The Theory of Firm Under Perfect Competition

Perfect Competition and Revenue

A commodity with profit earning potential is obviously not produced by one firm. Instead, there are a bunch of firms competing with each other to lure customers towards their brand. As there are a wide variety of commodities which differ in characteristics, the market for these also differs. Perfect competition is one such classification. Though hypothetical to a large extent, it is the simplest type of a market form.

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What is a Market?

A market can be seen as a place where the producers and consumers of a commodity come in contact with each other. However, it is not necessary for buyers and sellers to assemble at a particular place and make transactions happen. Rather, the most important condition is that the producers and consumers should be able to communicate with each other whether physically or through other means like internet, telephones etc. Market refers to the whole region where buyers and sellers of a commodity are in contact with each other to effect purchase and sale of the commodity.

Perfect Competition and Revenue

Perfect Competition

The market form of perfect competition is as real as the Pandora’s box i.e. it doesn’t exist. However, it is the simplest form of a market among the bunch. The market for some products, for example, agricultural goods like wheat and rice, does come close to enacting the characteristics of perfect competition.

A perfect competition is the market situation where there are a large number of sellers competing to sell a homogenous product at a price fixed by the market. In such a case, a uniform price prevails in the market. This is decided by the industry itself (market forces of demand and supply).

There are a large number of buyers and sellers, which renders the contribution of an individual insignificant. With reference to price, no individual firm holds the remote. The supply and demand of the commodity, combined from all sources(i.e. the industry), helps in deciding the price. The firm merely has to accept this price. In a nutshell, the firm is a price taker and the industry is a price maker.

Features of Perfect Competition

The characteristics that set apart perfect competition from other market forms are:

Large number of Buyers and Sellers

As discussed, there is no individual firm or consumer controlling the market. This is because there is such a large number of producers and consumers that the contribution of an individual seems negligible.

The significance of this characteristic is that in the large crowd of buyers and sellers, no individual buyer and seller can control the demand and supply respectively. Under such conditions, the price of a commodity is determined by the market forces of demand and supply. This uniform price prevails in the market and all transactions occur at this price.

Homogeneous Product

Homogeneity of the product ensures that every firm produces products that are identical in all respects(shape, size, colour etc). This characteristic robs the element of choice from buyers. A buyer has no incentive to prefer a producer over another. The products can be readily substituted as they are completely identical. This also implies that the buyers are willing to pay the same price for the products of all firms in the market. This further ensures uniformity in prices.

Freedom of Entry and Exit

In a perfect competition, every seller has the choice to enter or exit the industry. There are no barriers to their entry and exit. This characteristic ensures that there are no abnormal profits and losses in the long run. Lets us first understand what is meant by abnormal losses, abnormal profits and normal profits.

Abnormal losses refer to the shortage of earnings over the total production costs. Abnormal profits refer to the excess of earnings over the total production costs. Lastly, normal profits refer to minimum profits, which are needed to carry out the business. The total production costs of a firm include normal profits.

Moving on, let us understand how freedom of entry and exit keeps abnormal profits and losses out of the equation. In the long run, if any abnormal profit occurs, new firms are lured into the production scene. This further leads to an increase in supply which reduces the price. This continues until profits are restored back to normal.

Note that in short run firms can incur abnormal losses or profits as in a short period of time a firm cannot exit or enter the market.

Perfect Knowledge among Buyers and Sellers

In a perfectly competitive market, buyers and sellers possess perfect knowledge. This implies that no firm can charge a different price and no buyer is willing to pay a higher price for the same commodity. Sellers are completely aware of the prices prevailing in the market. Further, sellers are completely informed of the price of inputs. Each seller has access to a similar state of technology and inputs, as a result of which they have same cost structures. In a nutshell, this implies that uniform prices prevail.

Absence of Transportation Costs

If transportations costs are considered, the overall costs will vary from seller to seller. This would violate the point where all characteristics of perfect competition converge which is uniform pricing. Thus it is assumed that the transportation costs in a perfectly competitive market are zero.

No Selling Costs

In real market conditions, firms try to create a sense of difference among each other by advertising their products. The cost incurred on advertisements is known as selling costs. On the contrary in perfect market conditions, the products from all firms are completely identical and the buyers are completely informed about these products and their prices (which is uniform). Thus there are no selling costs in a perfectly competitive market.

Revenue and Perfect Competition

We are already aware of the fact that AR curve and demand curve are same. In perfect competition, uniform prices exist which are fixed by the market. In the light of such conditions the demand curve is perfectly elastic (a straight line parallel to the X-axis). Thus the AR curve is a straight line parallel to the X-axis.

Further, every unit of the commodity has the same price. Hence the revenue earned from selling every additional unit is equal to the price of the commodity always. It can also be said that AR=MR.

A Solved example for You

Q: Explain the nature of prices prevailing in a perfectly competitive market.

Ans: In a perfectly competitive market, prices are decided by the market forces of demand and supply. This means that no individual buyer or seller can control the price of the commodity. Further, units can be sold only at the price fixed by the industry. In other words, the firm is a price taker and the industry is a price maker. In essence, there are uniform prices in a perfectly competitive market for a commodity.

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