Question

A competitive market is characterized by many buyers and sellers trading identical products, with little ability to influence market prices. With nearly identical products and no influence over market prices, how do businesses compete with each other?

Imagine that you are going to start your own small business. How will you maximize profits and stay competitive in the market? Describe your business and use the concepts from this module and earlier modules to discuss the following:

a. What fixed and variable costs would you incur?

b. How will you determine the price for your product?

c. How much product you would produce?

d. Provide an example of one situation that would cause you to shut down production temporarily. Explain your answer using an equation with sample numbers.

e. Provide an example of one situation that would cause you to exit the market permanently. Explain your answer using an equation with sample numbers.

Answer 1

In a competitive market no firm has any ability to influence the market prices and all firms sell identical products. Thus here businesses compete on their costs. The firm which has low production cost can make supernormal profits in the short run. While a firm with higher production cost will have to leave the market if its costs exceed the prevailing prices. It should be noted that in the long run all supernormal profits of a competitive firm will be eliminated and they will have to operate earning normal profits only.

a.Fixed costs are those which are independent of the output produced that is they do not change with the change in output. The curve of fixed cost is a horizontal line parallel to output axis (x-axis).

On the other hand variable costs are those which changes with the number of output produced. It in turn depends upon the types of factors of production employed, costs of the factors of production employed etc.

Finally total costs(TC) equals the sum of total fixed costs (TFC) and total variable costs(TVC) i.e. TC=TFC+TVC.

Diagrammatically ,

b. A firm operating in a perfectly competitive industry can not choose the price it likes. It has to sell its product at the given market price always. In other words all firms operating in competitive market are price takers.

Therefore no question of price determination by a firm arises in a competitive market.

c. The determination of output in a competitive firm depends on the cost function, specifically the marginal cost (MC) curve of the firm. For any firm the optimal point of production is the point where its marginal revenue equals its marginal cost (MC=MR). i.e. where the MC curve cuts the MR curve from below.

In a competitive firm since it is a price taker with no control on price, its average revenue (AR) and MR curve are the same which is a horizontal line at the given price parallel to output axis (X-axis).

The short run equilibrium of a competitive firm with profits could be as shown below. Here the firm produces output equal to OM.

The long run equilibrium of a competitive firm could be as shown below. Here the firm produces output equal to ON.

We can see that in long run all profits (supernormal profits) are eliminated.

d. If the prevailing price in the market is less than the average variable cost of the firm then the firm shuts down in the short run or shuts down temporarily.

In the above figure we see that the firm’s AVC is greater than the prevailing price P_M. so the firm will have to suspend its production in the short run.

e. As seen in part d of the answer, a firm shuts down in short run or temporarily when it is not able to recover even its AVC with the given price i.e. when AVC > P.

In the short run only variable factors of production can be varied, so a large change in average cost of production can’t occur. But in the long term all factors of production and cost function itself can be varied, thereby making it possible to get huge changes in the average cost of production. But even with this if a competitive firm is not able to cover its costs in the long run then it will have to shut down permanently and exit the market.