Set out the distinctive features of the perfectly competitive model pf the market for goods and services? What are the implications for a business strategy aimed at enhancing profitability?

University Degree Business and Administrative studies

EC131-ECONOMICS FOR BUSINESS

ID-0527196

2. Set out the distinctive features of the perfectly competitive model pf the market for goods and services? What are the implications for a business strategy aimed at enhancing profitability?

In the ordinary sense, the world market refers to a physical place where commodities are bought and sold. However, in economics the term market does not necessarily refer to a particular place, but to the mechanism or arrangement by which buyers and sellers of a commodity are able to contact each other for having economic exchange. The structure of market is the subject matter of this topic.

Market structure refers to the types of market in which producers or firms operate. Various market forms are broadly classified on the basis of competitiveness of the market structure. The competitiveness of the market structure refers to the extent to which individual firms have the power to influence the market price of the commodity. The less power an individual firm has in influencing the price of the commodity, the more competitive is the market structure. One of the extreme forms of market structure is perfect competition where a firm has absolutely no power to influence the price of the commodity. We are going to talk about the distinctive features of the perfectly competitive market model for goods and service.

In order to understand the characteristics of a perfectly competitive market we should firstly understand the factors determining these market forms.

Number of Buyers and Sellers- The power of a seller to influence the market depends upon its share in the total supply. Smaller is the number of sellers, larger would be the share of each firm in total supply and, therefore, larger would be the power of the firm to influence the price. On the other hand, if the number of sellers in the market were large, the power of a seller to influence the market would be less. On the basis of number of sellers in the market we distinguish between monopoly, where there is only one seller, perfect competition and monopolistic competition, where there are large number of sellers and oligopoly, where there are a few sellers. Similarly, the number of buyers determines the degree of control a buyer has on the market. If there were only one buyer of a commodity, which is known as monophony, it would exercise a large control on the market.
Nature of the Product- Different market forms is distinguished from each other on the basis of nature of the product. The amount of competition in a market depends on how similar are the goods produced by different firms. In a perfectly competitive market, goods produced by different firms are homogenous. Therefore, no single firm in such a situation is able to influence the price. But different producers in a monopolistic competitive market produce differentiated product. As a result, different producers of similar goods are in a position to charge different prices of the goods they produce.
Knowledge about Market- Different forms of market is differentiated from each other in terms of the knowledge or lack of knowledge. If the buyers and sellers have full information about market conditions, the price at which the product is being sold by other sellers and nature and the quality of the product, then a single price would prevail in the market. So, perfect knowledge about the market conditions ensures uniform price in the market. This is the characteristic feature of perfect competition.
Freedom of Entry or Exit of the Firms- Different forms of market is differentiated from each other in terms of the nature of entry of the firms into the industry. Freedom of entry or exit of the firms means that there are no restrictions-natural or manmade-on the entry of new or prospective firms or on exit of the existing firms. Freedom of entry or exit ensures that producers end up earning minimum profits or normal profits.
Degree of Price Influence- Different forms of market may differ from each other in terms of their influence determination. A perfectly competitive firm cannot have any influence on the market price; it is considered to be a price-taker. A monopolistic on the other hand, has on price great power in influencing the price of the commodity; a monopolist is a price-maker.

Characteristics of Perfect Competition-

Perfect competition is a market structure in which there are a large number of producers (firms) producing a homogeneous product so that no individual firm can influence the price of the commodity. In this type of market, the price is determined by the industry, i.e., by all the firms taken together, by the forces of market demand and supply. An individual firm takes the prices as given and he has to take decisions about the amount of output to be sold at that price. Thus, the firms under perfect competition are assumed to be price-taker ...

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Characteristics of Perfect Competition-

Perfect competition is a market structure in which there are a large number of producers (firms) producing a homogeneous product so that no individual firm can influence the price of the commodity. In this type of market, the price is determined by the industry, i.e., by all the firms taken together, by the forces of market demand and supply. An individual firm takes the prices as given and he has to take decisions about the amount of output to be sold at that price. Thus, the firms under perfect competition are assumed to be price-taker rather than price-maker.

