Perfect Competition

<Last updated 10.04.2020>

Dear reader,

Hi! If you are interested in Economics, I’ve prepared the below to help you with your studies and understanding of these interesting concepts. You should take a look at this short article in which I discuss an important market form called Perfect Competition, the ideal market form.

In the past, market was an actual physical location where buyers and sellers met and transactions (buys and sells) were taking place > This required the buyer and the seller to meet at a location. Today in modern society this is not required because the information needed for transactions to take place is fast and can be done from a distance with the help of the new means of communication and technology. For example by using the internet and the mobile or smartphone.

Since no physical location is needed, the market is considered today only as: A mechanism that allows the communication between buyers and sellers, the information exchange and transactions to take place.

The are different market forms due to the different market conditions.

Competition between businesses (suppliers) makes possible to have different market forms (with consumers having the same level of competition).

The level of competition that exists in a sector depends mainly from:

> the number of businesses.

> the degree of homogeneity or differentiation of the product produced by the businesses of the sector.

The ideal market form is Perfect Competition. This ensures the optimal allocation of resources and the production of goods and services people need and want. Many businesses produce and provide homogeneous products, or services, to a large number of consumers. (i.e. agriculture: fruits and vegetables, i.e.  stock market: brokers offering stocks to many buyers).  It is rare to find such a market in reality. However, it provides a point of reference and helps in comparison purposes with the other market forms.

a) The large number of businesses: they are price takers (taking the price as given). A business must choose what quantity to produce. This choice won’t affect the market price.> Makes almost impossible for businesses to cooperate and affect the price based on their interests.

b) Perfect homogeneity of the product: this is the product that is produced and supplied to the market and has no physical or real difference (to consumer’s perception) compared with its homogeneous products. Consumers are indifferent from which business they are going to buy the product. If a business increases the price of the product no consumer would want to buy. > Leads to incentives for advertisement. So, more advertisement is needed for businesses to stand out and hit the competition.

c) The complete freedom (no barriers) to entry or exit to the sector: There is no legal  or other economic barrier for businesses to enter, or exit, the sector.

When businesses have economic profit, in the long-term, new businesses enter the sector, market price decreases and economic profit of businesses decreases. When businesses have economic loss, in the long-term, businesses exit the sector, market price increases and economic loss of businesses decreases.  Entry and exit stops when businesses have economic profit = 0.

For the competitive business (perfectly) demand is perfectly elastic. If the business increases the price above the market price level (MP) then nobody would want to buy from that business the individual business’ quantity of the product demanded will be 0.

The goal of every business is to maximize the profits or minimize the losses by producing the optimum level of production.

Total revenue Equation (Gross Revenue) TR = P x Q (TR = Total Revenue, P = Price, Q=Quantity)

Since Price is fixed in perfect competition, the business can only choose Quantity in order to increase revenues and profit.

Average Revenue (AR): the Total Revenue per unit of product sold. Marginal Revenue (MR): the increase in Total Revenue from a unit sold.

Since the Price is fixed the increase in quantity sold by one unit increases revenues by an amount that equals the price. AR = (P x Q) / Q = P = MR

The optimum level of production is the one that maximizes Profit, or minimizes Costs. It can be done with both ways. In the following example, when producing 6 units of the product, the business is maximizing its profits.

When production is 0 the business is in loss since there are fixed costs. After the increase of production Total Revenue increase and TC increase with decreasing rate. At the Point where TR = TC (Q=3) Loss = 0.

After production increases, where TR>TC, the business generates profit. The optimum level of production is when Q=6, at that level the business maximizes profit.  The levels Q=3 and Q=8 show economic loss/profit zero and they are called break-even points.

Comparing Marginal Revenue (MR) with Marginal Cost (TC): The business, in the short-term, manages to succeed in producing at the Optimal Level of Production where Marginal Revenue = Marginal Cost = Price in perfect competition. 

The level of output that maximizes profit is not the same as the level of output that minimizes cost per unit, and so profit per unit of output. When Q=6 the business maximizes profits and MC = MR > this point where this equation is satisfied, it is optimal level of production or optimal output (profit side).

“I hope I am clear on this one. If not, contact us on social media and we will do our best to help you.

Thank you for reading my articles and watching my videos.”

Marios Kyriakou