the point of tangency of the given production-possibility curve with the highest possible indifference curve.