Forms of Market: Perfect Competition PDF

# Forms of Market: Perfect Competition ## Chapter 12 ### Concept of Market - Ordinarily for an individual, it would mean a shopping complex. - But, for a student of economics, this is not correct. - In economics, the concept of market has a special meaning. - It does not refer to any geographica...

# Forms of Market: Perfect Competition ## Chapter 12 ### Concept of Market - Ordinarily for an individual, it would mean a shopping complex. - But, for a student of economics, this is not correct. - In economics, the concept of market has a special meaning. - It does not refer to any geographical area where goods are sold and purchased. - Instead, it refers to all systems (or arrangements) that bring the buyers and sellers in contact with each other to settle the sale and purchase of goods. - The system could simply be an electronic mail or a telephonic communication that brings the buyers and sellers in contact with each other and settles the sale and purchase of goods. - Online marketing does not involve any shopping complex. ### Concept of Perfect Competition - Perfect competition is said to exist when there is a large number of sellers and buyers of a commodity, and no individual buyer or seller has any control over its price. - Product is homogeneous and its price is determined by the forces of market supply and market demand. ## 2 Concept of Perfect Competition Perfect competition is a form of the market where there is a large number of buyers and sellers of a commodity. Homogeneous product is sold and its price is determined by the market forces of supply and demand. An individual buyer or seller has no control over price. ### Features of Perfect Competition - **Large Number of Firms or Sellers:** - The number of firms selling a particular commodity is so large that any increase or decrease in the supply of one particular firm hardly influences the total market supply. - Accordingly, any individual firm fails to make any influence on the price of the commodity. - It is, said that a firm under perfect competition is a price taker. - In other words, it has to sell its products at the prevailing market price. - **Large Number of Buyers:** - Not only is the number of sellers very large, but the number of buyers is very large as well. - Accordingly, like an individual firm, an individual buyer is also not able to influence the price of the commodity. - Any increase or decrease in individual demand will hardly make any difference to the total market demand. - Accordingly, an individual buyer under perfect competition is also a price taker. - **Homogeneous Product:** - All sellers sell identical units of a given product. An important conclusion can be drawn from this feature. - It is that buyers will have no reason to prefer the product of one seller to the product of another seller. - Thus, the price of the product throughout the market will be the same. - **Perfect Knowledge:** - Buyers and sellers are fully aware of the price prevailing in the market. - Buyers know it fully well at what price sellers are selling a given product. - As a consequence, only one price prevails in the market. - **Free Entry and Exit of Firms:** - A firm can enter and leave any industry freely. There is no legal restriction on the entry or exit. - **Independent Decision-making and Freedom from Checks:** - There is no agreement between the sellers regarding production, quantity and price. - Nor is there any restriction regarding the sale and purchase of any commodity. - **Perfect Mobility:** - Factors of production are perfectly mobile under perfect competition. - Factors will move to that industry which pays the highest remuneration. - **No Extra Transport Cost:** - For one price to prevail throughout the market, it is essential that there is no extra transport cost for the consumers while buying a commodity from different sellers. ### Three Vital Conclusions - **A Firm Under Perfect Competition is a Price Taker, not a Price Maker** - This is explained in terms of the following reasons: - **Number of Firms:** - The number of firms under perfect competition is so large that no individual firm, by changing its sale, can cause any meaningful change in the total market supply. - Accordingly, market price cannot be affected on the basis of market supply. - **Homogeneous Product:** - All firms in a perfectly competitive industry produce homogeneous product. - In such a situation, if any firm fixes its price higher than the existing market price, buyers would shift from this firm to other firms in the market. - The policy of higher price (higher than the existing market price) will simply fail. - **Unnecessary Loss due to Lower Price Fixation:** - Firm demand curve under perfect competition is perfectly elastic. - It means that a firm can sell whatever amount it wishes to sell at the existing price. - In such a situation, the policy of attracting buyers by lowering the price would result in unnecessary loss. ### Demand Curve of the Firm Under Perfect Competition is Perfectly Elastic - Demand curve of the firm is perfectly elastic ($E_d = ∞$). - It means that the firm can sell any amount of its output at the prevailing price. - Firm's demand curve is indicated by a horizontal straight line parallel to X-axis. - This shows that the firm is to accept the price as determined by the forces of market supply and market demand; it can sell whatever amount it wishes to sell at this price. - This is illustrated in Fig. 1. ### Observations - **Fig. 1 shows that at the given price OP, the firm can sell (or buyers can buy from the firm) any quantity of the commodity it produces.** - **Price remains constant whether quantity demanded is OA or OB, or even zero. A perfectly elastic demand curve simply indicates that the firm has no control over price.** ### Check Your Clarity On the Difference Between Consumer's Demand Curve And Firm's Demand Curve - Demand curve shows the relationship between price and quantity demanded. - In case of consumers' demand, it is the relationship between price and quantity demanded of a commodity in the market. - The consumer may purchase the commodity from any of the various producers/sellers of the commodity in the market. - On the other hand, in case of firm's demand, it is the relationship between price and quantity demanded of a firm's product in the market. - Quantity demanded of a firm's product, obviously, is equal to sales/output of that firm. - Therefore, firm's demand curve also shows the relationship between price of the commodity and firm's sales/output of the firm. - [Accordingly, instead of quantity, one can also write output/sale on the horizontal axis of the above diagram.] ### A Firm Under Perfect Competition Earns Only Normal Profits In The Long Run - This is owing to the fact that there is freedom of entry and exit for the firms under perfect competition. - In situations of extra-normal profits, new firms will join the industry. - Consequently, market supply will increase. - Market price will fall. - Extra-normal profits will be wiped out. - In situations of extra-normal losses, some firms will leave the industry. - Consequently, market supply will fall. - Market price will rise. - Extra-normal losses will disappear. ### What Prevents A Perfectly Competitive Firm To Lower The Product Price And Capture The Entire Market? - **Why should a firm lower the price when at the existing market price, it can sell any amount it wishes to sell? It makes absolutely no sense.** - **Under perfect competition, there are a large number of buyers and sellers of a product. Each firm produces only a small fraction of the total market supply. It has a limited production capacity. Now, if an individual firm lowers the price, all buyers in the market will rush to this firm for supplies of the product. But, by definition, the firm is so small that it cannot produce enough for all the buyers in the market. Hence, the possibility of capturing the entire market by lowering the price is ruled out.** ### Summary - **Market is a mechanism or an arrangement that facilitates the sale and purchase of goods and services by bringing buyers and sellers in contact with each other.** - **Perfect Competition is a form of the market in which there are a large number of buyers and sellers of a homogeneous product. Price is determined by the forces of the market supply and market demand. An individual firm is a price taker.** - **Features of Perfect Competition: (i) Large number of firms or sellers, (ii) Large number of buyers, (iii) Homogeneous product, (iv) Perfect knowledge about the product and its price, (v) Freedom of entry into the industry, (vi) Independent decision-making and freedom from checks, (vii) Perfect mobility of the factors of production, (viii) No extra transport cost.** - **Shape of Firm's Demand Curve Under Perfect Competition: It is a horizontal straight line under perfect competition. It indicates that elasticity of demand ($E_d$) = ∞.**