Larger Number of Buyers and Sellers- There are a large number of buyers and sellers of the commodity under perfect competition, each too small to exert any influence on the price of the commodity by his actions. This means that under perfect competition, firms produce such a small part of the total market output that a change in his output will have no noticeable effect on the market supply and, hence, the price of the commodity. A firm is, therefore, a price-taker rather than a price-maker.
Homogeneous Product- Under perfect competition all the firms produce homogenous or perfectly standardized commodity. The homogeneity of the product refers not only to the ‘ physical characteristics ‘ of the commodity. It is important to note that it is the total conditions surrounding the sale of the product, which we must consider. Therefore, homogeneity of the product implies both the physical characteristics of the product and the conditions surrounding the sale. I.e. environmental factors. Thus, the products of various firms under perfect competition indistinguishable from one another, i.e., they are perfect substitutes one another.
Freedom of Entry and Exit – Perfect competition is characterized by freedom of entry and exit. There are no restrictions, legal or social, on the entry of new firms into and the exit of old firms from the industry. The condition of free entry and free exit ensures that all the firms under perfect competitions end up earning only normal profits in the long run. If existing firms were earning super-normal profits, new firms would enter the industry and increase the total supply; this would reduce the market price and wipe out the super-normal profits.
Perfect Mobility of Resources- Another important characteristic of perfect competition is that resources are perfectly mobile. The characteristics ensure that resources or factors of production can enter or quit the firm at will. This implies that resources are able to switch over from one use to another. This condition is essential to make entry of the firms into and exit of the firms from the industry possible.
Perfect Knowledge- Consumers, firms and resource owners under perfect competition have perfect knowledge about the market conditions. Each firm knows the price prevailing in the market and would not sell the good at a price below it. Similarly each buyer has knowledge about the market price and is not willing to purchase the product at any price above it. This characteristic of perfect knowledge would ensure that price differences are quickly eliminated and a single price for the commodity would prevail throughout the market. Each firm therefore makes use of the best available techniques to minimize the cost of production.
Absence of Transport cost- Buyers and sellers do not incur any transport costs in purchasing and selling goods. This assumption is necessary to maintain uniform price throughout the market. Otherwise, prices for identical goods would differ.

Now in order to aim to enhance profitability the firm should follow rules of profit maximization.

In the short-run, a firm should produce if and only the profit or average revenue is greater/equal than the average variable cost or total revenue is greater/equal than the total variable cost. (AR>=AVC or TR>=TVC)
A necessary condition for the firm to be producing its profit maximizing output is that marginal revenue should equal marginal cost. (MR=MC).
For equality of marginal cost with marginal revenue to ensure profit-maximization rather than profit-minimization, it is sufficient that the marginal cost be less than the marginal revenue at slightly lower output and that the marginal cost exceeds marginal revenue for slightly higher output. Basically the MC curve should intersect MR curve from below.

The figure above shows a situation of perfect competition making normal profits. The three rules of profit maximization are applicable here as well. AR=AC, MR=MC and the MC curve intersects the MR curve from below.

Under perfect competition no single firm or single consumer can influence the price cause of its negligible share in total supply or total demand of industry. However, price is determined by the collective actions of all firms in the industry through the supply curve of the industry and the collective actions of all the consumers through the industry’s demand curve. Thus short run equilibrium price and quantity is determined by the interaction of market (or industry’s) demand and market (industry’s) supply.

The equilibrium price is at P and the equilibrium quantity is at Q. When the price of the good rises there will be an excess of supply over demand, which will pull down the price to equilibrium. When the price of the good falls there will be an excess of demand over supply, which will pull up the price to equilibrium. Thus at the intersection of P and Q, there is neither excess supply nor excess demand and, therefore, the price has neither a tendency to fall nor a tendency to rise.

The individual firm in perfect competition is assumed to be facing a perfectly elastic demand for its product because variation in its output over the range feasible for it will have such a negligible effect on total supply and price that the effect can safely be assumed to be zero. The price is given to all the firms as determined in the industry by forces of market demand and market supply. The perfectly elastic demand does not imply that the firm can sell an infinite amount at this given price. It only means that the variation in production feasible for it to make will leave price unaffected.

The short run equilibrium of the firm can be illustrated by combining the short run costs curve with the demand curve faced by the firm. Since the firm is price-taker, it has to decide the amount of output it should produce at the given price so as to maximize profit. Thus the firm is output-adjuster under perfect competition.

The firm in a perfect equilibrium market cannot increase its profitability by altering its price because the price of the product is entirely controlled by the forces of demand and supply. Thus the firm can enhance its profitability by reducing its cost of production, investing in research development, employment and training of efficient workmen and

Proper utilization of internal and external resources.