Question

a) What are the characteristics of a competitive market?

b) For a competitive firm, show how the price is determined by the industry. Use diagram to show a competitive firm that is making only the normal rate of profit. What is the difference between firm’s equilibrium andindustry’s equilibrium?

Answer 1

Characterstics of a competitive market.

• VERY LARGE NO. OF BUYERS ANS SELLERS -There are many buyers and sellers in the market.
• HOMOGENEOUS - Each company makes a similar product.
• PERFECT INFORMATION - Buyers and sellers have access to perfect information about price.
• TRANSACTION COST - There are no transaction costs.
• ENTRY OR EXIT -There are no barriers to entry into or exit from the market.

B. In a competitive market conditions a firm is a price taker because other firms can enter the market easily and produce a product that is indistinguishable from every other firm’s product. This makes it impossible for any firm to set its own prices. There are two main reasons. First, there is no difference between its product and that of every other firm in the market. Therefore, no one will pay extra for a firm’s product the way that they might pay extra for something like Nike shoes. Second, if a firm were to succeed in setting a higher price, more firms would enter the market, attracted by the higher profits that were available. This would increase supply and drive down the price of the firms product.

In competitive market firms sell homogeneous products and it is easy for a firm to enter the market. These two factors make it impossible for firms to set their prices above the market price. This makes them into price takers.

* Diagram of normal rate of profit or zero economic profit :.

*THE DIFFERENCE BETWEEN INDUSTRY EQUILIBRIUM AND FIRM EQUILIBRIUM:

The industry equilibrium yields both equilibrium output as well as equilibrium price. Both in the short run as well as long run, the point where the industry supply curve and demand curve meet signifies both equilibrium price and output of the industry.

However, equilibrium of the firm indicates equilibrium output only. It is well-known that under perfect competition, industry is the price-maker while the firm is the price-taker. The firm has no control over price; it has only to decide how much to produce at the given market price determined by the industry’s demand and supply.

The firm may be in short-run equilibrium but the equilibrium of the industry in the short-period is a matter of accident.In the short-run, the firm may be undergoing losses or enjoying extra profits and yet be in equilibrium. This means that the industry will not be in equilibrium as its output will tend to change due to the entry or exit of firms.In the long run every firm, in equilibrium, enjoys only normal profits. Therefore, the industry also is in full equilibrium since there is no entry or exit of firms and output of the industry is also stable.