Perfect Competition

University Degree Business and Administrative studies

BRIAN MCKEOWN MICRO ECONOMICS OUTCOME 2 PART (B)

Perfect Competition

In a perfectly competitive market the firm is so small that it cannot influence either the price or the quantity ultimately sold in the market.

Features

Price equals marginal cost. Given that price equals marginal utility (how much satisfaction a consumer places on a good), marginal utility will equal marginal costs. This it is argued is optimal.

If a firm is less efficient than other firms it will make less than normal profit and be driven out of business. If it is more efficient it will earn supernormal profits. Thus competition will act as a spur to efficiency.

The desire to earn supernormal profits and to avoid making a loss will encourage the development of new technology.

The lack of advertising (all goods are homogenous) will lower firms’ costs.

There is perfect knowledge between all competitors that means that everyone is on a level playing field.

The long run equilibrium is at the bottom of the firm's long run average cost curve therefore will produce at the lowest cost output.

Consumer gains from lower prices, since not only are costs low, but there are no long run supernormal profits. This means there is perfect mobility.

If consumer tastes change the price change will lead to the firm responding.

These last two points are said to lead to consumer sovereignty. Consumers through the market decide what, and how much is produced.

The Short Run and the Long Run

The short run under perfect competition is the period during which there is too little time for new firms to enter the industry. In the short run the number of firms are fixed. Firms could be making large or small profits, breaking even or making a loss.

The long run under perfect competition is the period of time that is long enough for new firms to enter the industry. In the long run the level of profit will affect the entry or exit of firms. Normal profit is the level of profit just sufficient to persuade firms to stay in the industry, but not high enough to attract new firms. This level of normal profit will vary from one industry to another. Supernormal profit is any profit above normal profit. If economic profits are being made new firms will be attracted into the industry in the long run. This will have the effect of increasing supply and reducing price and profit for those firms already in the industry. Economic profits will be completed away.

The diagram below shows the short run equilibrium for a firm in perfect competition.

This long-run equilibrium is shown in the diagram below.

MONOPOLY

An industry where there is a single supplier of a good or service that has no close substitutes and in which there is a barrier preventing new firms from entering is a monopoly. In practice the boundaries of an industry are arbitrary, and the determination of monopolies is a long and costly business for institutions such as the Competition Commission.

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The diagram below shows the short run equilibrium for a firm in perfect competition.

This long-run equilibrium is shown in the diagram below.

MONOPOLY

An important feature of monopoly is that there will be barriers to entry. These may include: Legal barriers e.g. law, licence or patent restrictions, natural monopoly e.g. a unique source of supply of a raw material or economies of scale, economies of scale, production differentiation and brand loyalty, ownership of wholesale and retail outlets, mergers and takeovers, aggressive tactics and intimidation

A monopolistically competitive firm's own demand curve is highly elastic, permitting it to vary its price within a narrow range of prices. The other firms' products are either very close substitutes or, a large number of other firms' products are substitutes (not necessarily very close substitutes).

Since in a monopoly there is only one firm, the demand curve facing the firm is the demand curve facing the industry. The demand curve is the average revenue curve and a downward sloping average revenue curve will also mean the firm facing a downward sloping marginal revenue curve. Although the monopolist is a price maker and can choose which price to charge, it is still constrained by the demand curve. A monopolist (like a perfectly competitive firm) will maximize profits where MR = MC.

Equilibrium Price and Output

Although the monopolist is a price maker and can choose which price to charge, it is still constrained by the demand curve. A monopolist (like a perfectly competitive firm) will maximize profits where MR = MC. The supernormal / economic profit is shown in the diagram below.

The supernormal profit per unit is the difference between the average revenue and average cost. To get the total supernormal profit you then multiply by the output produced. This amount is equivalent to the area in the above diagram.

Long Run Equilibrium of the Firm

In the long run if typical firms are making economic profits, new firms will be attracted into the industry or existing firms will increase the scale of their operations. The industry supply curve will shift to the right, leading to a fall in price. Supply will go on increasing and price falling until firms are only making normal profits. This will be where the demand curve for the firm touches the lowest point of its average cost curve. This can be seen in the diagram below.

In the long run if the price falls below the average cost of producing the good (P2), then firms will make a loss and will leave the industry. If firms leave the industry supply will decrease and the price will rise until firms are just making normal profit - that is where the demand curve touches the lowest point of the average cost curve. Therefore under perfect competition output will always tend towards this long run equilibrium.

Price and Output decisions Under Monopoly

A monopolist must make both a pricing decision and an output decision. Whenever both decisions must be made the firm is considered to be a price searcher. A price taker takes the price as given (no effective control of the price) and simply determines the output to be produced given existing cost curves.

Disadvantages of monopoly

Their may higher prices and lower output than under perfect competition.

The possibility of higher cost curves due to lack of competition (x-inefficiency).

Firms may be less innovative as they have less incentive.

Advantages of monopoly

Economies of scale and scope.

Possibility of lower cost curves due to more research and development *

Innovation and newer products.

Oligopoly

An oligopoly is a market dominated by a few large suppliers. The degree of market concentration is very high (i.e. a large % of the market is taken up by the leading firms). Firms within an oligopoly produce branded products (advertising and marketing is an important feature of competition within such markets) and there are also barriers to entry.

Another important characteristic of an oligopoly is interdependence between firms. This means that each firm must take into account the likely reactions of other firms in the market when making pricing and investment decisions. This creates uncertainty in such markets - which economists seek to model through the use of game theory.

Economics is much like a game in which the players anticipate one another's moves.

The ongoing interdependence between businesses can lead to implicit and explicit collusion between the major firms in the market. Collusion occurs when businesses agree to act as if they were in a monopoly position.

KEY FEATURES OF OLIGOPOLY

* A few firms selling similar product

* Each firm produces branded products

* Likely to be significant entry barriers into the market in the long run which allows firms to make supernormal profits.

* Interdependence between competing firms. Businesses have to take into account likely reactions of rivals to any change in price and output

THEORIES ABOUT OLIGOPOLY PRICING

There are four major theories about oligopoly pricing:

(1) Oligopoly firms collaborate to charge the monopoly price and get monopoly profits

(2) Oligopoly firms compete on price so that price and profits will be the same as a competitive industry

(3) Oligopoly price and profits will be between the monopoly and competitive ends of the scale

(4) Oligopoly prices and profits are "indeterminate" because of the difficulties in modelling interdependent price and output decisions

THE IMPORTANCE OF PRICE AND NON-PRICE COMPETITION

Firms compete for market share and the demand from consumers in lots of ways. We make an important distinction between price competition and non-price competition. Price competition can involve discounting the price of a product (or a range of products) to increase demand.

Non-price competition focuses on other strategies for increasing market share.

Consider the example of the highly competitive UK supermarket industry where non-price competition has become very important in the battle for

Sales

Mass media advertising and marketing

Store Loyalty cards

Banking and other Financial Services (including travel insurance)

In-store chemists / post offices

Home delivery systems

Discounted petrol at hypermarkets

Extension of opening hours (24 hour shopping in many stores)

Innovative use of technology for shoppers including self-scanning machines

Financial incentives to shop at off-peak times

Internet shopping for customers

PRICE LEADERSHIP IN OLIGOPOLISTIC MARKETS

When one firm has a dominant position in the market the oligopoly may experience price leadership. The firms with lower market shares may simply follow the pricing changes prompted by the dominant firms. We see examples of this with the major mortgage lenders and petrol retailers.