Question

A. In terms of productive output, what must a business that competes in a "perfect competition" market do in order to try to maximize profit.

B. What are price takers, and why are firms that compete in a "perfect competition market" limited to being price takers?

C. In the real world, so-called "perfect competition" does not and cannot exist. Based on the nature and benefits of free competition, why is this reality actually a good thing?

Answer 1

A. In a perfectly competitive market, there are large number of firms and each firm is too small to be able to affect the market price of the product. Hence, each firm is a price taker and the market price is determined by market forces that is, market demand and market supply. A firm in a perfectly competitve market can only maximize its profits by choosing the quanitity at which profits are maximum. This can be shown as follows:

The diagram on the right hand side shows the demand and supply in the industry. The equilibrium price and quantity are Q and P respectively. Since a firm is price taker, diagram on the left hand side (which shows demand and supply of a firm) takes the price as determined by market forces. This is the demand curve (D) of the firm. The demand curve of the firm is also the Average Revenue (AR) and the Marginal Revenue (MR) curve of the firm. In the diagram, where the Marginal Cost (MC) curve intersects the MR curve, equilibrium quantity (Q₁) is determined. At this point the Average Cost (AC) is also minimum. This is the quantity at which profits of the firm are maximized.

B. Firms in a perfectly competitve market are price takers as shown in the diagram above. That means, they cannot determine the price at which they want to sell their goods. This is because products sold in competitive maket are homogeneous and have very close substitutes. Therefore, if any firm sets the price of its product above the market determined price, then consumers will make their purchase from elsewhere and the firm will not be able to sell anything. Hence, these firms are limited to being price takers.

C. In the real world, perfectly competitve markets do not exist. In free competition, firms cannot earn anything over and above normal profits. Although, perfect competition is good for the consumers because they offer products at competitive prices. Hence, the consumer surplus is maximum. But in such a market, producers have no opportunity to earn higher profits. Therefore, firms do not have any incentive to innovate and expand. If innovation doesn't happen, the economy doesn't improve. Consumers also lose becuase they continue to consume same quality of products with same old features and hence, consumers also lose in the long run. That is the reason why it is good not to have perfectly competitive markets in reality.