Question

Explain how each of the assumptions of perfect competition contributes to the fact that all decision makers in perfect competition are price takers.

If the assumptions of perfect competition are not likely to be met in the real world, how can the model be of any use?

Explain the difference between marginal revenue, average revenue, and price in perfect competition.

Answer 1

Perfect competition is a form of market which consists of large number of buyers and sellers dealing in a homogenous product. The product is homogenous in the sense that the product of one seller is perfect substitute for other seller.

The basic assumptions of perfect competition are:-

1. Large number of buyers and sellers, 2) Homogenous prodct,3) Perfect knowledge about the market, 4) Freedom of entry and exit, 5) Independent decision making, 6) Perfect mobility of factors, 7) No extra transport cost.

While examining each of the assumption of the perfect competition we can conclude that all the decision makers in a perfect competitive market is a price taker.

a)The assumption of large number of sellers implies that no individual seller can influence the market price by his own action. As there is large number of sellers in the market the supply made by a single seller is negligible in the market. The supply made by an individual seller is only a small fraction of the market supply. If one seller tries to increase the price level by reducing his supply, the fall in supply by one seller will not have any influence in the market supply. If one seller rise the price by reducing the supply the buyers will quit the seller and he will buy the product from some other seller. Thus each seller is a price taker and output adjuster in a perfect competitive market. The individual seller adjusts his quantity of output according to the ruling price in the market. Thus each seller is a price taker in the market.

b)The assumption of large number of buyers also reveals that the individual buyer has no control over the price of the product in the market. The demand made by a buyer is only a small fraction of the market demand. If one buyer reduces his demand in order to reduce the price, the effect of his action is zero as there are numerous buyers to the product in the market. Thus like the individual seller the individual buyer is also a price taker.

c) The assumption of homogeneous product says that the products are identical in size, shape, colour, weight or in any other respect. The buyers have no special preference to the product of one seller. The absence of product differentiation and perfect substitutability in use creates a situation that the individual firm has no monopoly over his product and price determination.

d) The assumption of perfect knowledge of the market states that the buyers and sellers are fully aware of the ruling price. The seller cannot practice price discrimination. Thus the firms are accepting the ruling price.

e) The freedom of entry and exit assume that if the firms in shortrun earns super normal profit at the prevailing price, new firm will enter into the industry in longrun and the supernormal profit will disappears. On the other hand if the existing firms suffer losses in shortrun some of the loss incurring firms will quit the industry in longrun and the loss will disappear in longrun. The determination of price is also affected by the free entry and exit of the firms. So the firms are price takers in the market.

f) The assumption of independent decision making states that there is no tacit or open agreement between the firms regarding the quantity of production and price. The firms do not forms trust or cartels. The absence of agreement compels the firms to accept the ruling price in the market.

g) Perfect competition assumes the perfect mobility of factors.

The factors are free to move from one firm to another. The perfect mobility of factors ensures the single price to the factors too.

i) No extra transport cost means buying a product from one seller rather than the other does not involve any extra transport cost. Buying product from any of the firms in the market involves the same transport cost. This means that only one price prevails in the market. All the buyers and sellers accept the ruling price determined by the market demand and supply.

Average revenue is the revenue per unit of output sold. It can be calculated by dividing the total revenue by the number of units sold. Under perfect competition different units are sold at the same price. So the average revenue is equal to the price. If the different units are sold at different price the price per unit will not be equal to its average revenue.

Marginal revenue is the net addition to the total revenue by selling an additional unit. It is the additional revenue from the sale of additional unit. Under perfect competition an additional unit is also sold at the market price. Thus under perfect competition MR=AR=Price. No difference exist between marginal revenue, average revenue and price.

Perfect competition is an imaginary market. Most of the assumptions of the market do not exist in the real world. Even though the perfect competition is an important tool in the theory of pricing. The model of perfect competition create the necessary framework to make the economics a positive empirical science. The perfect competition is used in micro economics to explain actions of individual sellers. The effects of barriers to entry into the market, sticky price, heterogonous product and imperfect information are useful study and the basis is actually derived from the assumption of perfect competition.